Firms must prove sustainability of investment products

LexisNexis Due Diligence Services, Compliance Solutions, LexisNexis BIS

sustainability, diligence

Investments based on Environmental, Social and Governance (ESG) principles are on the rise, with a growing array of financial services firms offering ‘sustainable’ products. Now, regulators are catching up. New regulations and guidelines require companies to disclose sustainability across their supply chains—from raw materials to finished products. How should compliance and risk management professionals respond?

New European requirements to prove a product is ‘sustainable’

In December, the European Parliament became the first supranational regulator to agree to set common standards to determine whether an economic activity is environmentally sustainable. Its “taxonomy regulation”, which is part of its action plan on financing sustainable growth, will require firms to prove that all financial products that claim to be sustainable meet strict new criteria. This is a significant change, because pension funds and banks can currently sell and label financial products as ‘sustainable’ without an independent review of these claims. Sirpa Pietikainen, lead negotiator for the European Parliament’s Environment Committee, has called the taxonomy “probably the most important development for finance since accounting”.

This regulation requires large public interest companies in the EU with more than 500 employees to disclose how and to what extent their activities are associated with environmental sustainability. Compliance officers at these firms must demonstrate that their economic activity should contribute towards one or more listed environmental objectives, including climate change mitigation and restoration of biodiversity.

Global standards becoming more stringent

The new regulation is expected to impact on all financial services firms trying to sell a ‘sustainable’ product, not just those in the EU. This is because companies outside the EU, which do not face mandatory ESG disclosure requirements, will need to demonstrate their ESG commitment to compete against companies who can demonstrate that they are meeting the European Parliament’s regulations.

In the last year, 120 companies have adopted the standards set by the Sustainability Accounting Standards Board in the US. This lists 77 standards to assist companies in reporting “financially material, decision-useful sustainability information to investors”. Last November, the US Chamber of Commerce produced ESG reporting best practices. It recommends that ESG disclosures “should discuss the company’s approach to risk management, making the connection, to the best of their ability, between the ESG topics on which they report and the company’s long-term value creation strategy.”

This trend is spreading across the world. 43 stock exchanges have published sustainability reporting guidelines for companies listed on their exchange. The Australian Securities Exchange was among the first when it published an ESG reporting guide for companies in 2015, while Denmark and Hong Kong published their own guides in 2017 and 2018 respectively.

A further incentive for companies to prove their ESG credentials comes new measures for ESG performance which have been devised by other companies. Jaclyn Jaeger, an editor with Compliance Week, writes: “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.”

The motivations for companies to improve their ESG reporting are not simply related to mitigating financial and legal risks. Surveys show that more and more people – particularly young people – want to buy from, invest in and work for firms which make a positive contribution to society. A company that can demonstrate its sustainability credentials is more likely to attract customers, investors and talent, and therefore be more profitable and financially sustainable in the long-term.

What should compliance officers do?

Much of the onus will be on compliance officers to report on sustainability of their firms’ practices, and those of its third parties. They must ensure the data they keep is consistent with the reporting requirements of regulators. They must ensure data is reliable and accurate. They must screen third parties against negative news databases, and ensure this monitoring is regularly updated.