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Why ESG should really read GES 

Published 30 March 2022 in Magazine • 12 min read

The governance aspect of ESG is a fundamental driver of environmental and social quality. Our experts outline the methodology required to ensure board-level leadership in sustainability.


Governance is often explored and assessed from a technical and mechanical perspective (with hard criteria such as number of independent directors, size of board, diversity of the board and management, compensation structures and ownership structures) that seems detached from environmental and social dimensions. Governance metrics do not pertain directly to sustainability, carbon footprint and other environmental or social dimensions. ESG is then seen as a juxtaposition of three different dimensions (environmental, social and corporate governance), which are combined but are not necessarily related. These three dimensions are thus best measured separately, and a composite index can be constituted that cumulates or averages separate measures of the different dimensions.  

A fundamental alternative perspective starts with the fact of what truly constitutes governance. Put simply, Governance is the art and structure of decision-making at the top of organizations. High-quality governance will drive quality decision-making within the organizations in all areas – including environmental and social choices. It could be argued that if we were able to capture good governance – and assuming that environmental and social choices are pertinent to the future of an organization – the quality of the governance itself would be a driver of environmental and social choices.  

However, current governance methodologies tend to focus on the mechanics of board and management functions rather than on the fundamentals of what drives good governance. Let’s begin by analyzing why ESG is a key investment dimension, then explain why an integrated solution can be successful, based on governance, and how we see such a methodology being implemented.


Why ESG? 

A causal relationship is needed between a company’s ESG practices and risk and returns. Weak governance, environmental and social practices can damage corporate reputation, which has material impacts on market performance. Investors focusing on companies with solid ESG practices benefit the most, since investment risk is lower. 

ESG investment is also about opportunities. Investing in clean technology, renewable energy or other emerging industries will help create new growth leaders. Driven by these global megatrends that will continue for years to come, ESG companies will enjoy upside potential.  

An ESG approach has an impact on value and the world around us. We are living through a period in which companies are struggling with risks such as global warming, poor labor practices and board scandals. By investing in companies that seek to provide solutions, investment professionals play their part in creating a better world, in which wealth creation will be stronger and healthier.  

Bu8ild better boards

Towards an integrated ESG methodology 

Although many investment firms have been trying to figure out how to include ESG analysis in their investment decisions, the integration remains inconsistent and financial returns disappointing.  There are multiple challenges: it is inefficient and costly to conduct field research on individual companies; it is difficult to distinguish between firms that merely provide ESG disclosure and others that truly implement ESG practices to reduce risk and take advantage of opportunities; it is hard to generate alpha using products and services from third-party ESG rating providers.  

Among the most widely used approaches to ESG analysis are: (1) conducting bottom-up research on individual companies; (2) relying on companies’ ESG disclosures; and (3) using third-party ESG ratings.  

Conducting bottom-up research on individual companies is an in-depth, fact-driven approach that leads to first-hand understanding of a company’s ESG issues, which provides the necessary insights for investment, monitoring and active engagement. Research at this level is detailed and comprehensive, for example, quantifying the material impact of ESG issues on firms’ revenue, financing, valuation, and risk. Boutique investment firms typically do not have the resources to cover a sufficient number of companies for effective diversification. Assigning a monetary value to ESG issues is also computationally difficult with questionable results. And finally, the methodology tends to focus on the output rather than on the driver: a company may have low carbon footprint because of its business model rather than by the will of the board to improve its impact. The risk is then to capture a status rather than a dynamic: is the organization naturally in a low carbon footprint context (industry, business model, etc) or is it actually working on improving its footprint? Returns tend to reflect dynamics rather than status.  

Relying on companies’ ESG disclosures in the form of detailed corporate social responsibility (CSR) reports or specific ESG policies is not a good way to obtain information. These reports or policies are not legally binding, non-standardized, hard to verify and often incomplete. As a result, a CSR report may not be a trustworthy source for understanding a company’s ESG beliefs and practices. CSR reports are often criticized as being a “window-dressing” exercise. Relying on information disclosed in CSR reports or assessing how detailed these reports are rarely adds alpha.  

Relying on third-party ESG ratings does not lead to quality ESG insights either. Although there are many ESG research providers selling information and opinions in the market, their ratings do not necessarily provide consensus views and often provide contradictory opinions. It requires tremendous effort from investment managers to interpret the noisy signals and filter ESG information. Applying ESG ratings from third parties does not systematically create consistent and significant alpha.  

Our perspective: G drives E and S  

A top-down, governance-driven approach can lead to true ESG insights for many companies across industries. Several characteristics are commonly seen in successful businesses: an effective and efficient board, capable management, credible internal controls, good relationships with stakeholders, and good management of the environmental and social aspects of their business. For all these characteristics, good governance is the foundation. 

