Environmental, social and governance issues are becoming a major part of everyday life for investors. Not only is there societal pressure to ‘do the right thing’ but financial regulators and governments are mandating new checks on it, too. For the moment, at least, the mainstream focus has turned to the environmental and social risks of any capital allocation, but investors still need to be aware of how governance is a crucial part of investment decision-making.
Infrastructure companies or projects with poor governance practices can pose significant risks to investors. These risks can be translated into a slump in the value of companies due to a lack of board supervision, counter-power to the management or independence within the board.
‘G’ is the big factor
For NN Investment Partners, governance has always been a core part of its assessment of infrastructure deals. However, the firm’s increased focus on ESG means it now thinks about it in a more consistent way.
Alistair Perkins, NNIP’s head of infrastructure debt and project finance, says: “Governance aspects were always included in the due diligence for the project, especially the framework and strength of the shareholders, which now are clearly defined in the governance part of the ESG analysis.”
He believes the ‘E’, ‘S’ and ‘G’ risks are interrelated because often the projects that have good governance also have the best and most reliable ESG data. “Whereas, typically in projects where there’s less good governance, often the quality of the ESG data is severely lacking,” he adds.
According to Karen Azoulay, head of infrastructure debt at BNP Paribas Asset Management, “governance criteria have been in infrastructure investors’ minds for a very long time, while awareness still needs to be raised on the environmental and social criteria”.
This may be due to governance being more easily assessed by following a cross-sector approach. By contrast, Azoulay says that “environmental and social are sector-specific and need to be adapted and assessed differently depending on the underlying assets”.
As infrastructure is a long-term investment, a project that has a fit-for-purpose governance framework can help address issues that may arise during the lifetime of the project.
Although there are a multitude of ‘G’ aspects that can be assessed, focusing the same amount of effort on every single one of them would be very resource-intensive. Henry Morgan, sustainable investment manager at Foresight Group, says investors should therefore look at what mechanisms they can put in place to further what is considered to be good or best-in-class governance.
“It is important for investors to undertake a materiality assessment to understand what matters most to them and their stakeholders, and focus their attention on assessing those that are deemed most important,” he says. Investors could look to external reporting frameworks, such as the EU Green Taxonomy, to establish what ‘G’ elements are emphasised, he adds. Helpfully, regulators have increased their focus on good governance under the Solvency II framework. Investors can require qualifying infrastructure assets to meet the Solvency II criteria, notes Gareth Mee, UK sustainable finance consulting leader at EY, while a manager’s governance framework should be viewed via its fund prospectuses and investment committee papers.
Mee adds that many fund managers are developing ESG policies designed to evaluate governance through a number of metrics, “covering legal and regulatory issues, business ethics risks, employee compliance and operational risks”.
BNPP AM has established a mandatory procedure to assess the ESG quality and risks associated with the projects it finances through its European Infrastructure Debt fund. The analysis of the sponsor and project is carried out by BNPP AM’s independent sustainability centre, which has the right of veto on all projects. At the sponsor level, governance represents a significant weight in the analysis.
BNPP AM’s Azoulay says the firm’s expectations on the governance pillar have been quite stable over time and she does not think that governance is a moving target. “We look for suitable independence, expertise, diversity and protection of minority shareholders to ensure proper monitoring of the management in place,” she says.
However, NNIP’s Perkins thinks it is the governance part that can change the most during the life of infrastructure investments, whereas the environmental and social factors are often quite static.
“For example, if one equity owner sells to another shareholder, you can have a completely different governance structure or a change in the management team during the life of the asset,” he says.
NNIP looks at the shareholders to consider their ESG culture and conviction, and also the strength of the management team where possible. It does not have diversity targets currently, but rather asks about the strategy of the company.
Ownership and management
This a realistic approach as a long-term infrastructure asset will typically change ownership more than once in its lifecycle and it is important to ensure it does not end up in the hands of those with a less responsible approach to management, believes Foresight’s Morgan.
“It’s not unheard of for investors to write into their terms of sale that they (as the original investor) must give their approval to any potential future purchaser, so as to ensure the reputational risk of the asset ending up in the wrong hands is sufficiently mitigated,” he says.
It could also be useful to assess the ‘end of life’ or decommissioning plan for a given project. For example, Morgan suggests checking if there is a facility in place to ensure the site will be returned to its natural state once the asset has reached the end of its useful life.
As part of their due diligence, investors should assess the history and experience of the appointed fund managers and be confident the senior management team is capable of the correct oversight role.
Mee at EY says the management team should have significant experience across the full life cycle of projects – normally with a collective average of no less than 15 years. He adds that diversity is increasingly a factor, and though we are moving in the right direction, “there is still a long way to go to ensure a diverse talent pipeline”.
Morgan adds: “For debt investments in particular, good governance is ensured through requirements such as security mechanisms (such as step-in rights) and restrictions on activities which may be detrimental to the interests of debt providers.”
He believes a clear approach towards remuneration for good ESG conduct and training, along with established committees with fair representation are good examples of governance: “That should be consistently revisited and refined to ensure the best possible governance practices are in place.”
One of the challenges in infrastructure is assessing the governance of the project’s supply chains, which can be widely diverse and span a huge range of countries. NNIP’s Perkin, for example, says component manufacturers can be internationally sourced so “it’s really very difficult to follow that entirely”.
The asset manager looks at the major product parties involved to check their company policies, how they source the materials, and how they operate in the labour market. But it does not look at the subcontractors or who those people are contracting with or smaller supply chain members. “That is something that we might consider in the future, once it gets more developed, but it’s not something that can be done particularly well at the moment,” Perkins says.
Another difficulty for investors is assessing governance according to different regions or jurisdictions. Every project has to comply with regional laws and regulations, and typically the asset manager appoints someone locally with the right expertise into an oversight role.
EY’s Mee says: “For renewable energy infrastructure projects in particular, local regulation energy yield assessments are carried out, which give the project team insights on the infrastructure asset and, if used properly, can contribute to stronger corporate governance.” He adds that investors should consider any local political objectives aligned with infrastructure investments, as they could benefit from incentives such as guaranteed tariffs and subsidies.
Both NNIP and BNPP AM’s projects are all in Europe where standards are well-harmonised. BNPP AM’s Azoulay says that although for governance it is true that practices might differ between countries, “our expectations are the same regardless of the region”.
Investors can use their materiality assessments to give a focus on which issues are deemed most important to consider in new regions or jurisdictions. “However, investors should seek local guidance on how the localised governance requirements differ to their normal areas of operation and adapt their assessment of governance factors accordingly,” says Foresight’s Morgan.
All investors should consider good governance because infrastructure companies, projects or fund managers with poor governance practices can pose big risks.
Asset managers now have a much more clearly defined process around governance, which should help their investors. Given the long-term nature of infrastructure investments, it is crucial they are aligned with investors’ beliefs.