Firms must make a focused effort to explain and backstop their environmental, social and governance (ESG) initiatives and provide the steps they have taken or will need to take to achieve their goals. Telling the right ESG story in the current environment requires adequate and accurate disclosures both on performance on ESG-related accounting and activity metrics as well as the underlying methodologies, policies and procedures employed.
A best practice methodology includes conducting materiality assessments and measuring the amount of ESG risk and its impact on valuations and operations in both routine and stressful environments. A thorough materiality assessment is an introspective look into a firm that allows it to accurately form its ESG narrative and identify areas where it might improve or would like to further develop.
Most respondents in our survey appear confident that they are telling the right ESG narrative, either agreeing or strongly agreeing that their ESG/Sustainability story is an accurate representation of their activities and mission.
Given the importance of ESG as a mechanism for disclosing and communicating companies’ journeys and performance on sustainability issues, that should be a promising development. However, our survey also confirmed that most companies still feel challenged by the issues of standardization and data integrity that primarily relate to storytelling. That raises concerns that might belie the accuracy and adequacy of their ESG stories and whether they are focusing on the right factors.
Although survey respondents appear to feel confident in the accuracy of their ESG stories, they also state that they continue to face challenges and issues around methodological standardization and data collection, among other issues.
In other words, despite the arguably clearer picture in the current environment, firms continue to struggle with the underlying methodologies and data that enable adequate disclosures of the ESG story. Perhaps that is partly a function of legacy issues from the past decade’s confusion and uncertainty. However, it may also be influenced by heightened temptations to meet “middle-of-the-pack” ESG disclosures and practices and avoid standing out, but while minimizing anticipated costs associated with complying and aligning with current norms. Companies may find it easier to embrace and disclose an unreflective slew of ESG factors and metrics with limited relevance, just to quickly appease certain internal and external stakeholders or align with competitors. However, that approach to ESG is an increasingly risky proposition; current improvements around standardization and heightened scrutiny also means the risks and potential consequences of improper ESG disclosures have also meaningfully increased. Technology is improving the ability to ask standardized questions and gather responses across a portfolio of assets. This enables the highlighting of outliers and risks against a benchmarked view. Technology is not only enabling easier collection of data, but also the continuous assessment of indicators to allow for real-time status of risks.
Green Crimes
Environmental crimes are rarely spoken of within the scope of financial crimes, despite the effects being just as damaging as more commonly recognized forms such as fraud. Until recently, environmental crime was seen as a lower-risk activity for criminal networks, as governments across the world placed priority on tackling drugs, counterfeiting and human trafficking. Across many countries, light sanctions for environmental crimes alongside limited efforts to follow and remove the profits, made participating in such activities a lucrative source of income for criminals. A few examples of green crimes that firms need to be aware of include illegal logging/ trade, trafficking of protected species of animal and plant wildlife, smuggling precious metals and even waste management.
Currently, it is extremely difficult for firms to detect potential environmental crimes as there is no specific criteria of what to look out for or a blacklist of companies that are known to engage in illegal activities related to environmental crimes. However, there are key indicators that should ring alarm bells for firms about the legitimacy of a business and the potential for green crime activity. The main aspect to look out for are potential major inconsistencies, (for example, boards with no experience in the industry in question or companies that hold significantly higher profit margins than others within the sector). This requires an element of proactivity and good industry knowledge to apply in each individual case. Proper due diligence is the best way to identify potential risks associated with green crimes or other ESG-related activity.
The Consequences of Getting ESG Wrong
At a minimum, firms that fail to adopt proper ESG practices are likely to misallocate resources and focus on factors of less importance, undermining the point of ESG and its focus on real issues, including the enterprise’s social license to operate, the use of common capitals (or natural public resources) and the negative externalities created by its operations.
Firms that do not adopt current recommendations substantially increase the likelihood of greenwashing, fraud and abuse, either knowingly or unknowingly. Failing to adopt best practices and proper policies and procedures creates conditions for unintentional misstatements and errors. Failure to do so can initiate problematic situations involving outright fraud and criminal malfeasance, both by the organization itself and opportunistic third parties. For company insiders, incentives are extremely high to make statements that suggest excellence in ESG metrics or activities around the level of adoption of policies and procedures.
The Overlooked G in ESG
The governance pillar (G) is sometimes overlooked in the context of ESG programs when compared to its environmental (E) and social (S) counterparts, yet it is the fundamental basis of any ESG compliance program and the initial path to develop and implement any ESG, impact or sustainable investment strategies and priorities for a company. This means defensible, thorough and efficient controls both on the source of data and its analysis. Transparency and discipline also allow stakeholders to understand and balance the business decisions and trade-offs associated with a comprehensive ESG program. It is, in short, the common thread that weaves together all ESG efforts.
Governance is an essential component of managing ESG risks well. The G pillar includes factors such as independence of the board, shareholder rights, executive compensation, risk and control procedures, operational due diligence, anti-competitive practices, business ethics, fraud and respect for the law and regulations. Instances of weak governance invite shareholder litigation and regulatory action.
ESG and Data Standardization
By 2021, 86% of S&P 500 firms regularly issued some kind of ESG-related report, up from 35% of publicly traded companies in 2010, according to the Harvard Business School article. There is no one-size-fits-all solution to a company’s ESG program and although there has been some regulatory guidance and stakeholder pressure, standardization is still lacking. Certain jurisdictions will have different views of ESG and how critical it is to their business’ success.
Regulatory requirements and client, investor and consumer expectations will influence the ESG-related data that is collected. With a variety of ESG reporting frameworks and standards, many organizations are faced with the challenges of aggregating data from their suppliers or portfolio companies or even at their own corporate level. Adding to confusion is the lack of or limited data that companies have access to or are able to aggregate for their own reporting purposes. There is also a lack of verifiable and consistent data. Most firms have limited in-house resources, which may lead to improper and/or inadequate internal controls of their ESG programs. Solutions that bring ESG expertise in-house can be costly. And as with any regulatory framework, it may take time to bring staff up to speed with ESG regulation and reporting expectations. Technology solutions can be beneficial in helping companies standardize their ESG data aggregation, but many providers tend to simply aggregate data without providing meaningful reporting and benchmarking.
According to our survey results, 61% of respondents cited a lack of standardization as a key ESG challenge and 61% cited limited data as their key challenge. Firms concerned about litigation and enforcement risk, particularly in jurisdictions where the regulatory framework is not clear, should ensure that any limitations and weaknesses in data and disclosures are themselves fully understood and disclosed, including any applicable data gaps and methodological limitations. In-house or external counsel should review any related disclosures prior to their release to ensure alignment with applicable local disclosure rules and regulations.
ESG Risks and Rewards
As discussed above, transparency is often an effective balm for organizations working with murky data. Delivering on stakeholder expectations while working with uncertain data can be difficult, but truthfulness about the uncertainty, along with a strategy to improve it, is a better outcome than being accused of greenwashing.
Many global regulators are focused on ensuring that firms are adhering to their ESG commitments by providing proper disclosure and reporting to investors. In short, a firm can’t simply state its commitment to ESG without being prepared to provide evidence of adhering to those commitments. Documented compliance programs, data and an understanding of the data’s lineage, and transparency about the data’s limits will be required to respond to client and regulator inquiries.
Successful firms, and those that face the lowest risk, are dispassionately introspective while assessing themselves. They take due diligence, internal education and risk management seriously.
References
Harvard Business School “Are Companies Actually Greener-or Are They All Talk?” by Rachel Layne
Harvard Business School article
