Governance and stakeholder management - ESG considerations i...

Learning Outcomes

This article explains governance and stakeholder management in an ESG-focused corporate finance context, including:

• Clarifying the purpose of corporate governance frameworks and stakeholder management, and how they support long-term firm value and risk control.
• Identifying key stakeholder groups—shareholders, boards and management, creditors, employees, governments, and wider society—and contrasting their primary objectives and claims on the firm.
• Distinguishing shareholder theory from stakeholder theory, and illustrating typical conflicts of interest among owners, managers, creditors, and other parties.
• Describing principal–agent relationships, the agency problem, and the role of internal and external governance mechanisms such as independent boards, regulation, audits, credit ratings, and the market for corporate control.
• Explaining how environmental, social, and governance (ESG) factors are incorporated into corporate finance decisions, capital allocation, and risk assessment.
• Differentiating key ESG risk types—including transition, physical, social, and governance risks—and linking them to operational, legal, reputational, and valuation impacts.
• Summarizing common ESG reporting practices, materiality considerations, and how ESG disclosures and controversies can influence analysts’ forecasts, cost of capital, and exam-style scenario analysis for CFA Level 1 candidates.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the principles and practices of governance and stakeholder management, including ESG considerations, with a focus on the following syllabus points:

• Explain the purpose of corporate governance and stakeholder management and identify key stakeholder groups.
• Describe conflicts of interest between stakeholder groups, particularly shareholders, directors, managers, creditors, and employees.
• Identify governance mechanisms (internal and external) designed to manage stakeholder relationships and mitigate conflicts.
• Analyze environmental, social, and governance (ESG) considerations in company practices and reporting.
• Evaluate the financial and reputational impacts of ESG-related risks and opportunities.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which stakeholder group normally holds the largest residual claim on a company’s value?
   1. Senior secured creditors
   2. Trade suppliers
   3. Shareholders
   4. Employees
2. A company emits large amounts of carbon and faces the introduction of a carbon tax. Which impact is most directly linked to this ESG issue?
   1. Higher cash balances
   2. Higher operating costs and potential asset impairments
   3. Lower debt ratios
   4. Lower effective tax rate
3. A board is composed almost entirely of inside (executive) directors and is elected on a staggered basis. What is the most likely governance concern?
   1. Excessive focus on long-term strategy
   2. Weak independent oversight and reduced accountability to shareholders
   3. Too much influence by short-term activist investors
   4. Excessive representation of creditors’ interests
4. Which pair best describes one advantage and one challenge of including ESG factors in financial analysis?
   1. Advantage: reduces data needs; challenge: lowers diversification
   2. Advantage: helps identify risk not fully captured in financial statements; challenge: data can be inconsistent and hard to compare
   3. Advantage: guarantees higher returns; challenge: increases agency conflicts
   4. Advantage: eliminates need for fundamental analysis; challenge: requires regulatory approval

Introduction

Sound corporate governance and effective stakeholder management are central to long-term business success and valuation. For CFA candidates, understanding how these concepts interact with ESG considerations is critical for risk assessment, investment analysis, and interpretation of corporate disclosures.

Corporate governance and ESG are no longer separate topics. Investors increasingly evaluate environmental and social practices through the lens of governance quality: Does the board understand these risks, and does it allocate capital accordingly? Likewise, corporate finance decisions—capital budgeting, capital structure, dividends, and risk management—must reflect both financial and ESG-related impacts.

Key Term: corporate governance
The system of oversight, controls, and incentives that guides an organization’s operations and decision-making, helping ensure accountability to shareholders and other stakeholders.

Key Term: stakeholder
Any individual or group with a vested interest in a company, such as shareholders, employees, creditors, customers, suppliers, governments, and local communities.

Corporate Governance: Purpose and Principles

Corporate governance refers to the system of rules, practices, and processes directing and controlling a company, balancing the interests of shareholders and other stakeholders.

In the CFA curriculum, the purpose of good governance is usually framed in three ways:

• Protecting shareholder rights and the integrity of the capital markets.
• Reducing agency problems between owners (principals) and those who control resources (agents).
• Supporting sustainable, long-term value creation by managing risk and allocating capital efficiently.

From a corporate finance standpoint, governance affects:

• Which projects the firm undertakes (capital budgeting).
• How those projects are financed (capital structure decisions).
• How much profit is retained or returned (dividends and share repurchases).
• How risk is monitored and managed (risk oversight, internal controls).

Strong governance frameworks generally emphasize:

• Accountability: Clear roles and responsibilities for boards and management.
• Transparency: High-quality, timely financial and non-financial reporting.
• Fairness: Protection of minority shareholders and other stakeholder rights.
• Responsibility: Ethical conduct and compliance with laws and regulations.

