Climate change is the biggest risk to the world as we know it. This was confirmed in the latest Global Risks Report of the World Economic Forum where environmental threats ranked as the top four most severe long-term risks facing the planet. The cost-of-living crisis, meanwhile, was a new entry at number one in the list of short-term dangers[1].
If global warming causes large areas of the world to become uninhabitable over the next twenty years, we should prioritise investments in innovation and new technologies to limit climate change. More immediately, many commentators believe companies should be doing more to protect their employees and customers against inflation.
Sadly, near-term profits usually trump longer or broader value creation as company Boards prioritise increasing today's cash flows above all else, but these dilemmas highlight how the three dimensions of ESG are closely linked rather than independent. And it always starts with good corporate governance – a well-run company is likely to have better environmental and social policies than a poorly controlled one.
He who stops being better stops being good (Oliver Cromwell)
For this reason, well-governed companies are usually expected to have lower risk – clearly important from an investor's perspective. A comprehensive study published in February which examined the relationship between governance and environmental and social (E&S) performance found that companies with more extensive Board risk oversight are more likely to institute E&S compensation, set environmental targets, establish an E&S committee/team, adopt policies that address E&S risks and opportunities, issue an external E&S report, as well as achieve better environmental outcomes, specifically lower CO2 emissions and lower monetised environmental costs[2].
Interest alignment
So what does good governance look like? At its heart, it is the protection of minority shareholders through a set of systems and processes to effectively monitor, control, and incentivise company management to create long-term value. Without it, regulation will eventually be forced upon corporates, increasing costs and administrative burdens.
SKAGEN's focus on good corporate governance is long-standing. For almost 30 years we have recognised it as crucial for long-term profitability and invested in companies with responsible management teams overseen by strong Boards with investors' long-term interests at heart. We similarly steer clear of those where we believe that weak corporate governance might jeopardise the financial interests of our unitholders. Over 70 companies are currently excluded from our investment universe for poor conduct in relation to the environment, corruption, or human rights – breaches closely associated with weak governance.
As active owners we also engage directly with our companies on corporate governance issues. In 2022, for example, we held discussions with a Japanese holding to seek improvements in its Board structure and recommended that it seek more diversification and independence among Board members in order to raise governance standards to a global level.
Japan has made big strides to improve governance – notably through the reforms of Shinzo Abe – and tackle the lack of external Board oversight, in particular. In 2021 its revised corporate governance code requires companies listed on the Tokyo Stock Exchange's Prime section to have at least one-third independent directors, a figure which has risen from 25% of firms in 2016 to 94% in 2022 according to ISS data[3].
Some progress has also been made in terms of gender balance with 79% of Prime-listed companies having at least one female director in 2022, up from 29% in 2016. This is clearly still well short of equal representation and also European comparisons where women typically make up around a third of Board members.
In October, the Asian Corporate Governance Association sent an open letter with proposals to further improve gender diversity on Japanese boards, while Japan also ranked 116th of 146 countries in the 2022 World Economic Forum’s Global Gender Gap Report (I am happier to report that Nordic countries took the top three positions).
Force for good
These developments highlight the positive role that stronger corporate governance can have in terms of value creation, as well as risk management. This is particularly important for active value managers like SKAGEN who seek revaluation triggers; catalysts that can include changing Board composition, shareholder policies or corporate structures. Indeed, there is research to suggest that companies who improve corporate governance mechanisms can increase the firm's value by 10–12%[4].
One interesting aspect of the recent study into Board risk oversight highlighted earlier was that despite the many positives linked to better governance, it is also associated with some worse social outcomes, namely lower community spending, fewer employee benefits and a higher likelihood of social risk incidents. This emphasises again that governance involves trade-offs and the need to prioritise different stakeholder interests.
It also underscores another important aspect of ESG – it is a journey rather than a destination. Learning is continuous and there is always room to improve, particularly as businesses become ever-complex. Although today's world is moving faster than Oliver Cromwell's, some things don't change.
[1] Source: 2023 WEF Global Risks Report, January 2023
[2] Source: Board Risk Oversight and Environmental and Social Performance, Amiraslani, February 2023
[3] Source: ISS, Japanese Companies Improve on Board Independence and Diversity, August 2022
[4] Source: Stanwick & Stanwick, The Relationship between Corporate Governance and Financial Performance: An Empirical Study, 2002