InvestmentsJun 27 2022

ESG debates should not distract from business fundamentals

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ESG debates should not distract from business fundamentals
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In the past few years there has been a healthy and positive shift in public consciousness towards environmental, social and governance issues, driven by a number of factors, chief among them: social media.

These shifts have prompted investors in key markets – Europe, the US, the UK and Australia, among others – to ask questions of the companies they invest in and the businesses that manage those investment activities.

Add in high levels of liquidity and discretion on the part of these investors, and you spur competitive pressure among corporates and investment managers. 

Throw in a regulatory domain that is seeking to keep pace with these changing requirements – and the potential risks it presents – and the operating environment becomes even more complex. And this is before you consider the complexity that current geopolitical tensions generate for all these stakeholders.

The result is great tension in the system.

Importantly, the players in this system tend to move at different speeds. Large, public companies need time to address systemic questions around sustainability and resilience, to allocate the necessary human, technological and financial resources to drive those strategic choices, while also retaining profitability.

Attitudes to behaviours that had previously been deemed acceptable changed overnight.

Regulators also need time to consult industry participants, draft policy, secure approval, promulgate and then enforce. However, investors – whether retail or institutional – have discretion to move capital rapidly to companies and fund managers that attend to their current investment goals.

By extension, fund managers and advisers need to move quickly to outpace their rivals in attracting these funds, often by creating and promoting new products that seemingly attend to the investment zeitgeist.   

But short-term imperatives do not always align with long-term planning, and the divergence in those time horizons creates both opportunity and risk for companies. The regulatory environment (and by extension, associated reporting requirements) is adjusting to these new demands, the ESG lexicon remains open to definition and therefore interpretation, and companies and fund managers are under pressure to retain existing investors or secure new ones.

It is perhaps not surprising then that in this context the risk of greenwashing has materially increased, and as a consequence enforcement agencies must respond. 

Enforcement action

We have seen this trend before. An extended period of global economic growth and perceptions (or reality) of an uneven playing field in terms of business practices, prompted the US Securities and Exchange Commission and US Department of Justice to start actively enforcing the US Foreign Corrupt Practices Act in the late 1990s (a law originally passed in 1977), which provoked a seismic shift in the anti-corruption and anti-bribery landscape.

Attitudes to behaviours that had previously been deemed acceptable changed overnight, with the role and size of legal and compliance functions given new importance. 

Compliance and risk management are too often seen as a brake on innovation and growth, as opposed to being enablers of sustainability and resilience.

Similarly, the global financial crisis of 2008 exposed practices that had been masked by economic growth, with some infamous Ponzi schemes perhaps the poster children for that era’s excesses.

Those fraud cases, allied with important global security incidents, prompted a significant overhaul and strengthening of anti-money-laundering and terrorism financing rules and standards, with 'know your client' checks taking on new meaning. 

These episodes, where propitious economic conditions recede and/or regulatory agencies catch up with new products or trends, suggest that ESG-related litigation and enforcement risks will rise for both companies and fund managers, regardless of whether it was a marketing faux-pas, confusion over new and evolving reporting requirements, or deliberate misrepresentation of data and evidence to lead an audience to a false conclusion.    

Internal tensions

Important, and common to all of these moments, is resolving the internal tension between the fear of missing out and risk management.

Executives that give sales teams a mandate to grow, to capture market share, to aggressively pursue profits, will always run a legal and reputational risk that people will seek to circumvent or bend the rules, especially if those rules are nebulous and their enforcers are perceived to be playing catch up.

But recent announcements and directives by regulators in the US, Europe and the UK surrounding greenwashing, climate-related disclosures, transparency, due diligence, accountability (among many others) all reflect the direction of travel. 

There is no questioning the complexity of today’s operating environment but compliance and risk management are too often seen as a brake on innovation and growth, as opposed to being enablers of sustainability and resilience.

Sustainable, resilient, profitable companies consider risk in its entirety, not just the ESG subset.

The debate over ESG, what it represents, how it is measured and how related activities are enforced will continue for some time but it should not distract from certain fundamentals.

Sustainable, resilient, profitable companies consider risk in its entirety, not just the ESG subset, and on an ongoing basis. They determine their risk appetite and design structures that align with that threshold.

Their policies and procedures provide parameters for their employees to operate within and safeguards for the organisation. And they regularly and routinely review their risk exposure to ensure they adapt to changing market conditions. 

Robust risk management may not be the most scintillating of topics, but it should make for a compelling story to investors, an endorsement of a company’s values (key to employee retention) and, ultimately, a good night’s sleep for company leadership.    

Nicholas Panes is vice-president of Charles River Associates