Making The “G” In ESG Meaningful – Pathways For Corporate Action Through Sustainability-Linked Finance. Part 2

By Michael Jarvis and Alla Morrison (TAI and IFC)

Sustainability-linked finance (SLF) is a significant market, but one in which the majority of incentives have been tied to borrower environmental commitments—the “E” in ESG, with S representing social commitments and G representing governance standards. Here we argue that there is untapped potential to encourage companies to be more ambitious on the “G.” Governance KPIs with targets that help manage corporate risk and benefit communities where companies operate could become part of the menu of options for SLF. In a first blog we laid out the current state of the market, while here we detail six areas with potential over time to lead to tested governance indicators in future deals.

For all the recent debating over the merits or motivations of ESG investing, especially in the United States, there has been relatively little attention to what the label entails in practice. In reality, the vast majority of corporate commitments have been under the environmental “E.”  There is growing attention to the social “S,” but as we detailed in our initial blog, the governance “G”  is missing. 

And yet governance practices matter. They matter for the sustainability and impact of investments. They matter from a development perspective – considering societal impacts in addition to business impacts. This is not about the sound corporate governance— the internal systems and controls—that should already be a prerequisite for any financing deal. This is about ambitious governance commitments from companies that go beyond business as usual. But it will require a framework, and possibly incentives, and herein lies the value of SLF.

Through interviews with civil society governance champions and SLF practitioners, research led by the Trust, Accountability and Inclusion Collaborative – Funders for Participatory Governance – and IFC – a member of the World Bank Group – identified six areas that offer potential for governance KPIs. The materiality of the KPI to the company is a core principle of SLF. When exploring possible governance KPIs, we aimed to apply not only the lens of materiality to the company, but also the lens of assuring a clear societal developmental benefit. We are also interested in prioritizing indicators that are not limited to any single industry sector, although some might have more relevance for certain sectors.

The six areas that came at the top and we think require a robust, multistakeholder discourse between investors in sustainable businesses, companies, and civil society advocates for governance that can yield huge societal benefits are:

  1. Tax. Through the taxes they pay, businesses provide a vital source of income to fund public services and infrastructure. Taxes also play an important role in the sustainable growth of economies by providing revenue to support governments’ ability to deliver on societal priorities, including health, education, and climate actions. Complying with tax rules is a core part of business responsibility and an important component of companies’ social license to operate. However, beyond legal compliance, companies can also take steps that inform the public about the levels of tax that they pay and inform debates about tax fairness. Such debates can become contentious, especially for multinational companies and in sectors where profit-shifting to low- tax jurisdictions has been commonplace. But greater transparency can help. Shareholders are among those demanding greater corporate tax transparency, as illustrated by multiple shareholder resolutions this past spring. Oxfam America finds that investors representing over $10 trillion in assets are calling for country-by-country reporting of tax data for large multinationals to inform investors of tax, regulatory, and geopolitical risks. A small but growing number of companies now disclose the taxes they pay in each jurisdiction globally.

    By committing to tax transparency in SLF deals, could companies mitigate stakeholder demands, while helping shift industry norms? One challenge would be to lay out progressive steps that companies can take, to ensure a continuous push for ambition.

  2. Lobbying. Transparency and integrity in lobbying are crucial to safeguard the public interest and promote a level playing field for businesses. These are especially important in an environment in which there are growing concerns about greenwashing and “openwashing”— claiming to be open or transparent while in reality maintaining proprietary practices. Corporates that make public statements in favor of a goal, such as net zero, while lobbying for policy and regulatory actions that run counter to that goal undermine the overall credibility of sustainable investment. Greater transparency and disclosure on lobbying activities can promote trust and confidence among company stakeholders as well as in the governments where those companies operate, supporting social license to operate. The investor case for responsible political engagement was articulated last year by the United Nations’ Principles of Responsible Investment. How might this be tracked? One promising development is the incubation of Principles on Responsible Political Engagement in a process led by the Organisation of Economic Co-operation and Development. This builds on existing guidance for governments to ensure lobbying transparency and integrity.

    Could adoption of such principles become a meaningful indicator suitable for SLF consideration in due course? 

