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Transparent and effective governance is key to corporate sustainability and overall ESG performance.GettyImages

The “G” of governance is often the forgotten sibling of ESG practices. Issues such as climate, energy efficiency, biodiversity, labour practices and supply chain management tend to get more attention.

For companies and investors, getting governance right not only brings its own sustainability benefits, it’s also foundational to making progress on the other ESG fronts of environmental and social.

“Governance doesn’t have as much sizzle as the ‘E’ and ‘S’ issues. But quality environmental and social strategies all stem from good governance,” says Dustyn Lanz, senior adviser with ESG Global Advisors in Toronto.

A report from the Responsible Investment Association shows that governance can take a back seat to environmental and social concerns even among industry professionals. The association surveyed investment managers, pension funds and other institutional investors about the ESG factors they systematically incorporate into their investment decisions. Only two governance factors cracked the top 10: board diversity and inclusion, and executive pay.

Still, governance plays an overall role in mitigating the threats that can arise from poor environmental and social performance. Good governance also promotes organizational ethics and transparency. That’s critical at a time when some critics question the effectiveness of ESG actions, and allege greenwashing in the form of lofty climate-change pledges that lack real-world substance.

“Governance is the means for investors to figure out if corporate leadership is gaming the system,” says Shelley Gilberg, national ESG markets leader at PwC Canada in Victoria. “It’s about a company saying it’s going to do X, and investors demanding, ‘Show us how you plan to do X.’”

Start with the composition of boards and executive leadership. “Is it just eight white guys who went to the same MBA program on the board? That’s probably going to have a different risk profile than a board that reflects its diverse stakeholders,” Mr. Lanz says.

Also under scrutiny is board and leadership experience on climate change, Indigenous reconciliation and other “E” and “S” factors. Effective ESG progress needs to be rooted in comprehensive strategies, says John Tabet, senior financial adviser with iA Private Wealth in Oakville, Ont.

He points to companies with net-zero pledges that, upon closer examination, plan to reach this goal by purchasing carbon credits. “The problem is that it hasn’t changed operations to reduce emissions and doesn’t have any substantial plan to do so,” he says.

Mr. Tabet would prefer investing in a company that may initially use carbon credits to meet climate-change regulatory requirements, but it has a strategy to use technology to cut emissions. That will also reduce costs and likely boost productivity long-term.

Those decisions begin with leadership, and governance focuses on leadership fitness. A key governance challenge today is measuring a company’s progress “because regulation and reporting remains fairly open-ended,” Mr. Tabet says.

Corporate sustainability reports can differ substantially from one company to the next. They can use different metrics, making comparisons hard, even among industry peers, he adds.

Change is coming with global ESG reporting disclosure expected this year from the International Sustainability Standards Board, and new climate-change reporting regulation from the Securities and Exchange Commission in the United States. The Canadian Securities Administrators is also expected to follow suit, Mr. Lanz says. “For now, there remains an element of the wild west because of limited standardization and regulation, but we’re at a tipping point.”

Governance will only grow in importance as rules tighten around a range of ESG issues, says Rosa van den Beemt, director of stewardship at BMO Global Asset Management in Toronto. She points to Canada’s Modern Slavery Act, for example, which will probably come into effect in 2024 and compel leadership to ensure supply chains involve no forced labour.

“All of this suggests ESG is rapidly evolving, and with that comes greater expectations for good governance,” Ms. van den Beemt says. “Governance has long been a key component of evaluating companies’ exposure to risk, even before we coined the term ESG.”

That underscores how the scope of governance is changing.

Concerns about weak governance came to the forefront in the early 2000s with the WorldCom and Enron scandals, which involved falsified financial reporting and incurred billions of dollars in losses. Governance remains in the spotlight whenever corporations implode, as seen months ago with the collapse of FTX, the cryptocurrency trading platform, and this month with the failure of Silicon Valley Bank. But at a time of ESG prominence, financial irregularities are far from the only material risks.

“Governance today is really what provides confidence in corporate social and environmental strategies,” Ms. Gilberg says.