Poor governance, in contrast, is often associated with misallocation of capital, higher probability of fraud or misconduct, and ultimately a higher cost of equity and debt.

Key Stakeholder Groups and Interests

Different stakeholder groups contribute resources to the firm—capital, labor, intellectual property—and expect compensation or protection in return. Understanding their claims is important for analyzing conflicts and ESG risks.

• Shareholders:

  • Owners of the company with the greatest residual claim on firm value after all other obligations are met.
  • Primarily concerned with long-term value creation, often measured by total return (price appreciation plus dividends), as well as voting rights and protection from expropriation.
  • Elect the board of directors and can influence strategy through voting and, in some markets, through shareholder activism.

• Board and management:

  • The board sets strategy, appoints and oversees senior management, approves major capital allocation decisions, and monitors risk.
  • Management implements strategy through operational and financial decisions.
  • Their objectives may include career security, compensation, and reputation, which do not always perfectly align with shareholders’ interests.

• Creditors / debtholders:

  • Provide loans or bonds. Their primary interests are timely interest and principal payments and preservation of capital.
  • Often protected through covenants limiting debt levels, asset sales, or dividend payouts.
  • May be public debtholders (bondholders) or private debtholders (banks, lessors). Private debtholders typically have more influence and access to non-public information.

• Employees:

  • Provide labor, skills, and firm-specific knowledge.
  • Seek fair wages, job security, career development, and safe working conditions.
  • Social ESG factors—such as labor standards, diversity, health and safety—directly affect employee well-being and productivity.

• Customers and suppliers:

  • Customers seek quality, safety, fair pricing, and data protection. ESG issues like product safety, responsible marketing, and data privacy are central here.
  • Suppliers seek stable demand and timely payment. They can be influenced by the firm’s ESG expectations, for example through supply-chain labor or environmental standards.

• Governments and society:

  • Governments regulate in the public interest, collect taxes, and set minimum environmental and social standards.
  • Wider society is affected by externalities such as pollution, job creation, or social harm from products. Growing stakeholder pressure means that previously external costs (e.g., carbon emissions) are increasingly internalized via taxes or regulation.

Key Term: shareholder theory
A view of governance that holds management’s primary objective is to maximize shareholder wealth, subject to legal and contractual constraints.

Key Term: stakeholder theory
A view of governance that management should balance the interests of all stakeholders who have a legitimate claim on the firm, not just shareholders.

Although shareholder theory emphasizes owners, it does not necessarily ignore other stakeholders. For example, treating employees well and maintaining strong customer relationships may support long-run shareholder value, aligning stakeholder and shareholder theories in practice.

Worked Example 1.1

Question:
A company increases dividend payouts and takes on substantial short-term debt to finance this decision. Who may be negatively impacted among stakeholders, and why?

Answer:
Creditors may be negatively impacted because higher use of debt financing raises default risk and weakens their protection, potentially jeopardizing timely repayment. Employees may also face higher job insecurity if liquidity problems later force cost-cutting or layoffs.

This example also illustrates a shareholder–creditor conflict: higher payouts benefit shareholders in the short term but can harm debtholders.

Stakeholder Conflicts and Agency Problems

Many governance issues are examples of principal–agent problems.

Key Term: principal–agent relationship
A situation in which one party (the principal) delegates decision-making authority to another (the agent), who is expected to act in the principal’s best interests.

Key Term: agency problem
A conflict of interest that arises when agents pursue their own goals rather than those of the principals they are supposed to represent.

Common agency relationships in corporations include:

• Shareholders (principals) vs. managers (agents).
• Shareholders vs. the board of directors.
• Controlling (majority) shareholders vs. minority shareholders.
• Shareholders vs. creditors, where actions benefiting equity holders increase risk borne by debtholders.

Typical conflicts:

• Owners vs. managers:

  • Managers may prefer lower risk, empire building, perks, or short-term earnings management rather than long-term value creation.
  • This can impact capital budgeting (accepting negative-NPV projects), financing (excessive debt or cash), and dividend policy.

• Majority vs. minority shareholders:

  • Controlling shareholders may engage in related-party transactions, asset transfers, or unequal voting structures that disadvantage minority investors.
  • Dual-class share structures, where founders retain superior voting rights, can entrench control.

• Shareholders vs. creditors:

  • Shareholders may favor riskier projects because they benefit from upside while creditors bear more downside.
  • Share repurchases or special dividends financed by debt can transfer wealth from creditors to shareholders.