By good governance, we do not mean the mechanical attributes of board and management, but the fundamental values and principles that drive the quality of decisions taken at the top of an organization. Among the principal values of good governance, we see a sense of accountability and responsibility of the individuals involved and of the organization as a whole. We see also long-term orientation, resilience, agility, and concern for customers and stakeholders as key drivers of organizational success.  

Good governance will thus drive the long-term orientation, values and quality of an organization’s resilience and agility in environmental matters as well as in social matters. In ESG, true G drives E and S. The catalyst for a good ESG policy starts with the governance which, in addition to triggering stock outperformance, enhances impactful and transformative environmental and social policies at the corporate level. Therefore, we place great emphasis on corporate governance. 

Indeed, there are fundamental tenets to governance. At the very base are character and values. A sense of accountability and responsibility combined with integrity and moral authority are hallmarks of the character required for good governance. This leads to other drivers such as a long-term view balanced with short-term efficiency, an ability to build resilience, often a combination of financial conservatism and innovation, stability and agility, passion, purpose, and compassion – all essential to true success – and, of course, open-mindedness and constructive dissent based on a diversity of views. Positive environmental and social impacts – in brief, stewardship – are hallmarks of good governance. 


Natural language processing on 10-Ks 

Over the past six years, we have developed a systematic approach to stewardship, governance and ESG analysis that serves as the foundation for portfolio construction and optimization. The recent rise of data science has allowed us to apply artificial intelligence (AI) and machine learning (ML) to the analysis of companies’ 10-K reports. Unlike CSR reports, 10-Ks are legally binding, standardized, complete documents that have been prepared by the top management team, approved by the board, certified by the auditors, and regulated by the US Securities and Exchange Commission (SEC).  

Just as many economic and financial theories find their roots in psychology, the study of the language individuals use gives insights into their personality traits. Similarly, a company can be viewed as having a personality, and studying its communications provides rich information. We used content analysis to measure the personality of organizations, which fundamentally drives key elements of how they are governed. NLP uses a word dictionary that reflects characteristics expressed to identify ways in which companies are similar to or different from one another.  

We started by identifying forward-looking messages embedded in company reports. We analyzed each report computationally sentence by sentence to reveal elements that related to corporate culture, behaviors, and actions. For the word selections, we leveraged our direct experience with boards. We used both implied and explicit words and adapted to changes in business language by regularly updating the word lists (see illustration). 

Our approach enables us to derive stewardship, governance and ESG communicated by companies, which helps with more objective investment decisions. In our proprietary research, ESG analysis serves as fundamental analysis. We believe that this process, with its new perspective, gives us an edge – one that is not available to most investment managers. 

“ A company can be viewed as having a personality, and studying its communications provides rich information ”


An Example of Innovative ESG portfolio construction 

The portfolio construction process in terms of identifying ESG companies can be largely quantitative. We give an example designed to select the top 100 companies from an investable universe – the S&P 500. In our framework, the key is how to cluster the words and combinations of words to extract the fundamental elements of good governance. Based on our governance practice and academic research, we looked at numerous components, such as time orientation, people, and stakeholder management, as part of a broader review involving many clusters. This broad analysis is conducted on a dictionary of more than 7,000 distinct words grouped into three categories (three filters), which constitutes the body of our governance scores from reading companies’ annual reports. This review allows us to diagnose the governance quality of every company for ranking and comparison. We apply a fourth filter to exclude sub-industries that could skew the ESG profile of companies. 

Filter 1: classical stewardship  

Classical stewardship refers to the multiple word lists that we created to represent stewardship beliefs, attitudes, values and actions. We update the word lists regularly.  

The dimensions that constitute stewardship beliefs include an obligation or willingness to promote good governance and take responsibility (accountability), a sense of purpose for greater achievement and social good (purposefulness) and a commitment to safeguard the future through a long-term perspective (long-term focus).  

The dimensions that describe stewardship attitudes include a willingness to take care of customers (care), an ability to win trust from employees (trustworthiness) and a propensity to act harmoniously with other stakeholders (harmony).  

The dimensions that indicate stewardship values include a strong passion to drive stewardship and lead with positive impact (passion), a sense of positive wellbeing to promote a vision of the future (positiveness), and a sense of psychological ownership or oneness to identify with the company (identification).  

The dimensions that characterize stewardship actions include an emphasis on innovation and creativity (innovativeness), a proactive and anticipatory approach to risk management (proactiveness), and a tendency to be conservative and prudent toward debt financing (prudence).  

Filter 2: resilience and agility  

The resilience and agility filter refers to the multiple word lists we created to measure crisis readiness and risk management. Prudence and adaptability are at the heart of good governance. In well-governed organizations, the board will be better prepared for crises, adopt long-term strategies and incorporate risk management. Good governance drives agility with the view that the organization will adapt to both growth and recession, as well as unexpected shocks. The 2008 financial crisis and the COVID-19 pandemic demonstrated that well-governed companies were rewarded by the market. We observed that the share price of well-governed companies dropped less during the correction and then, thanks to their agility and better positioning, rebounded better and for the long term. 

