Compliance playing an increasingly important role in ESG disclosure

Sustainable investing—an approach that considers ESG factors when making investment decisions—is only growing and constitutes a major force across global financial markets companies can no longer afford to ignore. According to a report by the Global Sustainable Investment Alliance, sustainable investing assets stood at $30.7 trillion at the start of 2018 across five major markets—Europe, the United States, Canada, Japan, and Australia and New Zealand—a 34 percent increase in two years.

EU will make companies prove their ESG efforts

Here’s the real kicker for compliance officers: Regulations around ESG disclosures are growing on a global scale as well, with the European Union leading the way. On Dec. 16, the European Parliament finalized a landmark agreement to become the first supranational regulator that will establish a common set of standards for determining whether an economic activity is environmentally sustainable or not.

Under the so-called “taxonomy regulation,” all financial products that claim to be “sustainable” will have to prove so based on strict criteria, supported by scientific evidence and drawn up by scientists and academics. Currently, pension funds and banks can sell and label financial products as “sustainable” without an independent review of these claims.

The agreement states an economic activity should contribute toward one or more listed environmental objectives, including climate-change mitigation and adaptation; sustainable use and protection of water and marine resources; protection and restoration of biodiversity and ecosystems; and more.

“The taxonomy for sustainable investment is probably the most important development for finance since accounting,” said Sirpa Pietikainen, lead negotiator for the European Parliament’s Environment Committee. “It will be a game changer in the fight against climate change.” It’s all part of an ambitious plan to make Europe the first climate-neutral continent by 2050.

Only solid fossil fuels, such as coal or lignite, are blacklisted. Gas and nuclear energy production are not explicitly excluded from the regulation. The Commission will start work on defining environmentally harmful activities at a later stage.

“The taxonomy for sustainable investment is probably the most important development for finance since accounting. It will be a game changer in the fight against climate change.”

Sirpa Pietikainen, Lead Negotiator, European Parliament Environment Committee

The regulation also requires large public-interest companies with more than 500 employees (approximately 6,000 large companies and groups across the European Union) that fall under the scope of the Non-Financial Reporting Directive to disclose information on how and to what extent their activities are associated with environmentally sustainable economic activities. These same companies are already required to disclose certain information on the way they operate and manage social and environmental challenges.

Toward U.S. standardization

In comparison, the United States currently has no mandatory ESG disclosure requirements. Thus, it will be even more important for corporate sustainability teams of U.S. companies to improve their ESG disclosures if they want a fair chance at competing for capital against economies with more stringent ESG disclosure obligations.

Making up for the lack of ESG regulations in the United States are organizations like the Sustainability Accounting Standards Board (SASB), which provides voluntary guidelines for companies to report sustainability issues considered financially material to investors. Since publishing its 77 industry-specific reporting standards in November 2018, 120 companies currently use the standards in their ESG reporting.

The Institute of Management Accountants, too, has issued guidance on how to use the COSO Internal Control Framework when doing ESG reporting. And, in November 2019, the U.S. Chamber of Commerce released its own set of ESG reporting best practices.

Additionally, 43 stock exchanges around the world now offer ESG guidance to issuers, a more than 200 percent increase since 2015, when the Sustainable Stock Exchanges launched its campaign encouraging all stock exchanges to guide issuers on how to report ESG issues.

Efforts are also underway to address the current lack of coherence in ESG disclosures by companies. One such initiative is the Corporate Reporting Dialogue, launched in 2018 to promote greater consistency and comparability between the dizzying array of ESG reporting frameworks and standards. In addition to SASB, founding members include the Global Reporting Initiative, Carbon Disclosure Project, Climate Disclosure Standards Board, Financial Accounting Standards Board, the International Accounting Standards Board, and the International Organization for Standardization.

Just recently, the group issued a joint report showing strong alignment between each of their frameworks and standards and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). The results provide a practical guide to assist organizations in understanding and implementing the TCFD recommendations when using the participants’ frameworks and standards.

Compliance officers’ role

So where do compliance officers fit into all this? Compliance officers can play a valuable role by working with the business to ensure ESG disclosures are accurate, truthful, and complete. “The role of the CCO in ensuring that ESG disclosures are accurate and truthful is significant, starting with compliance with environmental and health and safety laws, where applicable,” says Kristen Sullivan, a partner and sustainability and KPI services leader with Deloitte & Touche.

To assist the company with due diligence in this area, the following questions are a good starting point, Sullivan says:

• Is the data consistent with regulatory reporting?
• Is the data reliable and accurate? For example, does the company have strong internal controls over the reported data, similar to internal controls over financial reporting?
• Does the company obtain [third-party] assurance on the data?
• Is the company’s messaging consistent among the various outlets it communicates?

Ken Harman, senior principal consultant and private markets specialist at ACA Compliance Group, says, in the private-market space, “I often tell the compliance officers I work with to ask, ‘What are we representing to our investors in marketing materials or fundraising materials? Are we comfortable with substantiating our ESG or responsible investing program to investors or regulators?’ If you are, you’re probably in a good spot. If you’re not, I’d take it as an opportunity to develop the program so you are able to substantiate your efforts. That’s really what the SEC is interested in, looking at what is being represented versus what is happening in practice.”

Among public companies, developing a process for gathering all the ESG data a company has should be a cross-functional effort, involving the sustainability team, investor relations, risk, legal, compliance, finance, and human resources, for example.

Another consideration is who should own the reporting. “Investor relations tends to own the reporting,” says Bob Hirth, co-vice chair SASB Standards Board and senior managing director, Protiviti. But where ESG risks meet the definition of “material” under U.S. federal securities laws, public companies are required to include them in their filings with the Securities and Exchange Commission. In that case, the finance team tends to own the reporting, he says.

“The conversations we’ve had with our clients often include trying to understand what part of certain responsible investing or ESG frameworks resonate with how they invest,” Harman says.

Material ESG risks

One common pitfall among many companies as it relates to ESG disclosure is not aligning to the concept of materiality, Sullivan says. “Companies should not try to boil the ocean in terms of disclosure or initiatives undertaken,” she says.

Here, compliance officers can help the business by thinking more strategically about what is meant by “ESG” and how ESG risks—such as scarcity of natural resources, human rights abuses in the supply chain, workplace discrimination, accounting fraud, data breaches, and more—could have a material impact on the company’s long-term financial performance.

It’s also important to engage with relevant stakeholders—investors, customers, employees, even regulators—to understand the issues that most interest them. Monitoring industry peers and competitors is also important, Hirth says. “What have they learned from what their stakeholders want?” Maybe there are comparisons to be made, he says.

ESG disclosures are important for another reason as well: Someone is always keeping score, even if the company is not. While firms like Sustainalytics and MSCI specifically measure companies’ ESG performance, credit-rating agencies, like S&P Global Ratings and Moody’s, have also jumped on the bandwagon by providing separate analyses of a company’s ESG performance, in addition to their traditional credit ratings.

What’s important here is to “make sure that the company is providing all the relevant information that that rater wants,” Hirth says. “Tell your story. And get all the reporting out there in a complete, accurate, and timely manner.”