Six key due diligence risks for Environmental, Social and Governance (ESG) focused investments that you should consider
31 May 2021 10:30
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The US Securities and Exchange Commission (SEC) recently released an unprecedented Environmental, Social and Governance (ESG) focused risk alert for investment advisers, financial services companies, and funds offering ESG products and services. The SEC’s Division of Examinations shed light on potential due diligence pitfalls for companies, identified best practices for ESG investment examinations, and provided insights which can assist companies in enhancing their compliance practices. We break down the most important takeaways from the SEC risk alert. But first, let’s have a look at what ESG investing actually entails.
What is ESG investing?
“At its core, ESG investing is about influencing positive changes in society by being a better investor,” Hank Smith, Head of Investment Strategy at The Haverford Trust Company told Forbes earlier this year. Considering ESG factors in investment decisions not only benefits the environment and society but, for companies and investors, it can leverage competitive advantages by mitigating financial, reputational, regulatory, and strategic compliance risks. The three criteria critical for ESG investing are:
- Environmental: How do a company’s actions affect the environment? This includes questions of supply chain sustainability and the reduction of their carbon footprint.
- Social: How can a company improve its social impact, both within and outside of its community? Inclusion, gender equality, racial diversity and transparent hiring practices are all factors that should be considered.
- Governance: How are issues regarding executive pay, diversity of leadership and internal hierarchies addressed by a company?
Key challenges in a fast-paced ESG investment world
The global demand for financial services and investment products that incorporate ESG factors has substantially increased in recent years, with ESG funds regularly outperforming the global market averages. This is partly because of the rise in pressure by consumers, clients and investors demanding that companies implement global ESG frameworks, such as the UN’s Sustainable Development Goals (SDGs). With a growing interest in ESG investment options, the quality and consistency of ESG investing definitions has suffered. The SEC’s recent risk alert highlights six key challenges for ESG investing:
- Inconsistent ESG disclosures: The SEC witnessed a lack of adherence to global ESG frameworks, despite claims made by an investment fund or company that they are committed to ESG. Portfolio management practices often differed from established client disclosures, leading to an apparent underachievement of ESG scores contrary to a client’s expectation.
- Weak monitoring of ESG-related investing guidelines, mandates, and restrictions: Substantial weaknesses were noted in policies and procedures which govern the implementation and monitoring of ESG investment activities. Advisors often did not have access to adequate systems for tracking and updating potential adverse media screens of their clients.
- Unsubstantiated and misleading ESG investment claims: Marketing materials that describe unsubstantiated risk, return and correlation metric related to ESG investing have been present in a variety of contexts.
- Inadequate control mechanisms for ESG-related practices: Inconsistencies between actual practices and ESG-related disclosures and marketing materials were traced back to a weakness in control mechanisms. A widespread lack of adherence to global ESG frameworks despite contrary claims and the failure to update marketing materials in ESG-focused areas are two of the most frequent malfunctions of internal control mechanisms.
- Failure of compliance programs to address relevant ESG issues: The SEC witnessed numerous cases where companies who are substantially engaged in ESG investment were unable to demonstrate a sound and robust compliance and decision-making process. While a company claimed to work in adherence to global ESG frameworks, their compliance programs did not reflect this statement.
- Limited knowledge of ESG investment analyses: Finally, a widespread lack of knowledge was observed. Relevant employees did not possess the required awareness concerning ESG investment analyses. While generally in place, due diligence and compliance processes seemed to suffer from a lack of efficiency, due to limited internal understanding of ESG-related investment issues.
These six key risks for ESG investing make one thing clear: due diligence is key . Amid the growing significance of ESG factors for financial institutions, investors, and consumers, companies need to establish clear due diligence and compliance processes to identify possible risks and, most importantly, establish whether ESG claims are accurately reflected in a company’s actions and investment decisions. The question is how can a company best mitigate these issues? The answer is as simple as it is obvious: they need access to the right data.
How can enhanced data support sound ESG investment decisions?
The SEC’s risk alert should be a warning for companies who continue to engage with ESG issues in an inconsistent and untransparent way since this can result in various compliance issues. It should also encourage companies looking to invest in ESG to firstly use sources including news and legal data to assess a company’s or fund’s claim to promote ESG factors. In particular, access to news data for adverse media screening can help mitigate a number of potential risks:
- Regulatory risk: The failure to implement adequate control mechanisms to scrutinize the authenticity of ESG investments can have grave regulatory consequences, in particular given the global push towards more regulatory pressure to fight financial crime and other illicit practices.
- Reputational risk: Misleading customers, clients and potential investors with regard to ESG-related offers can have a negative impact on a company’s reputation, even if it only concerns third-party businesses.
- Financial risk: Insufficient validity of ESG efforts not only leads to potential fines for regulatory misdemeanour but can also mean that a company misses out on crucial ESG-based investment opportunities.
- Strategic risk: Ignoring ESG-related potential compliance pitfalls can have a devastating effect on a company’s long-term strategic prospects and is likely to impede sustainable growth.
The bottom line is this: risk monitoring tools that use enhanced data can support a company to identify potential compliance risks. But with an effective and robust due diligence process in place every, company can minimize their regulatory, reputational, financial and strategic risks linked to ESG investments.
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