Stumbling in the ESG stampede| RiskMap 2022

TOP RISKS: REPUTATIONAL

Stumbling in the ESG stampede

Maria Knapp | Partner & Steve Wilford | Partner

In 2022, companies will be under pressure to intensify their activities on climate leadership and responsible citizenship, as governments cascade environmental, social and governance (ESG) commitments to the private sector. The idea of putting ‘people and planet’ at the heart of business is no longer theoretical. Investor pressure, activist shareholders, regulatory action, consumers and governments scrambling to make up for lost time on climate action are all hitting companies hard.

We are in a historic moment: aware they are late to the game, governments are retaking the initiative and competing to display the required leadership on this issue. The recently concluded United Nations Climate Change Conference – COP26 – will be viewed as a historical marker when governments raised the bar and, in turn, obligations on companies. The geopolitics, too, of ESG will become increasingly charged as accusations of dressing up protectionist policies in the rhetoric of ESG begin to fly. Add in the drive among governments to seek economic advantage from the energy transition and the stark reality is clear: the number and power of stakeholders, and risks, in the corporate ESG ecosystem is at an all-time high. 

Climate-related issues increasingly referred to as headline-grabbing ‘climate-crisis’ in social media

 Are you ready? In order not to fall behind, the next 36 months will be critical for businesses to take the decisions that enable them to adapt and thrive in the long term. That means three things: hyper-investment in ESG activities; measuring impact not just policies; and not losing sight of social and governance issues alongside the headline-grabbing climate risk.

All businesses are on the frontline and their reputation is at stake. Companies that do not set bold targets will score poorly on sustainability indices and lose out on more favourable sustainable financing options. Companies that do not consider their full range of stakeholders will be criticised for being out of step. The persistent suspicion of greenwashing or window dressing will stalk every company’s action plans.

But in reality, the issues under the sustainability umbrella are not easily resolved and there are myriad trade-offs to be made. For instance, investing in carbon offsets might exacerbate social problems in the emerging markets in which those offsets are generated. Most companies still need to invest in technology solutions to support their sustainability disclosure and reporting, and to develop new organisational skills and infrastructure to manage their sustainability commitments throughout their operations and supply chains.  

Invest, invest, invest  

In 2022, businesses will enter a period of hyper-investment in ESG.

Companies are racing to bring in resources to set, measure and monitor sustainability commitments. The market for data analytics and AI-led tools for retrospective and predictive ESG reporting is due to double in the next five years. Underpinning those tools should be employees and business leaders who have the right skills to drive sustainability strategies and really test your performance. The market for talent is on fire and organisations are competing hard to attract the right people.

Companies globally are in a race to acquire ESG skills to meet the corporate sustainability challenge

 Next comes performance: set clear and auditable metrics to monitor performance, but understand that true risk and impact measurement should go beyond data gathering. Seeing the full picture through consultations with external and internal stakeholders will help you make an accurate assessment of your performance and take informed decisions about inevitable trade-offs.

But the real risk now is over-relying on data for reporting purposes that is often weak, unsupported, or just imperfect.

There are two reasons for this. First, there is a significant reputational risk from whitewashing, greenwashing, all colours of washing. The centre of gravity for the anti-greenwashing movement is the European Commission’s financial and non-financial disclosure regulations. The trading bloc was first big economic player out to introduce a Green Deal as part of its long-term economic performance strategy. Despite some delays, the regulations introduced so far set the standard for international best practice. Its initiative on substantiating green claims, as part of the suite of climate and human rights disclosure regulations, is a bellwether. The Securities and Exchange Commission in the US is following a similar path. US and German securities regulators have already issued significant fines to investors for misstatements about their green products. There is ambiguity around expectations, but there is a move towards more regulation from governments – in fact, companies have recently repeated calls for unified international regulation – and away from the wild west of multiple standards, which can be a costly headache for companies to comply with. Being caught out by activists is one thing, being hit by the SEC is quite another and can trigger significant litigation exposure.

Sustainability scandals in the media hit stock prices directly, and hard

Negative impact of sustainability scandals on stock price outweighs impact of positive sustainability profile

 Second, companies’ biggest reputational risk exposure is too often in their blind spot: their value and supply chains. For example, major polluting industries buy carbon credits to offset their emissions and the money goes to fund clean energy projects in emerging markets like Vietnam, India and Indonesia. However, the expansion of green energy deployment in countries with weak environmental and social standards has come with trade-offs, including human displacement and land disputes. Most Asian governments have fast-tracked large scale renewable energy projects in a bid to court green investors, without due consideration or assessment of their long-term environmental impacts. Such policies will exacerbate ESG risks in the clean energy supply chain. For global investors and companies making their net-zero pledges now, failure to adequately identify and address the full breadth of ESG issues associated with their offsetting strategy will invite accusations of peddling false solutions. It will also have immediate reputational, operational and legal repercussions. 

After E come S and G 

Many companies already have climate at the top of their agenda, but actual changes in companies’ climate footprints tend to be longer-term goals with 2030 or 2050 targets. In the meantime, social and governance issues are attracting renewed scrutiny and shareholder, employee and consumer engagement.

We know from years of compliance activities focused on governance, including anti-bribery and corruption, fiscal transparency, and financial crime, that good governance is all about culture. It takes time. It requires the right incentives and constant oversight. Where possible, companies will need to weave social and governance issues into the risk management systems and the ‘new’ day job of current corporate functions. Some of those functions some may need to be restructured and ‘modernised’ to be up to the challenge. 

Social and governance performance are not just ‘soft’ concepts. Taxonomies are being better defined now to capture what is expected of companies, including in the areas of DE&I, labour standards and information governance. For instance, disclosure on labour rights, human rights and diversity is increasingly becoming law. The EU and several of its member states  have introduced disclosure and monitoring obligations on companies related to modern slavery in their own activities and the activities of their suppliers and subcontractors. The same trend for regulating social performance is happening outside the EU. For instance, California's gender parity law, in effect since 2019, requires public companies to elect at least one female director to the board. Similarly, India's market regulator is in the process of implementing new rules on diversity performance metrics for listed companies.  

This is a time of transition 

Although we cannot yet see the endgame, we do know that changes are happening fast. Companies striving to grasp the complexities of ESG implementation are already being scrutinised by their investors, regulators and consumers on how they act and adapt. The result is a transition risk of not moving with the times, not appealing to the right stakeholders and not getting it quite right. There are still sceptics who decry the ESG dynamic as a passing fad, but the trend is clear: companies’ reputations are at stake and inaction poses the greatest risk of all. 

 

Rising to the new ESG dynamic: five things to consider

  • A tailored risk assessment that includes quantitative and qualitative information on material risks throughout your value chain, identifying all hotspots.
  • Retrofitting your existing exposed critical assets/production processes with better technology/equipment to make them more ESG resillient.
  • Making ESG considerations front and centre in new market expansions/business development, going beyond traditional concerns such as cheap labour, manufacturing costs and low tax.
  • Accepting that taking ESG seriously costs money and will require business leaders to go beyond short-termism and manage shareholder expectations on company financial and sustainability performance. The value to be gained from this strategic approach could be considerable.
  • Realising that the technology of measurement and the public's understanding and scrutiny of it is moving extremely fast. Presume a timeframe and then halve it.

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