Total time: 11:54

Sara Rodriguez: Hi everyone, and welcome back to The Hitchhiker's Guide to ESG Investing. I'm Sara Rodriguez, Research Analyst at Sage Advisory, and today I'm joined by one of my team members, Andy Poreda, who is also a Research Analyst. How are you today, Andy?

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Andy Poreda: Doing great, Sara. How are you doing?

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Sara Rodriguez: I'm doing well. Today we will be wrapping up our series of episodes breaking down the letters in ESG by talking about the G, which stands for governance. Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. While environmental and social factors may be what come to mind when we think about ESG investing, governance is the backbone that holds it all together. It involves balancing the interests of a company's many stakeholders such as shareholders, senior management executives, customers, suppliers, the government, and the community. Without strong corporate governance, companies cannot manage environmental and social risk as effectively. In fact, weak corporate governance is a common thread found in many company failures. We saw this recently in 2015, when it became known that German carmaker Volkswagen had been installing software services in 11 million diesel cars to manipulate emissions test results. Andy, can you tell us what implications this had for Volkswagen?

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Andy Poreda: Absolutely, Sara. So, the Volkswagen scandal that occurred in 2015 is a great example of when bad governance results in a negative outcome for a company. What essentially happened was, in order to pass emission testing on 11 million of their vehicles, they had software services installed so that cars would pass the tests of the various nationalities and their stringent standards. So what that did was have two different modes where one of the models would have 40 times more nitrous oxide emissions than they are supposed to have, but they (Volkswagen) were able to use this software, and essentially pass the test. Once that scandal broke, what ultimately happened was, the idea of a company cheating, in dealing with our air is a huge issue. They’re damaging our environment, and nationalities were very upset about this, and it meant the company had to pay $25 billion dollars in fines. More notably, it really destroyed the reputational brand value of Volkswagen as a company. The stock dropped in half due to the scandal, but also the brand value that had taken decades to build up was eroded. Volkswagen has had to try to do their best to make up the difference here over time. I think the big thing, Sara, to realize is why did this happen? A lot of times when we look at leadership failures and what went wrong with companies, we have to look at the top, and that's the management and the board of directors. So, when we look at this, I think board composition is really the interesting story. A lot of experts have analyzed this and said that Volkswagen’s board structure and how they set it up, led to some problems and had that a negative outcome. That includes a lack of diversity on the board, and that includes their two-tiered board structure that occurs in Germany. I think just overall, Volkswagen had created a culture that people were not allowed to speak up if they thought there were issues, and so that groupthink and lack of questioning attitude really led to this problem. So, we'll see what happens with Volkswagen in the future, but it's a great case study in what can go wrong with bad governance.

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Sara Rodriguez: So, it seems like this governance failure translated into also being an environmental failure, as the emissions Volkswagen was hiding were polluting the air. So, Andy, you talked a bit about Volkswagen’s Board of Directors, and we know that the Board of Directors is really a primary stakeholder in influencing corporate governance. Can you talk a little bit more about issues relating to a company's board of directors and board composition?

3:54

Andy Poreda: Yes, absolutely. So corporate governance is a governance area that we look at. It’s a great area to look at because a lot of times if you look at outcome from an environmental and social perspective, that's where we want to look—the leadership in the board of directors will ultimately help set a policy and an overall vision for the company, and that’s going to drive environmental and social outcomes. So, we really want to look at how this board is structured, and will the structure that we have lead to positive outcomes for a company? This is a very holistic area to look at, but it can be things that we need to look at in terms of what is our board composition? Is it an independent board, meaning are the CEO and the head of the board the same person? We see that in a lot of companies, and that lack of independence can be a red flag for getting that question in attitude that we're talking about between management and the board. Also, we see diversity sprinkled into that as a discussion point, and we find that diversity can mean a lot of different things, whether it be gender, ethnicity, experience, but these types of decisions, we see that for long term outcomes, having a diverse board is a positive attribute. So that's another key aspect. Also, a lot of boards have different oversight committees that are tied to them. I think with that and these oversight committees, whether they be an accounting board, a sustainability board, there are a lot of different things that can be put in place, and the effectiveness of these advisory oversight committees can also help steer a company in a positive direction. I think that the board structure is a is a big part of it. The other big part that I think is really important to note, is that executive compensation is going to be tied to the board's actions. What we're seeing now is that we have executive compensation where we have incentive-based compensation. If a company is giving an extra reward due to ESG metrics, and whether or not they achieve it, this is a measure companies can use to actually make sure that their leaders are held accountable and are able to impact change. It ties those two together, which we're seeing is a very beneficial thing, if we want to see ESG outcomes in the future.

