MANAGING ESG REPORTING AND COMPLIANCE RISK

ESG (Environmental Social Governance) also called Sustainable Investing, Socially Responsible Investing, Green or Ethical investing has become a growing investment trend. Investors are increasingly choosing to invest based on their values and are placing their funds with investment companies that are making a positive impact on society and the environment and thereby are delivering sustainable impact, as well as financial returns. The investment industry has traditionally concentrated on financial growth as a measure of success. Measuring sustainable impact however is still in its infancy, as is the accountability and auditing of these practices. Currently the standards to measure the impact of investments can be subjective and inconsistent, there appear to be different of shades of green and there have been allegations of companies and investment funds jumping on the ESG and ‘woke capitalism’ trend and misusing it for profits. How can compliance professionals manage the risk of a new investment style which has so many unknowns?

ESG investing has been around since the 1960’s as ‘Ethical’ or ‘Socially/Corporate Responsible’ investing and was initially mainly exclusionary based where investors would shun stocks they felt did not align with their values or were causing harm, such as for example firearms or tobacco producers. In the 1990’s interest continued growing along with the scope of investments as climate change issues were being brought to the fore. In 2004 Kofi Annan, the former UN Secretary General, called on over 50 CEO’s of major financial institutions to join in an initiative to integrate ESG into capital markets and this was when the term ESG was formally coined. This initiative resulted in the Principles for Responsible Investment (PRI) being developed in 2006. The PRI contains six principles on incorporating, implementation and transparency on ESG investing and by signing the Principles the investors involved commit to adopt and implement them. The principles are voluntary and aspirational. There are currently 4,902 signatories. Following on from the PRI the Sustainable Stock Exchange (SSE) initiative was launched and had its inaugural meeting in 2009. The SSE initiative promotes voluntary commitment from stock exchanges to promote ESG disclosure and performance among its listed companies. The ESG investment style keeps gaining traction and according to Bloomberg’s January 24th 2022 report Global ESG assets may surpass USD41 Trillion by 2022 and USD50 Trillion by 2025. Spurring the growth trend is an increasing appetite from investors to also integrate ESG into their investment aims as well as seeking financial returns.

A conundrum coming to the fore now is ESG metrics and how to report on performance. As ESG reporting to date has not been actively regulated or prescribed in most jurisdictions, companies use many different methodologies to report. For example in Switzerland where the market for Sustainable investments grew by 30% in 2021, around 25% of ESG investment goals were measured by the UN Sustainable Investment Goals while about 50% use a combination of measuring factors: qualitative, SDG contributions, physical/social indicators and successful engagement activities ( Source Swiss Sustainable Investment Market Study 2022 by the University of Zurich).

There are also jurisdictional variances on reporting standards for ESG investments, for example the EU mandates specific disclosures on ESG funds which came into force in 2021 (Sustainable Finance Disclosure Regulation (SFDR)). The US and the UK do not have specific regulations on disclosures yet. However the SEC in the US are looking to issue disclosure rules to come into effect in 2023 and the UK will adopt standards into law by 2024 or 2025. There are 8 other jurisdictions that are working on tightening ESG measurement and reporting standards.

Amongst the myriad of potential pitfalls that have come become apparent in the reporting and accounting for with ESG themed investments three of them currently in the spotlight are: green washing, unintended and unforeseen consequences and actual impact being negligible and overstated and potentially misleading

With the increased focus on regulating ESG reporting and much more scrutiny as a result, there have been a number of institutions fined for greenwashing. Greenwashing essentially means making something look greener than it actually is. Greenwashing could be anything from promoting positive behaviours and outcomes to hide negative outcomes to selective disclosure or completely misleading consumers and investors on the environmental practices of an organisation. For example Volkswagen got caught up in a greenwashing scandal in 2015 when it was found that their vehicles had been installed with software that cheated in emissions tests making the results look much better than they were. VW admitted that over 11 million cars had been fitted with the so-called cheat device software. The consequences were global: it cost the automaker at least USD38.7billion, there were lawsuits filed by the US SEC and other jurisdictions against Volkswagen for defrauding investors and executives of the company were charged and prosecuted.

In May 2022 Deutsche Bank in Frankfurt was raided in a USD1TRN greenwashing scandal. The bank’s funds division, DWS, has been accused of overstating the ESG factors incorporated in a large number of investments.

Also in May 2022 BNY Mellon’s investment adviser division was fined USD 1.5MN for allegedly misstating and omitting ESG parameters and quality reviews in its mutual funds. The regulator also alleged that compliance staff were unaware of missing quality reviews in prospectuses and client documents for a period of time.

According to Bloomberg banks have invested USD4TRN into fossil fuels since the 2016 Paris agreement came into effect. One of the goals of this agreement however was to direct financial resources towards a sustainable low carbon future. Most of these banks advertise themselves as sustainable and responsible banks that are incorporating ESG issues in their investment mandates.