• Management vs. employees:

  • Cost-cutting for short-term earnings may conflict with employee job security or safety.
  • Poor labor practices can later create social and legal risks affecting all stakeholders.

Mitigating agency problems often involves aligning incentives.

Key Term: performance-based compensation
Remuneration that depends on achieving specified performance targets, such as profit, return on equity, or share price performance.

Equity-based pay (shares, stock options) and profit-sharing can align managers’ and employees’ interests with shareholders, but poorly designed plans can also encourage excessive risk-taking or short-term focus.

Worked Example 1.2

Question:
A founder holds 51% of company voting rights through dual-class shares, while the remainder are widely held. What is one governance risk, and what mechanism might address it?

Answer:
There is a risk that the controlling shareholder could pursue personal benefits (for example, related-party deals or entrenchment) at the expense of minority shareholders. Appointing a majority of truly independent directors, supported by strong disclosure and related-party transaction policies, can help protect minority investors.

Managing Stakeholder Risks: Governance Mechanisms

Governance mechanisms are tools and structures designed to manage stakeholder relationships and mitigate conflicts.

Internal Governance Mechanisms

Key internal mechanisms include:

• Board of directors:

  • Sets strategic direction and approves major investment, financing, and payout decisions.
  • Monitors management performance and can hire or dismiss the CEO.
  • Oversees risk management, including ESG risks such as climate exposure or data privacy.

• Board structure and composition:

  • Independent (non-executive) directors are expected to provide objective oversight.

Key Term: independent director
A board member with no material relationship to the company (other than their directorship), supporting their ability to provide objective judgment.

• Boards may be staggered (only a fraction of directors elected each year) or non-staggered (all directors elected annually). Staggered boards can make major changes or takeovers more difficult, limiting shareholder influence.

• Board committees (audit, remuneration, nomination, risk) allow focused oversight of specific areas.

• Internal controls and audit:

  • Systems to ensure accurate financial reporting, safeguard assets, and comply with law.
  • Internal audit teams and external auditors provide assurance that management reports fairly and that risks are identified.

• Executive and employee compensation:

  • Linking pay to long-term value creation (e.g., through multi-year performance measures and share ownership requirements) can reduce short-termism.
  • Incorporating ESG-related metrics (such as safety, emissions reductions, or diversity targets) into bonuses can signal commitment to sustainability.

• Codes of conduct and whistleblower mechanisms:

  • Formal policies on ethics, anti-corruption, and conflicts of interest.
  • Protected whistleblowing channels support early detection of misconduct or ESG violations.

External Governance Mechanisms

External mechanisms involve forces outside the company that discipline management:

• Regulation and listing requirements:

  • Securities laws mandate disclosure, protect shareholder rights, and penalize fraud or misrepresentation.
  • Stock exchanges may impose governance codes (e.g., requirements for independent directors or audit committees).

• External audit:

  • Independent auditors provide opinions on whether financial statements are fairly presented. Weak or compromised audits are often linked to governance failures.

• Credit ratings and lenders:

  • Credit rating agencies assess default risk. A downgrade increases borrowing costs, providing incentives for prudent capital structure and risk management.
  • Private lenders (banks) often negotiate covenants that limit risky behavior and require regular information.

• Investor activism:

  • Institutional investors and activist funds may engage with management to improve capital allocation, governance, or ESG performance.
  • Tools include shareholder proposals, public campaigns, and voting against directors.

• Market for corporate control:

  • Underperforming firms may become takeover targets. The threat of acquisition can encourage managers to focus on shareholder value.
  • However, defensive measures like poison pills or staggered boards can reduce this disciplining effect.

Worked Example 1.3

Question:
A listed company faces a shareholder activist campaign demanding cost reduction and asset divestiture. What positive and negative effects might this have for the company?

Answer:
Positive effects may include improved operating efficiency, sharper strategic focus, and stronger accountability to investors. Negative effects might include excessive emphasis on short-term earnings, underinvestment in long-term projects (such as R&D or ESG initiatives), and potential damage to relationships with employees, customers, or communities if cuts are poorly managed.

ESG Considerations in Corporate Finance

ESG factors influence corporate finance decisions because they can materially affect cash flows, risk, and ultimately valuation.

Key Term: ESG (Environmental, Social, Governance)
A framework for assessing corporate behaviour and performance in environmental stewardship, social responsibility, and governance practices.

Why ESG Matters Financially

From the curriculum:

• The material financial impact of ESG factors has increased. Environmental disasters, social controversies, and governance failures have caused large losses for shareholders and debtholders.
• Governments and regulators are tightening rules on climate, labor standards, and corporate conduct, forcing companies to change their practices.
• Environmental and social issues that used to be treated as negative externalities are progressively being internalized through taxes, regulation, or legal liability.

