- “Environmental, Social, and Governance” reporting frameworks are being embraced by global businesses as they seek to meet a growing array of expectations that “what is good for business should be good for society and the planet.”
- Significant risks are growing for companies and organizations that ignore or overstate their commitment to ESG principles and standards.
- Business leaders should determine whether their organization has internal processes to ensure it has robust transparency, accountability, and monitoring controls in place—especially to avoid ‘greenwashing’ schemes which have become an increasingly prevalent risk in the global marketplace.
- Organizations that proactively move toward the highest denominator will be best positioned to attract investment and avoid negative publicity, enforcement and/or shareholder actions, and internal strife, including from whistleblowing.
Blue Star Strategies: What is “ESG” and how and when did ESG-consciousness emerge?
Charles Di Leva: ESG refers to Environmental, Social, and Governance reporting frameworks and standards relevant to an organization’s sustainability- and financial-related disclosures. There is no universally agreed definition of ESG and the precise details of ESG expectations can vary depending on the context and sector in which it is being applied or to which standard-setting body the organization is reporting. In this respect, there have been complaints about an “alphabet soup” of many different ESG-related standards bodies. To that end, efforts to consolidate ESG criteria and reporting standards are currently underway, including as announced in Glasgow at the 26th UN Climate Change Conference, or “COP 26.”
ESG-consciousness emerged out of a growing belief that financial investment and business should be “sustainable,” “green,” “ethical,” and/or “socially responsible.” ESG is an evolution of “corporate social responsibility” known as “CSR.” Particularly during the 2002 World Summit on Sustainable Development and the 2015 UN Sustainable Development Goals, businesses began to embrace the concept that “what is good for business should be good for society and the planet.” The UN Global Compact for business and discussions around sustainability at the World Economic Forum (WEF) are precursors to today’s ESG.
BSS: Can you breakdown the ‘E’, ‘S’, and ‘G’ of ESG? What are the most prominent individual indicators of ESG?
CDL: Environmental indicators focus on greenhouse gas emissions, water pollution, water and energy and consumption, hazardous and solid waste generation, biodiversity impacts, (including impact of forests and protected areas and species), and compliance records. Social indicators focus on workplace health and safety, labor rights including avoidance of child and forced labor, workplace relations, diversity and gender policies, and relations with local communities, including with disadvantaged and vulnerable groups. Governance indicators focus on transparency, accountability to boards and shareholders, stakeholders and regulators, anti-corruption practices (especially when operating in certain developing countries), and accounting, compliance, monitoring, and reporting systems.
With COP 26 underway, indicators related to organizations’ greenhouse gas emissions and climate-related risks and impacts from and to their operations are prominent. With many organizations claiming that they are offsetting their climate impact, it will increase requirements on how offsets are verified and to ensure there is no “double counting.” In part to address this risk, there are huge expectations that the COP will finalize the “Paris Article 6 Rulebook” that will establish integrity for the carbon market.
BSS: As much as it is helpful to understand what ESG is, is it also helpful to define ESG by what it is not?
CDL: Aside from recent EU regulation, most ESG reporting is currently voluntary. Failure to report ESG data to a sustainability reporting service such as the Global Reporting Initiative (GRI), is not the same as environmental data required under a government issued permit, although the kind of data requested in each case may be similar. Voluntary ESG reporting is also not the same as the requirements that U.S. businesses have to report on “material” environmental risks under the U.S. Securities and Exchange Commission (SEC) S-K regulations, Item 101.
However, when one looks at the EU ESG Action Plan with its Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy, there is a growing and complex set of legally binding requirements being issued by the EU that have the potential to make such ESG-related reporting legally binding beyond the EU borders. The U.S. SEC is aware of this potential impact and has proposed to enhance its ESG related requirements, particularly those related to climate reporting, and an extensive notice and comment process is now underway.
Moreover, the SEC has issued a sample letter of what it might require in the future. With these proposals, it is clear that the context of what is considered legally “material” is expanding, especially related to an organization’s climate footprint and, in some cases, its supply chain.
BSS: What explains today’s high demand and urgency for ESG practices, principles, and standards?
CDL: Every year, more investors understand the value of “ESG investing.” Thus, many organizations see the need to claim that they or those that they support will be “carbon neutral,” environmentally and socially responsible, and are meeting human rights principles. ESG reporting will be essential to validating the credibility of such claims. Investors have also seen that failure to address ESG criteria may lead to consumer boycotts or pension fund divestment. Moreover, NGOs, a growing numbers of shareholders, and the media are increasingly pressuring investors to shun entities that do not report and/or conduct their business operations in accordance with ESG standards.
