Why Governance Matters to ESG Investing

By Commonfund Institute, an AGB Mission Partner October 18, 2022 Blog Post

Opinions expressed in AGB blogs are those of the authors and not necessarily those of the institutions that employ them or of AGB.

According to the Financial Times, “Investing within an ESG [environmental, social, and governance] framework is now the fastest-growing segment of the asset management industry.” In line with this growth is the increasing number of nonprofit institutions considering ESG strategies and those that have already implemented them into their investment discussions and portfolios. With this growing interest comes a critical need for a strong governance framework to ensure an institution stays true to its mission and goals when deciding how to incorporate these strategies.

While each institution has its own unique definition of ESG, these three factors are often considered as one bucket. But is it fair to say that institutions should use the same criteria to evaluate environmental, social, and governance factors? An article published in the Wall Street Journal earlier this year argues “no” and goes on to say that governance is merely “an overlay whose systems sit on top of and are embedded into the organization; the environmental and social components of ESG are outcomes.” To a certain extent, this is true, and we would go even further and argue that instead of bucketing governance with environmental and social considerations, it is foundational if you are intentionally seeking environmental and social outcomes. Commonfund is a strong proponent of sound governance and firmly believes it is critical to ESG implementation and the management of any pool of capital. Without a strong governance system in place there is no way to effectively and strategically evaluate ESG considerations or ensure they are in line with the mission of the organization.

Focusing on governance is essential to ESG and endowment management. Here are three reasons why:

1. Governance is the glue.

Nonprofit institutions need to have a strong governance framework in place to clearly articulate their values and mission and evaluate all environmental and social investment opportunities that amplify them. Having defined policies and standards to monitor ESG considerations and other portfolio allocations will help ensure they remain in alignment with the mission of the institution, creating a space for transparency, measurement, and accountability, and providing insight into an investment’s strengths and weaknesses. Utilization of an ESG scorecard is an effective way to measure governance factors and stay on top of key issues. The Institutional Shareholder Services ESG Scorecard, for example, looks at:

  • Climate, social, and governance risk
  • Key industry issues
  • Impact of products and services under the UN Sustainable Development Goals (SDGs)
  • Industry risk profile
  • European Union (EU) taxonomy

This system of checks and balances provides guidance on how to invest in ESG strategies without compromising mission or fiduciary duty and can protect the institution’s ethical integrity and values alignment. With sound governance policies in place, fiduciaries can better evaluate strategies and opportunities that meet the unique requirements of their institution.

2. A lack of governance can be consequential.

A good governance structure is an institution’s safeguard against potential issues and scandals. Those on the board or investment committee of a nonprofit or public institution have a clear responsibility to act in the best interest of the institution:

  • The duty of care requires that they act in good faith and take their job as a board member seriously. It is essential that they oversee the funds of the institution as if they were overseeing their own funds.
  • The duty of loyalty addresses conflicts of interest, but also goes beyond.
  • The duty of obedience is to adhere to the original purposes of the organization and stay true to its mission.

At times, these responsibilities can be blurred or misrepresented, leading to potential scandal or conflict. Such happenings can be exacerbated by social media, which only heightens our awareness of them. In August 2022, the Royal Foundation, a European charity founded by Prince William that is focused on conservation among a handful of other social issues, received scrutiny for not only operating an environmentally focused foundation that had half of its investible assets in food corporations with ties to deforestation “but also for keeping its investments in a bank that is one of the world’s biggest backers of fossil fuels.”[1] If the foundation had a process in place that included strong policy and evaluative metrics of its sustainable and social investments pools, this situation and the conflictual headlines that came with it might have been mitigated. A good governance structure can uncover blind spots in an institution’s investment strategy and portfolios that create enterprise risk and put the institution’s brand and reputation in jeopardy.

3. Nonprofits have a responsibility to future generations.

Governance is multifaceted and affects all aspects of an institution, but it is particularly important to maintaining intergenerational equity—maintaining purchasing power for future generations. The economist James Tobin said, “The trustees of endowed institutions are the guardians of the future against the claims of the present. Their task in managing the endowment is to preserve equity among generations.” We would argue that mission-focused institutions are responsible for the endowment as well as its related stakeholder, environmental, and community assets. While ESG may be a recent addition to board and investment committee discussions, it is becoming more and more apparent that the effects of climate change—–e.g., the uptick in wildfires, droughts, rising sea levels, flash flooding—can’t be denied. These issues impact a great majority of nonprofits, and governing bodies have a very important role to play. Well-founded governance policies and procedures help develop strategic conversations and approaches and may take the form of a working group or subcommittee of the investment committee. Employing one of these “groups” would provide structure around how an institution can start moving from thinking about ESG investments to adding considerations to its investment policy and ultimately its portfolio. Industry research, such as the Knight Diversity of Asset Managers Research Series: Ownership and Teams Diversity Metrics or the Investing in Racial Equity-A Primer for College and University Endowments, supports the theory that integrating responsible investing practices into an investment decision-making process can have a positive impact on performance. Positive investment performance is a key metric in ensuring the long-term health of an institution and may also help preserve the longevity of society and our planet.

The article referenced earlier in this post argued that “governance shouldn’t be evaluated,” and we are making the case that not only should it be evaluated, but it is also foundational. Governance, or more precisely, good governance practice, is essential to developing, implementing, and monitoring environmental and social aspects of a nonprofit’s portfolio construction and investment strategy and to ensuring its longevity. Good governance truly is the glue of an institution, and we would argue it’s the most important work for the board or investment committee to do regarding investment decisions of all types.

1Source: https://apnews.com/article/queen-elizabeth-ii-entertainment-forests-royalty-prince-william-921652eb91ede88601bf1a534e14448b

With Thanks to AGB Mission Partner: Commonfund

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