Key Term: negative externality
A cost of a company’s actions that affects other parties (such as pollution) but is not originally borne by the company unless regulations or other pressures force it to internalize the cost.

For corporate finance, this means:

• Capital budgeting: Expected cash flows from projects must reflect ESG-related costs (e.g., carbon pricing, remediation costs) and opportunities (e.g., demand for green products).
• Capital structure: Firms with weak ESG practices may face higher borrowing spreads or reduced access to capital markets.
• Cost of capital: Strong ESG performance can lower perceived risk, potentially reducing the cost of equity and debt. Severe ESG controversies can have the opposite effect.
• Working capital and operations: Supply-chain ESG risks (e.g., forced labor controversies) can disrupt sourcing or sales.

Environmental Factors

Material environmental issues include:

• Climate change and greenhouse gas (GHG) emissions.
• Air and water pollution.
• Resource use (energy, water, raw materials).
• Waste management and recycling.
• Biodiversity and land use.

Environmental factors affect both costs and revenues:

• Higher compliance costs, environmental taxes, and required capital expenditures (e.g., installing scrubbers, upgrading to cleaner technology).
• Physical damage or business interruption from extreme weather events.
• Shifts in customer demand toward low-carbon or environmentally friendly products.

Key Term: materiality (ESG)
The extent to which an ESG factor can reasonably be expected to affect a company’s financial position, performance, or business model and thus influence investor decisions.

Key Term: transition risk
The risk that company assets, products, or business models lose value as the economy transitions toward lower-carbon or more sustainable activities, driven by policy, market, or technological changes.

Key Term: physical risk (ESG)
The risk of loss or disruption to assets, operations, or supply chains arising from acute events (storms, floods, heatwaves) or chronic environmental changes (sea-level rise, long-term drought).

Transition and physical risks influence:

• Expected cash flows (through higher costs, lost revenue, or capex).
• Probability of distress (e.g., stranded assets in fossil fuel sectors).
• Required returns, as investors demand compensation for risk.

Social Factors

Social factors concern a company’s relationships with people:

• Employee relations: wages, working conditions, health and safety, labor rights.
• Diversity and inclusion in the workforce and leadership.
• Human rights in the supply chain and operating regions.
• Customer issues: product safety, data protection and privacy, fair marketing.
• Community relations: local employment, impact on indigenous or vulnerable groups.

Poor social performance can lead to:

• Legal liabilities (e.g., labor lawsuits, data breach fines).
• Production disruptions (strikes, boycotts, community protests).
• Reduced productivity and higher turnover.
• Reputational damage affecting sales and recruitment.

Well-managed social practices may support:

• Higher employee engagement and productivity.
• Stronger brand and customer loyalty.
• Easier regulatory and community approvals for new projects.

Governance Factors

Governance is both a separate ESG pillar and the mechanism through which environmental and social issues are managed.

Key governance aspects include:

• Board composition, independence, and skills (including ESG knowledge).
• Shareholder rights (voting structure, protection of minority shareholders).
• Executive compensation design and alignment with long-term performance.
• Audit committee strength and quality of internal controls.
• Policies on bribery, corruption, lobbying, and political contributions.
• Whistleblower protections and incident reporting.

Weak governance is associated with:

• Higher chance of fraud, misreporting, or misallocation of capital.
• Poor oversight of environmental and social risks.
• Higher volatility in earnings and cash flows, and greater downside risk.

Worked Example 1.4

Question:
A listed resources company suffers an environmental disaster due to a tailings dam collapse, leading to significant fines and reputational damage. Identify two ESG risks and which stakeholders are affected.

Answer:
The company faces physical risk (damage to assets and disruption of operations) and social and governance risks (harm to communities and questions about risk management and oversight). Stakeholders affected include shareholders (through lower valuation), creditors (higher risk of default), employees (job and safety concerns), local communities and governments (environmental and health impacts), and the natural environment itself.

ESG Incorporation in Corporate Finance Decisions

Analysts increasingly include ESG factors in financial models rather than treating them as separate qualitative comments.

Linking ESG to Cash Flows and Discount Rates

When valuing a project or firm, ESG factors can be incorporated as follows:

• Adjusting cash flows:

  • Include expected costs of compliance, carbon pricing, remediation, or penalties.
  • Reflect changes in demand (e.g., higher sales of sustainable products or loss of customers after a controversy).
  • Model scenario-specific capex (e.g., investments in cleaner technology or data security).

• Adjusting discount rates:

  • If ESG risks increase uncertainty or downside risk, investors may require a higher expected return (higher cost of equity or credit spread).
  • Conversely, firms with robust ESG practices and stable business models may be perceived as lower risk, reducing their cost of capital.

