Environmental, Social, and Governance (ESG) has evolved from an initial concept allied to corporate social responsibility into a major driver for companies, particularly for corporate board and shareholder behaviour.    
Climate change has become its poster child, and charges of ‘greenwashing’, its unwelcome sibling. ESG has perhaps become the touchstone of that most elusive goal shared by most businesses, a ‘best-in-class’ corporate reputation. 

Beyond the boardroom, ESG is exerting a growing influence on supplier and buyer decision-making. Shareholders and investors are keen to understand the long-term strategies of companies they invest in and the role ESG plays in steering them.  

At the start of June, climate diplomats came together for the Bonn Climate Conference, a follow-up event to COP26, to debate net zero progress amid renewed energy security concerns. The meeting was described by many as being in disarray and full of disappointment, with many citing the war in Ukraine and the consequent energy and food crises as the cause of stilted progress.

Fresh headwinds and definition dilemmas

The geopolitical environment is presenting new headwinds; an energy and cost-of-living crisis affecting even high growth markets like China, as well as most of the North Atlantic and EU economies. Governments, and therefore regulators, are facing electorates that are ever more mindful of ESG measures that are just window dressing with a bill attached. The UK, for instance, has recently suspended full closure of a controversial shale gas facility, in addition to looking at re-issuing North Sea drilling licences. Europe, as a result of the war in Ukraine, is on a path of zero dependence on Russian oil and gas within a couple of years, with a doubling in wholesale prices well under way and increasing pressure on EU Member States to grow renewable energy production.

There are also growing questions around the scope of the very label ´ESG´, with some arguing that its definition is becoming too broad for practical purposes. The OECD has said that tax avoidance costs governments globally 4-10% of revenues which might otherwise be spent on education and other social support; should tax transparency and justice now form part of any ESG scoring system? Should “tax cooperation” be considered a way to introduce tax issues into the ESG scoring system?  

This, and related issues, give rise to the joke that the letters ’S’ and ’G’ in ’ESG’ are silent. Some markets have, however, started to take the ’S’ and ‘G’ seriously. In 2003, Norway led the way by mandating that women must form 40% of any major company board. The European Commission subsequently proposed a law that required a minimum of 40% female board members in listed companies across the European Union by 2020. Today, Austria, Belgium, Denmark, France, Ireland, Italy, Germany, the Netherlands and Spain have adopted similar regulations. This demonstrates that there is an increasing political momentum for ethnic and other diversity measures to be encouraged, if not mandated.  

For now, the focus of regulatory change is on the ’E’ of ESG. According to the Harvard Law School Forum on Corporate Governance, over 85% of investors and over 90% of major business leaders now want quantifiable metrics they can use to evaluate their ESG impact. Much of this is now investor driven via collaborations such as the Institutional Investors Group on Climate Change, which is writing to businesses demanding more disclosure on the impact of decarbonisation in order to steer the world onto a path that will allow us to stay below a 1.5C global warming limit in this century.

Regulatory crackdown 

In the investing context, while it now has been proven that ESG funds helped to stabilize the market for ESG stocks (Europe Corporate Governance Institute, June 2022), regulators are grappling with ESG’s new and complex criteria for investment selection. This has caused the U.S. Securities and Exchange Commission (SEC), and other regulators, to increase scrutiny of companies’ claims concerning their ESG credentials, and to monitor their ESG-related communications more closely. 

In March 2021, the SEC formed an ESG Task Force for the sole purpose of investigating ESG-related violations. At the same time, the SEC also announced that it intended to create rules for company disclosures related to ESG factors, including climate disclosures. The goal of the SEC’s ESG decision was to create standardised, comprehensive disclosure requirements, making it easier for investors to compare ESG criteria between companies.

On March 17, 2022, the SEC proposed a rule that will require SEC-registered companies to include certain climate-related disclosures in their registration statements and periodic reports. This includes information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.

Interim public statements and annual audited financial statements are, therefore, squarely becoming placed at the nexus of public company communications regarding ESG. This is generating new and nuanced challenges and risks for financial accounting and audit firms. 

What regulatory and financial risks of their own will financial accounting and audit firms face when, in the eyes of regulators and investors, those evaluations go amiss? Government fines for violations of the US Foreign Corrupt Practices Act (“FCPA”) alone rose to US$2.8 billion in 2020. How long before a financial and accounting firm faces significant penalties and fines for incorrect reporting of FCPA or other ESG violations, even unknowingly? 

The EU legislation went even further by means of Regulation (EU) 2019/2088 of the European Parliament published on 27 November 2019. This focused on sustainability‐related disclosures in the financial services sector. The regulation contains a definition of “sustainable investment” (article 2 no. 17) and imposes rules on subjects acting as financial market participants and financial advisers concerning the disclosure of information on sustainability issues.  

Financial market participants and financial advisers should, therefore, communicate data with regard to how they take ESG factors into account at two levels: 

1) Their decision-making processes for investment related decisions;   
2) All financial products that they sell on the EU markets.

The European financial world is, therefore, dealing with the new taxonomy for sustainable activities and looking for financial products that can be cataloged as pursuant to article 8 or 9 of Regulation 2020/852 from 18 June 2020 (so called “Taxonomy Regulation”), which amended the above mentioned regulation 2019/2088.

Ethics and energy

There are a new set of considerations for financial accounting and audit firms charged with evaluating the ESG compliance and financial vulnerabilities of companies and state bodies mandated with delivering vital energy resources to the public. These include what constitutes reasonable and ethical behaviour in pursuit of core corporate goals and the compatibility of those goals with ESG objectives. For such corporate entities in Eastern European countries, for example, the alternatives to buying Russian-generated energy are expensive (especially for those countries which are land-locked) and/or in the face of geopolitical relations of historic amity, such as for Hungary.

Many companies today are understandably confused as to the best way to approach reporting their ESG performance in a way that will be credible and accurate. Much of this confusion stems from a plethora of sustainability reporting frameworks. For many, the answer could well be the International Sustainability Standards Board (ISSB), which could do for sustainability reporting what the International Accounting Standards Board (IASB) does for financial reporting.

The ISSB, which was introduced at COP26, has the potential to remake ESG reporting. The Board aims to establish a global consensus for sustainability disclosures, simplifying the complex landscape and standardising the practice of non-financial reporting. It is unlikely to be a wholesale reinvention of the ESG reporting process or a panacea. Instead, it is intended to sit alongside existing reporting processes and provide consistent standards for organisations globally. The adoption of internationally recognised and consistent standards can only alleviate the risks and challenges which financial accounting and audit firms face in the evolving ESG context because only a truly holistic and comprehensive approach can be successful. 

RSM aims to be at the forefront of these reporting standards, with a particular eye on the needs of growth companies. It is these companies who will in time likely be the subject of the same standards that the SEC and others are imposing on larger companies, and who may also find strategic differentiation by taking a leadership position in this key area.

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