Compliance Risk and Diligence
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In today’s socially-connected world, companies understand that their success rests not only on their business performance, but also on their relationship with society at large. This explains why environmental, social and governance (ESG) disclosures are on the rise, driven by both regulatory mandates and investor pressure.
Growing concern about climate change risk, for instance, fuelled the worldwide growth of socially responsible investments by 34% to US$30.7 trillion by 2019.1 Even in East Asia, with only five percent of assets under management invested in sustainable projects,2 regulators have begun mandating ESG disclosures for issuers listed in Shanghai and Hong Kong.3
Society’s increasing interest in investing in ethical business practices and their outcomes has put pressure on investors and asset managers to integrate ESG into their investment decisions.
In addition to deflecting pressure from activists and regulators, ESG helps investors and other stakeholders flag opportunities or risks not identified by conventional financial analysis. ESG disclosures focus on the following key areas:
ESG disclosures represent an alternative way of assessing a company’s performance beyond its balance sheet, with a view to its effects on society at large. They also indicate an asset’s potential for value that sustains momentum even in the “new normal” post-COVID-19; a Morningstar analysis found that funds integrating ESG factors registered record growth in Q1 2020, beating Q4 2019’s previous record.4
More sophisticated research and increased reporting by public companies have cut through the lack of clear ESG standards worldwide, creating the potential for increased structure and standardization in the field.
Institutional, wealth management and personal investors demand clear, sustainable investing benchmarks. And millennial investors actively seek investment options that closely align with their values; this fast-growing group is “twice as likely to invest in companies or funds that target specific social or environmental outcomes.”5
To all these demands, ESG indexes provide an answer. In the Asia-Pacific region, the MSCI AC Asia Pacific ESG Leaders Index is a prime example: it derives its financial indicators from a proprietary index methodology that utilises ESG ratings to highlight companies that are “in a better position to manage ESG-related opportunities or risks.”6
By casting a spotlight on regional companies with high ESG performance relative to their sector peers, ESG indexes help Asia-Pacific investors integrate responsible investing into their investment decision-making processes.
ESG has also become an increasing factor in deciding M&A. PE firms that wish to avoid reputational risks and liability from compliance failures have begun integrating ESG in both due diligence and post-closing compliance.
In a 2019 IHS Markit survey, 90% of responding senior executives (representing PE firms, corporate entities and asset management firms) admitted they conducted ESG due diligence, “confirming that it has become a core element of the M&A process despite its relative newness.” 83% in turn were confident ESG “will become increasingly critical to M&A decision-making in the next 12 to 24 months.”7
Considering that many ESG benchmarks are far from established, creating due diligence and post-closing compliance standards for future M&As are a challenge for today’s investors, including PE firms and regulators – while presenting an opportunity for ESG benchmarking and analysis specialists.
Investment research provider Morningstar just bet big on ESG ratings and research company Sustainalytics, paying €55 million initially with additional payments to be derived from the company’s 2020 and 2021 fiscal year revenues.8 They’re confident that demand for ESG data, research and solutions will increase exponentially in the next few years – a bet they’re sure to win!
Hong Kong leads East Asia in ESG practice. As early as 2015, the Hong Kong Stock Exchange (HKEX) changed its rules to shift from a “voluntary” ESG reporting regime to a stricter “comply or explain” requirement.
The revised HKEX rules also compel companies’ boards of directors to assume responsibility for ESG, instead of delegating it to mid-level executives. Compliance will be mandatory starting on July 1 this year.9
The record is mixed where actual compliance from Hong Kong companies is concerned. While members of the Business Environment Council expressed support,10 the business community at large has struggled to comply, with only 39% of 500 randomly-chosen ESG reports found to have fully disclosed their environmental performance indicators.11
Despite its late start, ESG practice in China has entered a fast track. New ESG reporting guidelines have been promulgated by the China Securities Regulatory Commissions (CSRC) and the Shanghai Stock Exchange (SSE).12 And this year, the CSRC and the Ministry of Environmental Protection will require listed companies and bond issuers to disclose ESG risks associated with their operations.13
Beyond simply offering compliance, China’s financial sector has also taken some responsibility in formulating international reporting standards. Over 20 China-based asset management companies signed up to the United Nations Principles for Responsible Investment (UN PRI), including China Southern Asset Management and China Life Asset Management.14
ESG has never mattered more than in today’s post-COVID new normal. With ESG-related stocks encountering surprisingly strong demand and a growing investor base that demands proof of ethics beyond mere performance, ESG due diligence has become an essential part of the investment process.