BSS: Some have called 2020 a pivotal year for ESG. Do you agree with that?
CDL: Yes, but the Glasgow COP means that 2021 is not far behind! 2020 saw an extensive embrace of ESG with the European Commission and leading international standards-setting bodies committing to act to support ESG investment. Leading investment houses such as BlackRock and Goldman Sachs launched ESG related products that took in billions more in 2021. At the COP on November 3r, the IFRS Foundation announced the launch of the International Sustainability Standards Board (ISSB) with the support of major ESG framework and standard setting entities. The ISSB will operate alongside the International Accounting Standards Board (IASB) to promulgate and oversee accounting and sustainability standards related to financial disclosure for a number of different industry sectors. The IFRS announcement claims to be satisfying “the growing and urgent demand for streamlining and formalizing corporate sustainability disclosures.” The ambition of these actions is to move away from fragmented ESG standards and create a uniform baseline that jurisdictions can also adopt, if they choose, as regulatory disclosure requirements.
BSS: In what ways is the ESG landscape is evolving?
CDL: Advocates for ESG reporting see it as a logical partner to financial reporting. In the U.S., standard accounting principles cover assets and liabilities based on GAAP (“Generally Accepted Accounting Principles”) and include environmental factors only when seen as a material risk, such as the U.S. SEC 10-K on environmental assets and liabilities. Going forward there will be an increasing consensus that a company’s value proposition and bottom-line are about more than ‘money in, and money out’ and that a growing array of environmental, social, and governance criteria should also be seen as material. It is also evolving to become less fragmented, as noted above with actions such as those of the IFRS.
BSS: What are some of the more prominent regulatory and oversight bodies, institutions, and mechanisms that have the most traction in impacting the ESG landscape? Are there legal and/or otherwise binding requirements involved? Are there particular challenges to the standardization of ESG principles?
CDL: At this point, the ESG dialogue on regulation is focused mostly on the EU and the rules emerging from the European Commission. But, as noted above, the SEC is considering adding to the current 10-K reporting requirements to broaden those areas that some investors and the public see as “material” and critical for the future. The SEC also recognizes the importance of harmonization for such standards. Some businesses and government entities have argued that new proposed ESG-related reporting requirements under consideration by the SEC will be costly and difficult to measure and harmonize. It would not be surprising to see legal challenges to the proposed promulgation of such rules. Indeed, one of the reasons that IFRS launched its efforts to develop the ISSB was to reconcile the number of different ESG-related reporting frameworks and standards.
BSS: What are some of the notable differences between how public sector actors compared to private sector actors are engaging in the ESG space?
CDL: Publicly traded companies may face heightened scrutiny and diligence requirements depending on their jurisdiction. This is evident in the kinds of actions being taken in the EU and considered in the U.S. It is important to note that EU requirements have potential consequences for non-EU entities that wish to transact within the EU. Potential obligations may also differ depending on the size of the organization, with small and medium size enterprises likely to have fewer reporting burdens.
BSS: When it comes to ESG, are there corporate “best practices”? What about “greenwashing”?
CDL: I think this area is evolving but certain practices can help a company become more confident that it is headed in the right direction and avoid “greenwashing.” For example, companies that claim that they are offsetting their carbon emissions can choose between offsets that are easier to monitor and verify, with options to insure against impermanence. On the social side, a company that wants to avoid the risk of forced or child labor in its supply chain may, among other things, engage skilled staff to engage with the local communities in a form and manner they understand and to have reputable third-party monitors to report and verify its suppliers’ operations. It should be confident that these monitors are credible and convey their views independently and on time.
BSS: What organizations or businesses are most active in the ESG space and/or have had the greatest impact?
CDL: When you consider the billions in ESG-related funds set up by investment houses such as BlackRock or pension funds like CALPERS, financial firms have significant influence on the ESG related trajectory of many large organizations. University endowments are increasingly doing the same. Stock exchanges that list “green” companies can create incentives for companies to become more sustainable and thereby enhance their investment prospects. Rating agencies also have influence by highlighting the sustainability of certain investment offerings. That Tesla, as the largest publicly traded company, is associated with a climate-friendly vehicle shows the impact of ESG perception. Clearly, “impact investing” can support sustainability if it is based on sound operations and verifiable reporting.
On the public sector side, regulatory agencies like the SEC have the highest potential for impact. EU action on the sustainable finance disclosure regulation is also leading the way on ESG criteria. Multilateral financial institutions such as the World Bank Group and a growing number of development finance and bilateral aid agencies are also influencing their clients. Their contributions include large-scale issuance of “green” or “social” bonds, insisting that their total funding have a high percentage dedicated to climate co-benefits”, and helping “green” emerging market stock exchanges.
