ESG and mainstream investors alike agree: good governance serves as the foundation for a company’s ability to address risks and opportunities, and for creating long-term value for investors and other stakeholders. Best practices in corporate governance continually evolve based on market developments, expectations and, increasingly, regulatory environments – but are also based on the type of material risks companies are facing. And today’s E&S risks are increasingly complex and systemic in nature, with some of them - such as cybersecurity or climate change – requiring specific skills and expertise from board directors in order to be able to adequately oversee a company’s performance on E&S.  As risks evolve, so too must risk oversight. Board directors are catching up on this: in 2020 45% of directors surveyed by PwC said ESG issues are a regular part of their agenda, up from 34% in 2019.[1]

Especially now that we are grappling with long-term challenges, such as the consequences of the pandemic and the transition to a low-carbon economy, fund managers need to evaluate whether companies and their boards are sufficiently equipped to build back better. Recognizing this is a difficult task for companies themselves, how can asset owners integrate adequate analysis into their due diligence of fund managers?   

Changing (table) stakes

Relying on traditional Governance factors as captured by ESG data service providers might not suffice in assessing the level of ESG governance of investee companies. Board composition and independence are still important, but do not indicate whether there is ESG expertise on the board, or adequate oversight of human capital management. Alignment of executive compensation to long-term performance is still essential, but are there financial incentives for meeting business strategy and ESG goals such as climate targets or workforce diversity improvements, not only in visible roles but throughout the organization?

A corporate ESG strategy that is aligned with business strategy includes skilled and experienced board oversight of, and ESG integration related to: 1) strategy and capital allocation 2) reporting and transparency 3) risk assessments 4) accountability & compensation 5) stakeholder relations. Asset owners must ensure their asset managers have adequately assessed company Board capabilities and pressed for changes or enhancements when Boards are not sufficiently robust.

Furthermore, stewardship and engagement from fund managers with corporate boards are where the rubber hits the road in advancing good ESG governance practices. Engagement helps investors better understand which ESG topics are prioritized by boards and how mature a board’s level of expertise and oversight is. Conversely, engagement with investors may help a board to understand the priorities of this stakeholder group and to prioritize ESG issues accordingly.[2]

The proxy has power

Proxy voting can be a powerful tool to enact change, particularly to ask for better governance at the board and executive levels. One demonstration was the Exxon proxy fight earlier this year, whereby a small activist investor successfully placed three of their directors with in-depth climate experience onto the Exxon board in order to influence the company’s decarbonization actions, gaining the unprecedented support of very large institutional investors. [3] And in general, the 2021 proxy season saw majority shareholder support for ESG shareholder proposals in the US increase from 21 to 34, ranging from political expenditures to climate change strategy, to diversity and inclusion topics[4]. In Canada, the power of the proxy created change at TMX Group, where shareholders voted in support of a resolution on Indigenous inclusion and reconciliation – a resolution supported by the company’s board and management[5].

A Fund manager’s corporate governance guidelines, principles or voting policies are a good indication of how they approach good governance and what standards they set for ESG oversight. At BMO GAM for example, we evaluate the largest emitting sectors and vote against directors at laggard companies that do not have robust strategies and disclosures in place to manage climate risk.[6] As part of that evaluation, we look at the board’s responsibilities and oversight of a company’s climate strategy, including capital allocation, reporting and risk assessments. Transparent proxy voting policies can also explain how a fund manager generally approaches ESG shareholder proposals and can include an overview of ESG topics it typically supports.

If a manager publishes periodic Stewardship reports, look for statistics and engagement stories related to corporate governance and proxy voting, or ask them for examples of positive impact. Lastly of course, fund managers should disclose their voting records, including reasons why they voted the way they did by item; they should be able to demonstrate how they voted on ESG shareholder proposals, and provide examples.

Policy advocacy sets the bar higher 

Where proxy voting and engagement changes one company at a time, policy advocacy can set the bar higher for all companies within the same sector, market or on the same exchange. The regulatory stakes are increasing for companies in North America, partially due to investor advocacy. At the time of writing, there are regulatory proposals at the OSC to mandate certain ESG disclosure, in particular in line with the Taskforce for Climate-related Financial Disclosures (TCFD) [7]. In the US, the SEC is close to mandating ESG disclosure on human capital management, board diversity, including racial diversity, and climate change [8]. In both markets, regulators are acting on advice from investors and their industry associations through policy submissions and engaging in public forums.

Fund manager due diligence as such should include an assessment of the manager’s policy advocacy standpoints, actions and impacts. This can typically be found in annual Stewardship reports, but should include clear examples. Asset owners can also request links to public policy submissions made by the manager.

Walking the talk

Ideally a fund manager should set the same high bar for its own practices as it does for its investee companies. This can include membership of governance organizations, such as the Canadian Coalition for Good Governance (CCGG), the Council of Institutional Investors (CII) or the International Corporate Governance Network (ICGN). There are also local and global stewardship codes that guide fund managers and, in some cases, hold them accountable.

Due diligence checklist:

• Corporate governance guidelines or proxy voting policies
• General approach and voting records on ESG shareholder proposals
• Reporting on impact
• Public policy advocacy
• Good governance memberships and global Governance and Stewardship Codes, for example the Canadian Coalition for Good Governance’s Stewardship Principles[9]

Investors hiring external managers must ensure their own due diligence process in manager screening, selection and monitoring is as rigorous as the diligence they expect from those managers.  Their own governance can mitigate unfortunate errors in manager selection, errors which could pose reputational risk and possibly capital misalignment too. Understanding the diligence required to gauge the exposure screening and the necessary stewardship follow through is vital for all investors.

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