Unintended consequences are also an issue with ESG investing. Bryone Widdup, Partner at DLA Piper quotes in their new European report "Raising the standard: how can banks improve the quality of climate-risk financial reporting" : "Divestment frequently transfers emissions to companies that may be more thinly capitalized, less affected by pressure from activists and less motivated or able to take the actions required for real world emissions impact. This may ultimately make it harder to induce the lower-polluting behaviour that benefits us all"

Although the phrase ESG was coined with Environmental, Social and Governance as the three pillars of sustainable investing being intertwined and mutually beneficial, the three pillars can clash and cancel each other out, especially the E and S part. Environmental, regularly being client’s top priority out of the three measures of ESG, can at times cause unintended Social consequences. Take for example the case of Eskom, South Africa’s State owned, and sole, power producer. A study released by the Centre for Research and Energy and Clean Air (CREA) in October 2021 named Eskom the world’s most polluting company. The pollution is created by 15 coal fired generating plants at which the utility has not installed desulphurisation equipment to reduce its emissions. The utility is also heavily in debt and in constant need of recapitalization and credit from investors and lenders. Coal and its value chain are responsible for the livelihood of many communities in South Africa: around 335,000 people are dependent on coal for their income and Eskom employs over 44,000 people. South Africa has one of the highest unemployment levels in the world and the socio economic challenges associated with the high levels of unemployment are posing immense risks. If investors and lenders boycott Eskom and the coal sector and stop investing/lending to save the environment this would have a disastrous social effect on the communities dependant on coal and Eskom for their livelihood and gravely exasperate the unemployment problems in South Africa.

Solar panels and wind turbines although now seeming to be an alternative to our fossil fuel problem may create huge waste piles in future. Do we know how solar panels and wind turbine rotor blades degrade, do they contain chemicals that will be classified as hazardous waste in future (as what happened to asbestos in the building industry) and what will we do with all the old batteries that need to be replaced? Are we turning our planet into an even bigger dumping ground? Could we open ourselves up to future lawsuits and environmental pollution liabilities by promoting that our clients invest in these new alternatives with as yet unknown future consequences?

There are also many discussions about whether investing more in companies that already have good ESG metrics makes any difference to the cause. These companies already limit their footprint and will by default make a limited contribution to future improvement. It would make a bigger impact to direct funding and associated incentives to companies with low ESG performance, that are currently shunned by investors as their ESG metrics don’t reach the required levels, as any improvement from their side will make a bigger impact on the whole.

Green bonds, fixed-income financial instruments used to fund/support initiatives that result in positive environmental benefits, have also come under fire for supporting outcomes that would have been achieved anyway, even without extra funding, and therefore not contributing to a measurable increased improvement

So, in the vacuum there is currently in the measurement of ESG performance standards how can we as Compliance protect our firms:

Education is paramount for advisers that plan to incorporate ESG/ Sustainable investing into their portfolios or client advice. Jumping on the ESG bandwagon just for profit without sufficient knowledge could retrospectively lead to unintended consequences and fines once regulation comes into law in the next few years. It is better not to incorporate it into advice than to advise on it without skills.

Advisers should be familiar with current standards that are in place such as the PRI, the European SFDR, the Sustainability Accounting Standards Board (SASB), the Global reporting Initiative (GRI), the Task Force on Climate Related Financial Disclosures (TCFD) and the Sustainable Development Goals of the UN.

Let clients lead their investment choices. Make it part of the know-your-client process to establish client's views on ESG investing. Explain the meaning of ESG and establish if clients consider it of importance to incorporate this in their portfolios. If they do, establish how the three pillars, E, S and G rank in importance with clients. Explain how the E and S components often clash and make clients aware that the likelihood of unintended consequences is high with ESG investing, especially if they are investing in funds with a multitude of holdings. Use examples to explain unintended circumstances. For example in the recycling of glass a lot of heat is needed, especially to burn off labels and ink, and this adds to emissions. If clients place a higher priority on limiting emissions than reducing landfill sites, a glass reuse investment option may be better than an investment into recycling. Discuss the UN Sustainable Development Goals and let clients rank those in order of importance to them.

Include disclosure documents for clients that outline that the measurement of sustainability performance of ESG investments is still subjective and give examples of how different goals can conflict. Be transparent on investment documents about how impact will be measured and what is aimed for. Explain that some measures can be subjective and not quantitative.

Client investment documents on funds and investments that claim to be sustainable investments must be thoroughly checked by compliance and have disclosures in place where transparency is compromised or not possible, with an explanation of why it is not possible to disclose. A conflicts of interest potential of the three pillars of ESG also explained.

Measure the level of unmanaged risks compared to the managed risks in ESG investments (by risk rating each company/entity/fund held in the investment individually) and risk rate the investment as a whole accordingly.

ESG investing is here to stay and will continue growing at a rapid pace with investors increasingly looking for more than just investment returns in monetary value but also making a positive contribution to the planet The lack of globally recognized reporting standards and oversight is currently confusing to investors and the investment sector is receiving some negative pushback on this. However investor pressure has led to regulators globally working on, and very soon to be implementing, a raft of new regulatory standards for ESG investments including harmonizing criteria, disclosure requirements and benchmarks. Conforming to the changing standards is going to be a challenge for managers of ESG investments but will ultimately make the compliance oversight easier and facilitate the building of ESG reporting programs. In the meantime education, the availability of data and transparency in client advice as well as disclosure documents should prevail.