Exploring the G in ESG: Governance in Greater Detail – Part I

There is increasing evidence of the link between ESG and financial outperformance as better data quality, standardized data, longer data history, and heightened interest in assessing the materiality of ESG drives continued research. However, there is already substantial empirical evidence to suggest that the “G” aspect of ESG ultimately yields better corporate returns.

Governance data, unlike environmental or social data, has been compiled for a longer period of time and the criteria for what comprises good governance and its classification has been more widely discussed and accepted. Harvard researchers Gompers, Ishii, and Metrick (2003) constructed a Governance Index (G-Index) consisting of 24 governance provisions that weaken shareholder rights and ranked companies based on their scores.

Subsequent research from Bebchuk, Cohen, and Ferrell (2009) identified six corporate governance provisions that are associated with what is considered poor governance and that negatively affect valuation. These six provisions are called the “E-Index” (E for entrenchment), and while they (Bebchuk, Cohen, and Wang, 2012) found that both the G-Index and E-Index would have resulted in abnormal returns in the 1990s, the premium dissipated in the 2000s as the markets learned to distinguish between firms with good governance and those with poor governance and price these discrepancies accordingly.

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