The impact of the changing ESG regulatory environment on business
As part of their efforts to achieve net zero carbon and contribute to the SDGs, governments are increasingly incorporating ESG criteria into mandatory financial disclosures. But what does this mean for businesses?
Environmental, Social, and Corporate Governance (ESG) principles were established over 20 years ago, primarily to support selective investment and as criteria for reporting sustainability credentials. Until recently, ESG disclosures were voluntary. Companies adopted them as a differentiator and to add value to their business for investors and the public.
In recent years, and following the Paris Agreement (2015), governments have been implementing policies to lower their carbon emissions and to contribute towards the United Nation’s Sustainable Development Goals (SDGs). Among these regulations is companies’ adoption of mandatory ESG disclosures.
Growing the ESG policy ambition to drive the net zero transition
The European Commission, for example, has published or revised regulations focused on integrating sustainability into its financial policy framework. Manufacturers of financial products and financial advisers must disclose ESG information to their investors under Regulation 2019/2088 on sustainability‐related disclosures, and Regulation 2019/2089 (also known as the Low Carbon Benchmarks Regulation) aims to improve transparency and consistency in low carbon indicators. Earlier this year, the EU Taxonomy Regulation contributed to the establishment of an EU classification system for sustainable activities. Furthermore, Directive 2014/95 requires large public interest companies to publish reports on their policies related to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards.
With specific regards to reporting on climate impacts and action, the Task Force on Climate-related Financial Disclosures(TCFD) published its final recommendations in 2017. It provides a framework for businesses to develop more effective climate-related financial disclosures through existing reporting processes, allowing for a more reliable cross-market comparison. In September 2020, New Zealand became the first country to commit to mandatory climate risk disclosures aligned with the TCFD recommendations for publicly listed companies, large insurers, banks, and investment managers. In the UK, the 2019 Streamlined Energy and Carbon Reporting regulation (SECR) introduced mandatory disclosures related to energy consumption, greenhouse gas emissions, and energy efficiency actions that are applicable for quoted companies, unquoted large companies, and large limited liability partnerships (LLPs) as part of their annual reporting. Last year, the UK also published its Green Finance Strategy, with climate disclosures playing an important role in transforming finance for a greener future. Earlier in 2020, the UK government began exploring proposals to implement a regulation that would require listed companies to comply with TCFD recommendations in 2021. This process is now in the consultation phase.
How mandatory ESG disclosures can affect businesses
In the future, companies will face stronger oversight regarding the sustainability of their activities, as well as due diligence with ESG criteria forming a key requirement of investment decisions. To comply with mandatory ESG disclosures, companies must measure and manage their environmental and social impacts and have a governance structure that supports this.
Although this might seem overwhelming for businesses that have not yet started this journey, focusing on these aspects now can hedge against forthcoming compliance and climate risks. Companies should not use incorporating ESG criteria as a ‘tick box’ exercise but rather as an opportunity to improve their businesses, create positive impacts in their value chains, and improve investor relations.
In preparing for ESG disclosure, companies should evaluate their businesses and design a roadmap to mainstream ESG criteria into their operations. While this will surely require investments in the short term, it will likely bring long term value. Companies that have integrated ESG into their business perform consistently better than their peers and can even benefit from lower cost funding. For example, investors are becoming more aware of the risks climate change can impose on traditional financial assets, and might be willing to accept a lower return on investments linked to more sustainable activities.
What next?
Businesses have the opportunity now to start their ESG journey and to gradually adapt and prepare for the more stringent disclosure regulations—and the more robust investors’ due diligence—that are surely to come. Integrating sustainability into corporate practices and reporting today will ultimately enhance business value and allow companies to contribute towards a more sustainable tomorrow.