We, at Kroll, a division of Duff & Phelps, have also seen a steadily intensifying focus on ESG over the many years we have been assisting the financial industry. We have seen the financial industry adopt an increasingly positive attitude toward responsible investing. Within the last two years, our own firm has launched a formal ESG program and embarked on a path to becoming a Carbon Neutral® certified company. Not only do we believe it is the right thing to do, but our ESG initiatives have proven a source of pride among our employees.
Today, a majority of private equity firms, asset managers and funds now work to ensure that their present assets and/or future acquisitions all benefit from having ESG programs in place, each adjusted according to the standards set by each fund or their responsible regulators.
Today’s investors know that integrating ESG factors into their investment processes will help them achieve favourable outcomes: mitigating portfolio risks, increasing shareholder value, broadening opportunities, and ensuring peace of mind borne from knowing your company’s actions are in harmony with the world around it.
1 "2018 Global Sustainable Investment Review." Global Sustainable Investment Alliance. Global Sustainable Investment Alliance, June 2019. http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf.
2 "Annual Impact Investor Survey 2019." Global Impact Investing Network. United States Agency for International Development (USAID), 2019. https://thegiin.org/assets/GIIN_2019%20Annual%20Impact%20Investor%20Survey_ExecSumm_webfile.pdf.
3 Kao, Ernest. "Hong Kong stock exchange begins tighter environmental and social disclosure standard from 2016." South China Morning Post. South China Morning Post Publishers Ltd., December 28, 2015. https://www.scmp.com/news/hong-kong/health-environment/article/1895501/hong-kong-stock-exchange-begins-tighter.
4 Hale, Jon Ph.D., CFA. "Despite the Downturn, U.S. Sustainable Funds Notch a Record Quarter for Flows." Morningstar. Morningstar, Inc. April 9, 2020. https://www.morningstar.com/articles/977328/despite-the-downturn-us-sustainable-funds-notch-a-record-quarter-for-flows.
5 "Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice." Morgan Stanley Institute for Sustainable Investing. Morgan Stanley and Co. LLC, 2019. https://www.morganstanley.com/pub/content/dam/msdotcom/infographics/sustainable-investing/Sustainable_Signals_Individual_Investor_White_Paper_Final.pdf.
6 Moreolo, Carlo Svaluto. "The origin of ESG indices." IPE Magazine. IPE International Publishers Limited, June 2019. https://www.ipe.com/the-origin-of-esg-indices/10031442.article.
7 "ESG on the Rise: Making an Impact in M&A." IHS Markit. IHS Markit, 2019. https://www.mergermarket.com/assets/Ipreo%20Q1%202019%20Newsletter_AW_FinalLR.pdf.
8 Copper-Ind, Christopher. "Morningstar confirms buyout of Dutch ESG analysis firm." International Investment. Incisive Business Media, April 22, 2020. https://www.internationalinvestment.net/news/4014253/morningstar-confirms-buyout-dutch-esg-analysis-firm.
9 Kao, Ernest. “Hong Kong Stock Exchange Begins Tighter Environmental and Social Disclosure Standard from 2016.” South China Morning Post. SCMP Group, July 20, 2018. https://www.scmp.com/news/hong-kong/health-environment/article/1895501/hong-kong-stock-exchange-begins-tighter.
10 Koo, Adam; Ng, Simon Lamrad, Dr Nadira. "Hong Kong business is generally in favour of ESG disclosures." Business Environment Council. Business Environment Council Limited, August 13, 2019. https://bec.org.hk/newsroom/hong-kong-business-is-generally-in-favour-of-esg-disclosures.
11 Ng, Eric. "Hong Kong listed firms get ‘F’ on ESG report card, put on notice as rules become mandatory in 2021." SouthChina Morning Post. South China Morning Post Publishers Ltd., January 1, 2020. https://www.scmp.com/business/article/3044106/hong-kong-listed-firms-get-f-esg-report-card-put-notice-rules-become.
12 "The Shanghai Stock Exchange's ESG Guidelines will introduce matters such as mandatory disclosure of the environment." Weekly on Stocks. Securities Market Red Weekly, June 9, 2019. http://news.hongzhoukan.com/19/0609/liangshuang062158.html.
13 Davies, Paul et al. "China Mandates ESG Disclosures for Listed Companies and Bond Issuers." Latham & Watkins. Lexology LLP, February 6, 2018. https://www.lexology.com/library/detail.aspx?g=61af067d-4fd6-4ad9-91d6-bb01037fb166.
14 “Signatory Directory.” PRI. United Nations. Accessed December 9, 2019. https://www.unpri.org/signatories/signatory-directory.
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