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Sara Rodriguez: So, another part of governance is risk management, can you talk a little bit about the different types of risk management and how they play into how well a company is run?

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Andy Poreda: Absolutely. So, a lot of companies, depending on where they operate, we try to showcase risk from both the idea of critical risk management and systemic risk management. Critical risk management is the idea of a company having measures in place to prevent a singular low probability event that may have a very negative outcome from happening. A big example for say, an airline industry would be, what are you doing to prevent an airplane from crashing? There’s a lot that goes into that, but the idea that a company needs to prioritize this is often apparent to us as an investor, because, if the plane crashes, that's going to create a negative view of that airline from a brand value, they just lost $100 million dollar aircraft, there are lawsuits, there's a lot of negative things that can be tied to that negative outcome, and that's critical risk management. Systemic risk management is the idea that these things that can happen, they are larger issues that may not be readily apparent right now, but they're always looming. It could be something like climate change. What are the negative impacts that are going to happen from climate change to a company over the years? Or it could be something like in 2008 where we have a huge financial collapse and what a company is doing to help prevent that from happening. So, that is a little bit harder one to manage. Those big risks obviously have very negative outcomes and companies need to look at what those systemic and critical risks are, because they are obviously going to drive down a company's performance.

7:57

Sara Rodriguez: So, Andy, most of these governance factors sound like they're preventative measures, but how do we measure the outcome of a company that has good corporate governance in place?

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Andy Poreda: One of the things that we really see that makes a company successful is this idea of intentionality, which basically means that all these decisions that are being made from the board level on and the leadership at the top and what vision they have for a company, we're hoping that intentionality leads to positive environmental and social outcomes as well as a successful business. One of the things that we saw in one of the case studies that we did was a company, Waste Management, that was formed in 1987, very early on had an egregious accounting scandal, which almost killed the company. It was very tenuous if they were going to succeed or not. From this huge scandal from a very early stage, they had to make a lot of difficult and tough decisions to set up their board for success, as well as create a vision moving forward as to how this company was going to operate amongst its stakeholders, which are the community, its employees, and overall customers in general. So what we're seeing with Waste Management is now they're a ESG leader, in our opinion, and there's a lot of good things that they're doing for all stakeholders. From the environmental side, we're seeing them take measures like using their waste in a circular economy concept to power their renewable energy vehicles. That has a huge impact on the environment in a positive way. From a social perspective, one of the Waste Management areas that's really dangerous is that their workers have the fifth most fatal job in America. So, Waste Management has taken measures to make sure that they're making their workers operate in the safest environment possible and trying to decrease those fatalities. Most notably, because Waste Management usually operates in a lot of disadvantaged communities where they have these facilities, they have done a lot of engagement with the communities that they operate in, and have really valued them as a stakeholder in their company, and that is going to pay dividends for them moving forward. So, I think that we look at this, that just because you have a bad governance outcome, you can move forward from this, and ultimately, it's going to lead to success, because now Waste Management is a very large successful business, but in the mid-80s, it would not have looked like that. So, I think that is the key message to that we need to communicate, that this is very important, and good governance leads to positive outcomes, bad governance leads to bad outcomes.

10:26

Sara Rodriguez: So, there you have it. Without a strong governance foundation, companies are not able to outperform socially and environmentally. Bad corporate governance often manifests in controversy that can lead to financial and reputational damage, while the outcomes of good corporate governance are not as clearly visible. Andy, thank you for all your insight today. To read our Waste Management case study please visit us at sageadvisory.com You can also find us on Instagram and LinkedIn @sageadvisory. Thanks for listening.

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