The road ahead for ESG

This year could be a game-changer, says Andrew Probert, Managing Director, Head of ESG Advisory – EMEA, Kroll.

It’s one of the largest risks we face in our lifetimes, but after the COP27 conference closed last year, any expectation of a breakthrough agreement between governments to tackle climate change seemed unlikely. The conference saw the creation of a historic loss-and-damage fund to support countries most susceptible to the impacts of global warming, but it also witnessed efforts by some nations to water down commitments agreed at COP26 in 2021.

As government action to address our warming climate continues to face hurdles, we must look to the role that companies can play. Large-scale action at the intergovernmental level remains critical, but small steps agreed by industry to create net-zero supply chains and forge a circular economy have the potential to be just as important in the fight against climate change.

Environmental, social and governance (ESG) issues have been already creeping up the agenda for businesses for more than decade now. Investors are more often voting with their feet, with some divesting from companies in polluting sectors, for instance, while growing scrutiny from the media, consumers and regulators has put pressure on firms to take a stance on key environmental and social issues. But this year could be the most transformative for ESG developments.

Disclosure, disclosure, disclosure

Corporations will see a ramping up of ESG-related regulation in 2023, with a host of international frameworks coming to the fore.

Biodiversity is one area where disclosure will see increased attention. At the UN Biodiversity Conference (COP15) in Montreal, world leaders adopted a new Global Biodiversity framework, with requirements for large financial institutions to monitor, assess and disclose transparently any risks and impacts imposed on biodiversity through their operations, value chains and portfolios. Other flagship measures include the Taskforce on Nature-Related Financial Disclosures, with the next interaction (due to be announced in March 2023) delivering progress on disclosure metrics and measuring biodiversity impact across supply chains, and the Science-Based Targets Initiative. The latter will be required for companies linked to land intensive activities in their value chains, such as forest and paper products, and enable firms in these sectors to set science-based targets.

On a national level, more authorities around the globe are formally adopting international ESG standards.

On 1 January 2023, the Level 2 requirements for the European Union’s (EU’s) Sustainable Financial Disclosure Regulation came into effect for financial market participants. The measures could see in scope fund managers exercise more caution around disclosure, with some downgrading Article 9 funds (those that have a sustainable investments strategy).

These compulsory disclosures will create a fundamental shift by businesses in their approach to ESG, as they face the threat of fines for non-compliance. But that won’t be the only threat—as more businesses put forward their own ESG commitments, there have been growing greenwashing concerns that are giving rise to an increasing likelihood for litigation to be brought by activists, investors and other individuals. As that pressure grows, so, too, will the demand on firms and their boards to deliver reasonably adjusted disclosures and to hedge against potential litigations by seeking out third-party verifications and certifications.

Focus on due diligence to include wider issues

Alongside deeper disclosure requirements, there is also set to be a broader push on supply chain due diligence, including a move beyond decarbonisation to focus on social issues.

Nations are facing an energy and cost of living crisis, with the potential for a global recession to heighten social risks and inequality. That could bring more attention by regulators and firms to social issues, from human capital to diversity and inclusion to human rights.

Later this year, the International Sustainability Standards Board (ISSB) is set to publish its global sustainability-related disclosure standards. While the measures will create a comprehensive global baseline for ESG disclosure, the ISSB has also announced that human rights will be among its 2023 priorities. Further regulations and measures, including the EU’s Corporate Sustainability Due Diligence and the Global Reporting Initiative’s (GRI) new sustainability reporting standards, aim to either foster responsible corporate behaviour across value chains, including on issues related to human rights, or enhance human rights-related information flowing to investors.

However, rather than waiting for regulation to enforce such disclosures, companies are already taking steps to provide independent and verifiable evidence of human rights compliance in their supply chains. Research from Kroll has even confirmed that, in 2022, more than a third of businesses globally (35%) had already incorporated human rights factors into their compliance procedures—a rise from 24% in 2021.

Financial markets: new developments

In the financial markets, we expect ESG will continue to be the driver behind most investment flows into European exchange traded funds (ETFs) and exchange traded commodities, following a similar trend over the past two years driven in part by more vocal investors increasingly focus on ESG issues.

As the focus on ESG continues to grow, private markets will likely seek to have greater clarity on the context of ESG performance compared to industry peers and closely monitor ESG metrics against financial performance.

An increasing recognition of the importance of biodiversity in tackling climate change is also likely to filter into investors’ priorities. This year could witness greater formalisation, transparency and even regulation of voluntary carbon markets, which enable organisations to offset emissions by purchasing carbon credits created through projects that remove or reduce greenhouse gases. There are ongoing efforts to standardise the sector, including efforts by the Integrity Council for the Voluntary Carbon Market to establish a consistent global benchmark for high-integrity carbon credits. That could attract more investment into nature-based solutions that often use voluntary carbon markets as a testing ground and that aim to protect, manage and even restore natural ecosystems.

With a host of regulation and clearer standards bringing with it increasing requirements on companies and financial market players, 2023 could be a truly transformative year for ESG. Now is the time for organisations to review the progress they have made, and for those yet to take part, to consider and build a strategy for the years ahead.

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