Filter 3: modern stewardship  

The modern stewardship filter refers to the multiple word lists that we create annually to represent best-in-class stewardship, governance and ESG practices in the current year. Language evolves slowly. To achieve long-term value creation, we need to stay current with the changes in language and maintain our capability to select the best-governed companies.  

Filter 4: exclusionary screening 

We apply this screening to exclude several sub-industries from the investable universe regardless of their financial performance. This step is to minimize potentially negative ESG exposures based on moral values, standards, and norms. Examples include the oil, gas and tobacco industries. 


Does our Integrated ESG approach work? 

We created an unconventional model using NLP techniques on 10-Ks to discover ESG information embedded in corporate communications. Once we have the portfolio of stocks, we perform cross-validation to assess whether our selection will accurately capture ESG performance in practice. Cross-validation is essential to test the model’s ability to predict both financial and ESG performance with unknown datasets such as new 10-Ks.  

Validation of risk and returns 

A good ESG model should deliver on its promise of high returns and low risks. Typically, a fund with solid ESG integration should be expected to have lower risk exposure and above average long-term returns. Our methodology highlights important differences between well-governed companies and their peers. Based on the words they use, we find that well-governed companies are financially more conservative (controlling for size and industry), have less debt and higher liquidity, and that they invest more in innovation and are less prone to mass layoffs.  

Validation of social and environmental aspects 

In our model, we follow the key principle that governance drives environmental and social choices. In ESG, G drives E and S. To verify whether our selection of 100 stocks measures both environmental and social aspects, we benchmark our selection with the ESG scores from Sustainalytics and RobecoSAM. The scores from both providers range from 0 to 100, with 100 being the best performance score in social and environmental performance. We can see that well-governed companies consistently outperform the S&P 500 and bottom 100 companies across environmental and social ratings. 

Total investment impact  

Impact-Cubed is an independent rating company. Its ESG ratings have been used by institutional investors to report on portfolios, inform their product development and investment processes, and research and compare investment products. We used it to obtain a Portfolio Impact Footprint of our investments. To measure the overall ESG impact of our portfolio, we loaded our fund level data to match Impact-Cubed’s coverage of more than 10,000 global companies from 2018 to 2020. 

The comparison shows that our portfolio was in the top quartile of companies with the most positive impact in 2019, In fact, we are approaching the maximum possible ESG and sustainability performance. This again confirms our NLP analysis of 10-Ks and our belief that governance drives environmental and social choices. 

Backtest and live performance 

Our methodology reconciles the paradox that traditional ESG scores or rankings do not generate alpha consistently. When looking at the issue fundamentally, there should be a causal relationship between ESG practices and stock performance, since well-governed companies paying attention to ESG dimensions would have lower risks, notably on reputation damage, and higher upside opportunities, notably by investing in clean, renewable, and emerging technologies. The problem is not about the fundamental ESG idea, but genuine measures of ESG implementation at firm level. 


Generating alpha 

The UN Principles for Responsible Investment (PRI) have been widely accepted in recent years. ESG investing is becoming a mainstream investment approach. However, there is a significant hurdle to ESG analysis in terms of acquiring accurate, comprehensive, comparable, consistent, and audited information. The lack of a credible ESG ranking and scoring methodology has become a challenge for generating ESG alpha.  

Our systematic approach has generated consistent alpha with lower volatility. In addition, various cross-validation test results have shown that our portfolio has a positive impact on sustainability. During the crises in 2008 and 2020, our investments experienced lower drawdowns and quicker recovery. For us, ESG integration goes beyond aspiration and has a positive impact on portfolio returns. This approach has become a key differentiator. 


Didier Cossin

Didier Cossin

Founder and director of the IMD Global Board Center, the originator of the Four Pillars of Board Effectiveness methodology and an advocate of Stewardship.

Didier Cossin is the Founder and Director of the IMD Global Board Center, the originator of the Four Pillars of Board Effectiveness methodology, and an advocate of stewardship. He is the author and co-author of books such as Inspiring Stewardship, as well as book chapters and articles in the fields of governance, investments, risks, and stewardship, several of which have obtained citations of excellence or other awards. He is the Director of the High Performance Boards program and the Mastering Board Governance course.

Abraham Hongze Lu

Global Board Center Research Fellow at IMD business school

Hongze Abraham Lu is a CAIA charter holder and research fellow at the IMD Global Board Center. Abraham has worked with senior executives in many customized and open programs at IMD since 2005. He specializes in quantitative research in governance, strategy, and finance using text analysis and natural language processing techniques.


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