Ed. note: Today’s post is courtesy of Advisory Board Member Donato Calace and his colleague Susanne Katus – both from ESG IT service provider Datamaran. This is a two part post – today, they explain their views of what has changed in recent months that is shaping ESG policy. Tomorrow, they offer recommendations for addressing change today and for the future.
Until recently, Environmental, Social, & Governance (ESG) has been defined mostly by voluntary practices, as key policy makers (market authorities as well as national and international regulators) adopted a ‘sit and stare’ approach – letting markets decide how to deal with ESG. The tide has turned, with jurisdictions now racing to introduce strict requirements that bind companies to contribute to public policy goals governments are setting in relation to climate specifically, and ESG more broadly.
These developments have deep implications for companies, investors, and financial markets. Let’s look at five main policy trends that are significantly reshaping business:
- No more ESG standards alphabet soup. While new niche frameworks and guidelines will always pop up (let’s keep in mind that ESG evolves constantly), the European Union (EU) mandatory Sustainability Reporting Standards, and the International Financial Reporting Standards (IFRS) International Sustainability Standards Board (ISSB) are standards every company will have to look at. Consolidation of these standards is important, but it’s not the end game. Companies need to take ownership of the issues on which they will act and have a credible process to justify why and how relevant standards – and there will continue to a variety of relevant ones to use – facilitate accounting and reporting.
- The era of ESG taxonomies has begun. With mandatory standards and public policy goals, jurisdictions can’t afford leaving grey areas in terms of what ESG actually means. The EU was the first to launch a taxonomy defining which science-based technical thresholds and activities are sustainable and which ones aren’t, and now other taxonomies are emerging in Canada, China, in the United Kingdom. It can be expected that in 2022 the United States will take a similar path triggered by revising the investment fund name rule that US Securities and Exchange Commission (SEC) Chair Gary Gensler mentioned in his statement before the Financial Stability Oversight Council.
- Enforcement. Market watchdogs are sharpening their vigilance tools. Most recently, the International Organization of Securities Commissions (IOSCO) endorsed the IFRS ISSB. The European Securities and Markets Authority (ESMA) – essentially the European SEC – stated that their priorities include “consistency between the information disclosed within the IFRS financial statements and the non-financial information concerning climate-related matters, consideration of climate risks, disclosure of any significant judgements and estimation of uncertainty regarding climate risks while clearly assessing materiality.”
The US SEC published a sample letter asking companies for more clarity about their disclosure practices in relation to climate risk. The letter flags inconsistencies across report types as a potential red flag – why is a material risk in a company’s standalone ESG/sustainability report not covered to the same extent or at all within the 10k?
More recently, Gurbir Grewal, the SEC’s Director, Division of Enforcement, said that companies “omitting ESG” can potentially be in serious trouble. It’s not about misleading or false information pertaining to ESG content; it goes one step further to address corporate silence on ESG. Companies need to prove that nothing material has been omitted, and they can do that by disclosing their process for determining material risks and opportunities.
The SEC is focused on misleading information, too. Take the Allbirds example, a shoe company that had ambitions to be the first “sustainable IPO.” It dropped this claim before trading this month, under pressure from the SEC and environmental critics.
- Technology is key to strengthening internal controls. A recent report by the EFRAG Task Force on reporting risks, opportunities and linkages to the business model (PTF-RNFRO) summarizes good ESG practices. It unpacks the crucial role technology solutions play beyond ensuring data quality and comparability (on the latter, the Corporate Sustainability Reporting Directive, or CSRD, proposal adopted by the EU Commission includes the use of XBRL for data tagging). Optimizing the use of available technologies, particularly Artificial Intelligence (AI) and Natural Language Processing (NLP), also ensures a data-driven and auditable approach (i.e. reliable and verifiable) to risk identification and reporting, while enabling timeliness, connectivity of ESG and financial information, stakeholder inclusiveness, strategic focus, and future orientation. In short, it’s best practice.
- Next in line: ESG ratings. With black-box methodologies and poor correlations among their scores, ESG ratings are the next in line for regulation. ESMA has already asked the European Commission to take regulatory action on ESG ratings to ensure transparency, avoid conflict of interest, and better ratings for the benefit of market participants. As seen for other policies – ESG standards, taxonomy – it can be expected that other jurisdictions will follow.
Tomorrow we will look at what this means for companies now and in the future.