• Capital allocation:

  • Boards may prioritize investments that improve ESG performance (e.g., energy efficiency) when they have positive net present value (NPV) and reduce long-term risk.
  • Non-financial constraints, such as emissions targets or social commitments, may influence which projects are acceptable.

Worked Example 1.5

Question:
A utility company is considering two mutually exclusive projects:

• Project A: Build a new coal-fired power plant with higher short-term profit but high future carbon tax exposure.
• Project B: Build a renewable energy facility with lower current returns but minimal emissions.

Assume both have similar risk-adjusted financial NPVs when ignoring carbon pricing, but there is a high probability of stricter climate policy. How might ESG considerations influence the decision?

Answer:
ESG analysis would highlight significant transition risk for Project A, including potential future carbon taxes, stricter regulation, and reputational damage that could reduce cash flows or force early closure. Incorporating these ESG-related cash flow adjustments would likely reduce the true NPV of Project A. Project B, with lower exposure to climate policy risk and potentially improving demand for renewables, might have a higher risk-adjusted NPV when ESG factors are included, making it the preferable project.

ESG Reporting and Analyst Use of Disclosures

Companies increasingly provide ESG disclosures alongside financial statements, either due to regulation or investor demand.

Common elements include:

• Narrative disclosure in management commentary:

  • Discussion of material ESG risks and how they are managed.
  • Description of governance structures for ESG, such as board committees.

• Quantitative metrics:

  • Environmental: GHG emissions, energy and water use, waste and recycling.
  • Social: employee turnover, injury rates, gender diversity, training hours.
  • Governance: board independence, attendance, executive pay ratios.

• Targets and performance:

  • Emissions reduction goals, diversity targets, safety improvement objectives, and progress updates.

ESG reporting may follow frameworks or standards (jurisdiction-dependent), but at Level I you are not expected to learn specific frameworks in detail—only to understand that comparability, consistency, and materiality are key concerns.

Analysts use ESG information to:

• Refine forecasts of revenue growth, margins, and capital expenditures.
• Assess risk of fines, litigation, or regulation tightening.
• Judge management quality and risk culture.
• Identify potential rating changes and cost-of-capital shifts.

Exam Warning:
Companies may treat significant ESG-related costs as “externalities” (not recognized on financial statements). However, as regulations and stakeholder expectations tighten, these costs are increasingly internalized. In exam questions, be prepared to adjust your analysis when a case mentions potential carbon taxes, remediation costs, or social liabilities that are not yet reflected in reported numbers.

Revision Tip:
Mapping ESG factors to stakeholder groups can aid memorization. For example, climate risk affects shareholders (valuation), creditors (default risk), employees (health and job security), communities (environmental impact), and governments (policy response).

Summary

Effective corporate governance and stakeholder management underpin the long-term value and stability of companies. By clarifying stakeholder interests and recognizing patterns of agency conflict, analysts can better understand how boards and management should be structured, monitored, and incentivized.

ESG factors have become important to corporate finance. Environmental, social, and governance issues can materially affect company cash flows, risk profiles, and hence valuation. Transition and physical climate risks, social controversies, and governance failures can all increase the cost of capital and threaten solvency, while strong ESG practices can support financial stability and access to funding.

For CFA Level I candidates, the key is to connect governance structures and ESG information to core financial analysis: capital allocation decisions, risk assessment, and interpretation of disclosures and controversies.

Key Point Checklist

This article has covered the following key knowledge points:

• The purpose and principles of corporate governance and stakeholder management, and their link to long-term value creation and risk control.
• Identification of key stakeholder groups, their primary objectives, and the nature of their claims on the firm.
• The distinction between shareholder theory and stakeholder theory, and how they may align in practice.
• The agency problem and common principal–agent conflicts in corporate governance.
• Internal and external governance mechanisms, including independent boards, regulation, audits, creditor oversight, and the market for corporate control.
• The definition of ESG factors, types of ESG risks (transition, physical, social, governance), and their pathways to financial impact.
• How ESG considerations are incorporated into corporate finance decisions, capital allocation, and valuation (cash flows and discount rates).
• The role of ESG reporting, materiality, and controversies in influencing analyst forecasts, credit assessments, and the cost of capital.

Key Terms and Concepts

• corporate governance
• stakeholder
• shareholder theory
• stakeholder theory
• principal–agent relationship
• agency problem
• performance-based compensation
• independent director
• ESG (Environmental, Social, Governance)
• negative externality
• materiality (ESG)
• transition risk
• physical risk (ESG)