The rise of ESG and the importance of compliance

The pressure from stakeholders, be they lawmakers or shareholders, regulators or activists, or indeed society at large, on companies of all sizes, and across all sectors, to recognise, adhere to, improve, measure and report performance against ESG metrics is increasingly urgent and compelling.

Why is ESG reporting so significant in the business world of 2021, and what are the associated risks? As ever, and recognising the adage that prevention is better than cure, identifying potential issues early on, and ensuring an effective framework is in place to respond efficiently to developments, is key. That is particularly the case in the age of social media, where perceived transgressions are quickly and widely shared.

Whatever sector or jurisdiction a company operates in, effective due diligence of ESG issues and accurate reporting of the results of that diligence, as well as having regard to emerging calls for standardised global ESG disclosure, is essential. The US Securities and Exchange Commission’s recently announced Climate & ESG Task Force, within the Division of Enforcement, highlights the growing focus on gaps or misstatements in ESG-related disclosures.

 

Environmental goals
The increasing prevalence of, and focus on, company reporting is, however, only one side of the story. Recognising and improving – in a meaningful, measurable, way – the issues that are becoming as important to assessments of company performance as traditional financial metrics is key. Commitments to net zero carbon emissions and other environmental goals are laudable, but particularly in the absence of a single unified reporting framework, companies’ environmental impacts must be assessed, and reported, with care. Shortcomings in codes of conduct, human rights and other policies, sustainability reports and press statements are increasingly being identified, scrutinised, and challenged – whether in litigation or otherwise – by stakeholders, including investors.

As an early step, ensuring that an effective and comprehensive compliance programme is in place is essential; that programme should have regard to existing, and forthcoming, legislative developments including, for example (in respect of EU-domiciled companies, or those with EU-based subsidiaries or operations), the Sustainable Finance Disclosure Regulation and the Taxonomy Regulation; or (in respect of UK-domiciled companies), the Modern Slavery Act, and the anticipated legislation signposted recently by the UK Task Force on Climate-Related Financial Disclosure, to name just two examples. Similarly, the much-anticipated corporate governance reforms in the UK, announced by UK Business Secretary Kwasi Kwarteng MP last month (February 2021), will impact on ESG, on reporting obligations in this area, and the price of failure to comply. The significance of these reforms to company directors, whether at board level or otherwise, is critical. Internally, these non-traditional, non-financial, factors will impact decisions on executive remuneration. Externally, companies’ behaviours in those areas will be scrutinised and challenged.

 

Reputational and financial damage
The importance of human rights due diligence cannot be overstated, in the context both of the company itself, but also up and down the supply and value chain. Recent high profile scandals – often resulting in litigation – have revealed the appalling human cost of failing to ensure compliant behaviours, as well as, of course, the associated reputational and financial damage that inevitably follows. Awareness of, and adherence to, the requirements of the various benchmarking regimes, such as the World Benchmarking Alliance’s Human Rights Benchmark, is critical to ensure that best practice is observed. Such benchmarks – which represent independent assessments of companies’ human rights programmes – are useful bases upon which to develop and reinforce practices in this area, hopefully, before problems emerge. Not reporting on these issues is not an option and, as disclosure increasingly becomes mandatory, companies need to ensure that their performance will stand up to scrutiny in the light of the changing legal and regulatory environment.

But ‘hard law’ obligations are only one element of this fast-changing landscape. Consideration should equally be given to the broader societal expectations that are emerging from corporate performance and disclosures of that performance, not only in the context of environmental impact and human rights due diligence (as critical as they are), but also in respect of the multiple other issues falling within the scope of ESG. ‘Soft law’ developments, whether at national, regional or international level, often reflect changing societal norms; the UN Guiding Principles on Business and Human Rights is one such example. Recognising the emerging focal points, and improving performance in those areas, should be a priority.

 

Public scrutiny intensifies
To take one example, disclosure obligations in respect of ‘social’ issues has lagged behind that of ‘environmental’ and ‘governance’ issues, in part because the hard law requirements have not, thus far, been as stringent in this area. Treatment of employees, for example, such as in the context of the company’s employment model, or behaviour towards employees during the pandemic, is traditionally under-reported. But that is changing. Particularly as high profile scandals emerge, and resulting public scrutiny intensifies, companies will be under increasing pressure to report – accurately of course – on employee-related issues. As with many ESG issues, these can be difficult to measure, but it is clear that there is increasingly a demand to do so.

Ultimately, these are, or should be, board-level concerns; responsibility for companies’ performance, including by reference to ESG issues, lies with the board, and a close awareness of the requirements in this regard is fundamentally important. As ESG due diligence and reporting requirements continue to dominate the corporate agenda, ensuring best practice and compliance at an early stage will reap benefits, and hopefully avoid pitfalls, down the line.