ESG & the Regulatory Environment

Three things financial analysts need to know for 2023 and beyond

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A rising focus on corporate Environmental, Social, and Governance (ESG) performance is rapidly changing the regulatory environment and associated stakeholder expectations for businesses around the world. Investors, analysts, directors, and management teams alike are seeing the need to apply an ESG lens to virtually every decision-making process — from where to deploy capital and who to partner with to which new markets to enter. 

In terms of the emerging regulatory environment, three key topics are thematically consistent across global ESG disclosure regulations. These regulations boil down to the following: human capital management (HCM), ESG Fund parameters, and climate risk management. 

Each topic is included, in some shape or form, across ESG disclosure regulations specific to key global markets such as the United States, the EU, China, Singapore, the UK, and more. These regulations are rapidly changing what disclosure information is required by law and, in turn, changing the due diligence process and associated context for financial analysts worldwide.

Learning about ESG and not sure where to start? Take CFI’s free Intro to ESG course and get an overview of the framework. 

The #1 ESG Issue People Care About Isn’t Climate — It’s People

According to Just Capital, an ESG research and rating non-profit, the #1 issue the public cared about in 2021 wasn’t climate change, it was employees — and the 2022 data are pointing in a similar direction. The regulatory environment (and the people working on these policies and standards) have followed suit.  For example, the United States (US), the European Union (EU), and Singapore have incorporated disclosure requirements for public companies regarding their HCM practices and performance. Namely, these regulations are the “Human Capital Disclosure Rule for Public Companies,” “the Non-Financial Reporting Directive,” and the “Enhanced ESG Disclosure Regulations for Investment Funds Trading.” 

Now, what exactly is HCM?  HCM is broad in nature and refers to all things “people” within a company or an organization. Key HCM topics include talent management, compensation and benefits, diversity, equity, and inclusion (DEI), and many more. These regulations require the public disclosure of a company’s organizational development practices, programs and benefits, upper management demographics, and employee engagement, retention, and development strategies. 

Ultimately, a business is run by people. Those people need to be led and managed effectively toward a common goal in order for a business to be successful. Measuring HCM performance is imperative.

While HCM affects all stakeholders, investors and analysts should pay special attention to a company’s human capital management strategy. According to Accenture, human capital risks are those which negatively affect a company’s ability to be organizationally resilient in the long term. It directly affects the costs associated with employee turnover, retention, litigation, and whistle-blowing. A structured human capital strategy will mitigate these potential risks while increasing the company’s resilience in managing change. Increased resilience and employee engagement will lead to greater productivity, profitability, and overall longevity.  This directly influences an investor’s returns and fiduciary responsibilities to their clients.  The bottom line is, there’s a compelling case to be made that investors should seek out companies with active and methodical human capital policies, practices, programs, and performance measures.  This will ensure both compliance with respect to disclosure regulations and a more sustainable advantage over industry competitors.

As a company, building a strong human capital strategy that encompasses all areas mentioned above is key to long-term success. In the time of the “Great Resignation” and “Work from Home” (WFH), employees have more employment choices and are demanding more flexibility than ever before. Given these realities, it’s critical to address these concerns around people practices proactively.  It’s important not only for a firm’s reputation but also for its operations and customer acquisition pipeline.  

For instance, having strong DEI programs and policies in place is thought to attract more customers and produce a more efficient workforce by bringing in diverse mindsets and solutions. Diversity of thought helps hedge against biases and promotes stronger problem-solving capabilities. Greater employee retention and engagement should increase productivity and, thus, profitability by enhancing customer loyalty and satisfaction. It is, therefore, prudent for a company’s management team to deliberately hedge against potential human capital risks by developing a robust HCM strategy and actively complying with emerging and evolving disclosure regulations. 

Adapting to, hiring, and retaining talent in an increasingly global finance workforce is discussed in our recent webinar with Fred Swaniker and Scott Powell. Read the highlights and get the free full recording here. 

Growing Demand = Growing Diligence Requirements

Financial institutions are starting to integrate ESG Funds into their standard financial product offerings and incorporating these concepts into their business models. The US, EU, UK, and Singapore have all stressed the importance of labeling parameters and detailed disclosure of ESG investment strategies through policy action. 

Specifically, any entity selling a Fund that merely mentions ESG, sustainability, or impact, will now be required to report on specific factors related to these claims. These factors include detailed disclosure of how ESG issues are incorporated into their screening process, investment strategy, and client communications. Additional areas include discussion about potential material impacts these investments could have on the environment and society at large. 

According to CNBC, a record USD $69.2 billion was invested in ESG Funds in 2021. There are literally hundreds of ESG Funds available to US investors, making the buying process inherently complex and onerous. As a prospective investor, our due diligence process should include a screening of the Fund’s investment strategy. We should also look at whether the Fund Manager has completed a materiality assessment, whether it reports on potentially negative consequences (or externalities) of its investments, and how its internal methodology complies with emerging disclosure regulations and mandates. 

