As socially responsible investing has gone mainstream, regulators in Europe and the United States have stepped in and are now formalizing rules around disclosures pertaining to Environment, Social and Governance (“ESG”) claims. As a result, a broader audience is being captured by formal disclosure requirements as well as customer, employees, and investor requirements. For those companies who are just starting to consider these new requirements, don’t panic. ESG is a four-act play, and we are in intermission. Looming regulations, however, are flashing the lights that it is time to get back onto the stage.
Act 1: Socially Responsible Investors
The first act sets the stage. Enter the protagonist: socially responsible investing and the concept of ESG.
Socially responsible investing focuses on non-financial metrics that could have significant financial repercussions now or in the future. Sustainable investment funds were initially developed in the 1990s. In 2000, the World Resources Institute developed the Greenhouse Gas Protocols (“GHG Protocols”) to establish a set of rules for measuring and tracking carbon emissions. In the mid-aughts, the United Nations developed a working group with the big accounting firms to focus on how to pursue socially responsible investing in developing countries using many of the concepts now embedded in ESG criteria.
This early work evolved into broader applications with respect to private investors and the development of ESG-based investment funds. Equity analysts created ESG scores to assess the effectiveness of those funds. The growing adoption of ESG tenets in developing investment strategies, financial offerings, and quantified ESG rankings from financial reporting firms created the foundation for what was to happen next.
Act 2: Organizations and Their Stakeholders
The second act establishes the allies best able to help the protagonists overcome their limitations. Enter large corporations, investors, customers, employees, insurance companies, non-profits, and governments.
As demand for sustainable investing grew, investors found the niche market for their ESG funds becoming mainstream, motivating greater investment opportunities. Insurance companies realized the risk mitigation benefits of understanding ESG characteristics, increasing demand for ESG rankings and understanding of climate risk.
A broader set of companies developed their own climate action plans and marketed their sustainability goals in order to attract a growing pool of capital. ESG statements made by large companies began to proliferate, often as part of socially directed marketing campaigns. Some of those statements made their way into public presentations, less so into public financial statements. Realizing that certain investors were demanding metrics for ESG factors alongside financial measures, some of the large publicly traded companies began to track aspects of their sustainability, employment diversification, and regulatory efforts. Today, 96 percent of the S&P 500 firms and 81 percent of the Russell 1,000 publish sustainability reports in some form.
Some of the ESG claims tied to the environment include aspirational goals with long lead times as far out as 2050. For energy-intensive industries, those goals included shorter timeframes. Goals were and continued to be driven by stakeholders. Regulators noticed the proliferation of ESG claims, and investors indicated that they felt such claims were material, and therefore potentially subject to disclosure requirements. The U.S. Securities and Exchange Commission (SEC) proposed new rules to increase transparency, scheduled to be finalized before the end of this year.
The lights came on. The curtains fell. Intermission.
Intermission
The past year has experienced an intermission of sorts as various regulators have begun to issue their rules related to tracking and disclosure of ESG metrics.
The SEC delayed issuing their final rulemaking by a year to solidify recommended rules to align with its regulatory jurisdiction. The Federal government proposed a new rulemaking on carbon disclosures for vendors, that also has yet to be finalized. While both are imminent, the International Financial Reporting Standards (“IFRS”) – the international equivalent of Generally Accepted Accounting Standards (“GAAP”) – now includes standards explicitly pertaining to climate and sustainability accounting. The European Union encourages all of its members to adopt climate reporting requirements. Germany has specified carbon emissions and social reporting requirements, the UK has finalized carbon reporting for large companies, and Singapore is contemplating applying requirements to both listed and unlisted companies.
The next act is about to begin.
Act 3: Consultants and Law Firms
The U.S. is now in the third act where companies and investors, having faced their limitations, are ready to prepare for the upcoming challenge. Enter consultants and law firms to assist with corporate strategy, compliance, and implementation.
The new regulatory threat of enforcement begs for formal compliance programs and more formal support from the C-suite. Corporate efforts are turning to mitigating regulatory risk and preparing the firm for effective and ongoing implementation of ESG goals. Whereas marketing previously led ESG efforts, a new ESG or sustainability director, Chief Financial Officer, and/or General Counsel is now tasked with understanding, monitoring, and defending material ESG positions.
Corporate activities associated with realizing their ESG journey include:
At this point, motivation extends beyond the invisible hand of investors, customers, and employees to include the visible hand of government laws and regulations. This shift increases corporate requirements to one of operations, compliance and controls.
In a sense, a deus ex machina has appeared. Companies that already have navigated through their preparations and implementation may have a competitive advantage. Regardless of whether they have or have not earned higher returns, they now face reduced regulatory risk.
Act 4: Implementation and Achieving Objectives
The fourth act is where the protagonist implements what has been learned and earned to overcome the challenge. Having realized their limitations, enlisted allies, and addressed their weaknesses, the protagonists, with the help of their allies, are ready to face and conquer implementation.
Existing and new players come onto the stage to bring everything they have to offer. New characters include energy companies, clean energy technologies, big data, blockchain, artificial intelligence, insurance companies, human resource experts, governance experts, and many other parts of the economy required to make corporate responsibility and the energy transition cost effective and efficient.
As with every story, the protagonist may be transformed. It may be that the acronym of ESG could change to reflect something new. However, the journey has brought different aspects of the market that now incorporates ESG concepts (regardless of the name du jour) into its business operations. The protagonist will be able to declare victory and succeed.
The Grand Finale
How will your ESG journey end? As with every story, there is a constant retelling. Just as competition requires companies to constantly improve and innovate, the transition to a sustainable, circular economy will continue to be told in ways we can only imagine. Grounded in standard approaches, however, success can be realized with a standing ovation.