BSS: Which businesses have failed or otherwise learned hard lessons in the ESG space?
CDL: Airlines have been alleged to have exaggerated their carbon offsets. Chocolate companies that claimed their supply chain avoids child or forced labor have been sued by groups claiming this is not the case. Clothing and textile businesses, cotton producers, and sugar industries have all been charged with violations of human rights, health, and safety practices. Pharmaceutical companies are alleged to prevent access for the poor. There are also highly publicized reports of ESG funds investing in fossil fuel companies or agro-business linked to Amazonian deforestation, including in situations where certification organizations were shown to have falsely certified compliance.
BSS: What risks or pitfalls do companies and organizations incur by ignoring or otherwise not prioritizing ESG principles and standards?
CDL: The cost of capital for a wide range of entities that ignore ESG principles and standards will become more expensive over time. This risk may not be linear, but the long-term trend is going in this direction, especially for investments or businesses that have an ESG-related impact. Those that wait to adjust will find it more expensive and may face an increasing number of advocacy organizations that can launch public relations campaigns or legal actions against companies they perceive to be the cause of environmental or social damage. These may include shareholder actions. It may also make it harder for such companies to meet government procurement requirements that will disfavor awards to those with poor track records.
BSS: What new or emerging opportunities do you see as particularly opportune in the ESG landscape?
CDL: ESG-friendly businesses may find it easier to attract capital and recruit talented employees. They may find their products more marketable and lower the cost of adjusting to the steady growth of ESG related rules or guidelines. There will also be a role for those who advise organizations on how to meet the essential elements of ESG and to avoid being accused of greenwashing. SEC Chairman Gensler stated that one reason the SEC is working toward clearer ESG related guidelines is to help investors avoid getting lured into greenwashing schemes and the SEC has provided information on this issue.
BSS: How would you advise an organization that wants to get involved in the ESG space? What actions or steps should it pursue?
CDL: First, it is critical that a company engage its senior leadership from across its legal, financial, managerial, operational, and communication departments. A broad and diverse internal team should be assembled to understand what aspects of major ESG frameworks and standards are relevant to its particular operations and industry and how to assemble a report that will be clear, credible, and practical for replicating in the future. This exercise will often reveal areas ripe for change. A diverse team can help ensure there is a more candid view of the company’s strengths and weaknesses. The organization may want to engage an outside advisor to provide a critical eye over of their ESG systems. This engagement can include identifying environmental and social risks and impacts such as those related to human rights, labor, diversity, gender, and community outreach. Organizations should also see if there is a trade association to which they can associate whose members follow ESG reporting. If not, can they become a leader in doing so and use this approach to drive positive change?
Some organizations may already have a head start if they have internal management systems, such as from the ISO Series related to environmental and social management and sustainability. This may help them ensure they have the right degree of transparency, accountability, and monitoring controls in place. Depending on the jurisdiction, an organization may want to also seek outside legal counsel. For example, if an organization outside the EU will be transacting business inside the EU, a legal analysis of the potential impacts of the EU SFDR can be useful. The same may be true for the impact of the potential SEC action in the U.S. Clearly within the EU, the sophistication of the regulatory framework may lead some entities to realize they need expert analytical support.
BSS: Do you have any concluding thoughts or recommendations when it comes to ESG?
CDL: There is no going back on increasing ESG-related scrutiny faced by financial institutions and companies. The internet, satellites, drones, and other technologies together with increasingly dire scientific observations mean that regulatory scope and stringency will continue to trend upward. Those organizations that move toward the highest denominator and embrace transparency and accountability will be best positioned to avoid bad publicity, enforcement actions, and internal strife, including from employee whistleblowing.
I believe there will be a continuous increase in ESG “carrots and sticks.” Any organization raising public or private capital will face more demand to act in consistently with a range of global objectives, even those that are not legally binding. Ever-increasing transnational implications will require many such organizations to expand the scope of supply chain review beyond their direct control.
In closing, the ISSB’s newly released “Prototype International Financial Reporting Standard” provides a pithy summation for the increasing importance of ESG consciousness in for today’s global enterprises:
“The objective of sustainability-related financial disclosures on risk management is to enable users to understand how an entity’s existing and emerging sustainability-related risks are identified, assessed, managed and mitigated and whether those processes are integrated into existing risk management processes. Such information supports users of sustainability related financial disclosures in evaluating the organisation’s overall risk profile and risk management activities.”