The bottom line is stronger ESG disclosure mandates mean that Fund Managers will have to conduct more comprehensive due diligence. This reduces the risk of greenwashing and increases the likelihood that investor dollars will be allocated as presented.

Institutions that construct ESG funds must ensure compliance with these new regulations to protect the long-term success of the organization and the longevity of the Fund itself. A good starting point is that each Fund should present both the narrative and the numbers. The narrative speaks to the “what, when, where, how, and why” of the Fund; it is essentially the context that makes any quantified performance, or any numbers for that matter, understandable and actionable. Then we must have the numbers — including both the overall ESG performance of the Fund and its portfolio companies as well as the carbon “handprint” associated with the Fund.  

A carbon “handprint” refers to “financed emissions,” or the emissions associated with portfolio companies, whether these are equity investments or borrowers. Having both the numbers and the narrative aligned and coherent is critical to ensuring Fund compliance and enhancing client uptake. All and all, integrating and aligning an ESG Fund’s narrative and its numbers will help investors check all the boxes when performing due diligence and help it stand out among the expanding sea of ESG Funds moving into the future. 

Changing Climate, Changing Risks

Climate change has been identified as not only an existential crisis for the world’s most vulnerable but also one of the greatest financial risks of our time. What’s more? Climate change is being thought of as a “risk accelerant,” meaning it impacts a range of interconnected environmental and social risks, such as worsening the infrastructure of already marginalized communities.  

Regulators have taken notice and are acting to address it globally. For example, the US, EU, UK, Singapore, and China have all implemented disclosure regulations for climate risk management. Specifically, companies will now be required to disclose a range of qualitative and quantitative details regarding how they reduce their contribution to (and their risk exposure from) climate change. 

Financial analysts and investors should pay particular attention to how potential investments comply with these regulations. It can be assumed that if there is no climate risk strategy, there is no climate risk management (and, in turn, significant risk exposure). The stronger a company’s climate risk management strategy, the lower its exposure to a wide range of physical and transition risks. 

Companies that prepare for natural disasters (physical risks) and the transition to a low-carbon economy (transition risks) are actively protecting their long-term financial stability by hedging against both physical damage and associated policy, stakeholder, and market evolutions. Physical risks are the tangible dangers of climate change, such as wildfires, storms, and floods. For instance, damaged property and facility shutdowns, disruptions along the supply chain, and flooded distribution routes all have direct and quantifiable financial repercussions. Transition risks are those that may occur as the world shifts to a low-carbon economy — having social, technological, economic, and community repercussions. 

Specifically, investors should look at whether a management team has conducted a climate risk assessment, set science-based targets for the company’s carbon emissions, and whether they plan, track, and report on how they are mitigating climate risks and seizing associated opportunities. It is critical to assess these factors when considering whether to allocate capital to a particular opportunity or not. 

For management teams looking to increase their overall effectiveness and improve the organization’s appeal to ESG-centric investors, they must develop a proper climate risk management strategy. The TCFD framework provides a series of core recommendations for developing and disclosing a climate risk strategy. It also informs all disclosure regulations (in fact, the UK now requires TCFD to be followed as THE climate disclosure regulation). There are four main pillars of this framework: Governance, Strategy, Risk Management, and Targets and Metrics. 

  • For Governance, the TCFD recommends defining the roles of the board and management in assessing and managing climate-related risks and opportunities.  
  • For Strategy, the TCFD recommends describing identified climate-related risks and opportunities, their impact on a company’s strategy and financial planning, and its resilience when faced with different climate-related scenarios.
  • For Risk Management, the TCFD recommends describing the process of identifying and managing climate-related risks and how these processes are integrated into the company’s overall risk management strategy. 
  • For Targets and Metrics, the TCFD recommends disclosing the goals, metrics, and KPIs being used to monitor progress against emissions (Scopes 1, 2, and 3) and additional climate-related risks and opportunities.

A company’s management team must adhere to these four tenets to build a comprehensive and defensible climate risk management strategy, address investor concerns, and remain compliant with these emerging regulations.

Dive deep into and earn your ESG Specialization Certificate, covering everything from analysis to investment to business intelligence for ESG.  

What Does This All Mean for ESG in 2023?

Climate change is here, and so is the “age of ESG” — and its associated regulations. As investors, analysts, and company managers, it’s crucial to assess and address ESG disclosure requirements as they relate to human capital management, ESG fund parameters, and climate risk management. 

As a member of the finance community, being prepared to incorporate an ESG lens in all decision-making processes will help ensure a competitive advantage heading into a highly uncertain future. 

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