  3. Data governance.  Data is a key asset in many businesses, essential for decision making. But data management needs to balance business objectives and fast-changing public expectations. Data governance is not only about not misusing data but also the stewardship of data for the benefit of society. Companies can demonstrate leadership in shaping data governance policies and processes that give them legitimacy in using people’s data, thus supporting their social license to operate and potentially enabling their data to be used for wider societal benefit. Adoption of corporate data stewardship policy and practices could serve as a basis for a KPI in an SLF deal. Such a step will have more meaning as data stewardship standards are developed, enabling benchmarking.

    Going forward, we anticipate the emergence of market players with the expertise to audit such data practices, so they can play the role of credible third-party verifiers.  However, we are not quite at that stage yet.

  4. Open contracting/procurement. One out of every three government dollars gets spent on contracts with companies, so it comes as no surprise that public procurement is highly vulnerable to corruption. The IMF estimates corruption losses of 10 to 20% even in procurement systems with high integrity. Greater transparency through open contracting holds significant potential for creating societal and economic benefits. Proactive corporate disclosure and public support for open contracting practices can reassure investors of the reliability of a company’s deals with government. Commitments can extend beyond company disclosure of key government contract terms to sharing details of business-to-business arrangements. In addition to reducing risks associated with corrupt and anti-competitive practices, procurement also connects governance to social ambitions. For example, borrower companies can set verifiable targets in contracting with more minority-owned businesses, which can reinforce their social license to operate and yield societal benefit.

    Ideally, such data would be made public for immediate verification, but third-party validators could also confirm validity.  

  5. Beneficial ownership.  Beneficial ownership transparency is crucial to understanding who ultimately profits from the activities of companies.  It is an important tool for eliminating corruption and tax evasion, and for holding governments accountable. From a company perspective, improved transparency will support social license to operate, as well as mitigate against reputational and financial risks stemming from corrupt practices. For example, mining giant BHP committed to public disclosure of beneficial ownership as far back as 2016 and has signed onto the Extractive Industries Transparency Initiative global standard. Companies can go further by requiring suppliers to disclose their beneficial owners.

    Additional investigation will be needed to identify the degrees of ambition that can translate into progressive beneficial ownership targets. 

  6. Executive compensation.Evidence has shown that linking executive compensation to ESG performance positively impacts company performance. Applying ESG metrics in incentive plans is already fairly common practice at large firms. However, as demonstrated in the latest Sembler Brossy research, the vast majority (98 percent) of S&P 500 firms that incorporate ESG metrics into incentive plans do so in their annual incentive plans, while only 14 percent include metrics in long-term incentive plans. Evolutions in ambition and time frames for ESG performance-linked compensation could boost governance and sustainability outcomes. SLF could be a useful vehicle to deliver that ambition, although it may prove difficult to attribute the tangible outcomes to the compensation link. As this is an indirect way to incentivize ESG actions, there likely will be a preference to create a more immediate tie to specific ESG results. Comparability across different corporate compensation schemes could also be challenging.

Please reach out to us if you would like to discuss these categories, including illustrative indicators that could be used for meaningful corporate target setting. 

Since it is likely to be several years before the “G” gap starts to be filled, how to start? Both IFC and TAI want to encourage uptake of governance KPIs with broad benefits for the society and the building of a stronger track record for more regular incorporation into SLF transactions. To start, we will continue to refine a few prioritized indicators, while encouraging broader industry, investor, and civil society reflection and engagement on the range of potential governance commitments. It is hoped that some will become good corporate practice, regardless of whether or not they are incentivized through SLF.

We are especially intrigued to explore the potential in encouraging SLF data governance commitments, as well as those that can help assure against greenwashing. We recognize that the latter may require more of a composite index approach, as no single KPI can guard against cherry picking of targets, while falling behind in other performance aspects. In the year ahead, we will further document existing corporate practices, refine indicators that are ambitious but viable, and work with companies to pilot KPIs on these themes. 

We don’t want to do this alone. 

  • If you are a company seeking financing, why not consider governance commitments that can unlock reduced interest rates and coupons? Reach out to us.

  • If you are an investor, join the conversation on opportunities to boost the G in the ESG through sustainability-linked finance.

  • If you are a good governance champion, help us refine KPIs so they are practical, comparable, and ambitious enough to have a measurable positive development effect.

A decade from now, we envision corporate sustainability practices with a strong track record of meeting environmental, social, AND governance commitments to both shareholders and stakeholders. SLF can be one of the levers to help achieve this.

Let’s continue the conversation!

Read Part 1 of this article here.

Don't miss our latest publications Subscribe now to get our notifications