Why governance is key for investors in infrastructure
Players in the extractives, energy and infrastructure sectors around the world have for a long time been required to ensure that they run sustainable businesses in order to attract funding from prospective investors. ESG assessments have been a prominent tool for investors and financiers in these sectors, with project companies and their sponsors being required to be good stewards of the environment and to have the social buy in of the project affected communities. This focus on ESG is not surprising, given the long-term and capital-intensive nature of infrastructure projects. More importantly, these projects heavily affect natural resources and surrounding communities and therefore the standard of caution by investors has to be many notches higher. As the adage goes, with great power comes great responsibility.
To give a brief recap, ESG is a catch-all term encompassing a range of standards through which investors assess the impact of a project or company’s operations on environmental, social and governance issues, with a view to driving capital towards sustainable investments. Discussions on ESG have often placed the "E" and "S" aspects in the spotlight, many times assuming that the "G" (governance) is something that the project company should naturally be able to get right. The focus on E&S issues comes as no surprise given the increasing urgency to reverse the effects of climate change, caused by human activity. International treaties such as the Paris Agreement and numerous national climate change laws have made it essential that investors place particular emphasis on the environmental sustainability of any project into which they put in resources. On the social front, the change in demographics and rise of a socially conscientious society has also pushed social issues into the limelight and investors have to be socially conscious with the investments they choose to back. All these factors have amplified the calls for changes in how the extractives, energy and infrastructure sectors operate. Notably, some of the internationally accepted benchmark standards also seem to emphasize more on E&S issues. However, we do contend that understanding governance risks and opportunities in investment decision-making is also critical and will often invariably affect the social and environmental risk profile of a company. It is no secret that poor corporate governance can make or break a project and company.
This article focuses on the governance issues that infrastructure investors should look out for when evaluating a project or a project company and the importance of good corporate governance for project companies.
Typically, governance is considered the more traditional of the ESG assessment standards given that investors have always looked into corporate structures as part of their due diligence when they are making investments into any project or company. That said, corporate governance assessment under ESG goes beyond due diligence on regulatory compliance of corporate structures, instead focusing on issues such as how the project company makes its decisions, the role and makeup of boards of directors, shareholder rights and how corporate performance is measured.
In reviewing some of these considerations, the first issue we would like to highlight is that of board decision making. The approach taken by ESG driven investors has been to invest in companies whose policies and decisions are conscious - not only of financial returns, but also stakeholder interests. Such companies don’t just take decisions to benefit their shareholders. They take decisions that support their whole eco-system including suppliers (e.g by having policies to pay fair and prompt compensation to their suppliers), customers, employees and communities alongside their shareholders.
Another pre-eminent governance issue is that of diversity and equity in board composition. Investors are now demanding better representation of women and minority groups on company boards and in executive ranks, with equal compensation. In fact, extensive research – including by Standard & Poor’s (S&P) has established that firms with a balanced representation of women on their boards and in executive level positions, have greater financial performance than their less diverse counterparts.
Oversight of the management board is another important element of governance. Accountability and oversight of the C-suite and issues to do with conflict of interest must be considered when evaluating a company’s governance score. Infrastructure investors should look into the project company’s (or their sponsors’) basic internal controls, interactions with related parties and oversight mechanism for management. They should also check the management board’s expertise in managing the project throughout its life cycle. To emphasize this point, investors (be they lenders or otherwise) will sometimes want the comfort of contractual restrictions on change of ownership for project companies, which allows them to ensure that in the likely scenario where a project company has a major shift in shareholding, the newcomers share the same responsible business approach as the previous shareholders.
Finally, the element of ethical and anti-corruption practices for both the project company and its contractors cannot be emphasized enough. According to the 2019 RBC Global Asset Management Responsible Investment Survey, concerns over corruption and bribery came top of the list of investor ESG concerns, with investors citing tax evasion, bribery, money laundering and embezzlement as their most pressing concerns.
With this in mind, we dare say that it is a herculean task to achieve the "E" and "S" of ESG, without getting the "G" right. Given the risks posed by poor governance, it is a high time that this often overlooked aspect of ESG is given its pride of place.
The article was featured in the Business Daily on 13 July 2021 and can be accessed here.