The Changing Tide of the Role of ESG in the U.S.

In the U.S., environmental, social and governance (ESG) is moving rapidly from words to action. There is an undeniable rise in the importance of understanding ESG risks to businesses. Totaled together, the financial risk of ESG-related controversies is staggering. When Bank of America Merrill Lynch looked at 24 major ESG-related controversies from the past six years, the result was a combined loss of $534 billion market capitalization for large U.S. companies.¹

Amid this year’s events—including COVID-19 and Black Lives Matter—topics such as employee mental health, safety, diversity and inclusion are being discussed openly throughout many organizations. The events of 2020 have pushed ESG to the top of the agenda within the private sector without the need for regulations to force boards to make changes for the better. Moreover, despite some inertia, statements of intent such as those made by the Business Roundtable² a year ago, suggest that leaders in the financial sector understand that times have changed, and ESG issues are going to become a permanent and prominent fixture in investment decision-making and corporate behavior.³

Though U.S. regulators have yet to direct their focus to mandatory ESG due diligence, that hasn’t stopped investors, asset managers and business directors from seeing opportunities in developing programs that meet the scrutiny of their clients and employees.

Despite the Limited Federal Regulation, What Drives Changing Attitudes Among U.S. Companies to ESG

There have been some examples of industry-level self-regulation, including the announcement from major PE firms, such as KKR & Co. Inc. and TPG Capital, who opted to disclose the ESG impact of their investments this year of their own accord. This led to many of their peers following suit and is a trend that is expected to continue.² For instance, investment bank Goldman Sachs announced earlier this year that it will only take companies public that have at least one woman or non-white board member. If adopted widely, this rule could drive a move towards diversity for boards of both private and public companies.⁴

Additionally, U.S. firms are increasingly subject to state level regulations. California’s Transparency in Supply Chains Act, the first such regulation, has been in effect since 2012 and requires large businesses operating within the state to disclose steps taken to eradicate human slavery and trafficking within their supply chain.⁵ Under the Illinois Sustainable Investing Act, which took effect this year, agencies involved in managing public funds must “develop, publish and implement sustainable investment policies applicable to the management of all public funds under its control.”^6,7,8

CSR is Dead, Long Live ESG

Corporate Social Responsibility (CSR) represents a company’s efforts to have a positive impact on its employees, consumers, the environment and wider community. Many Executives argue that CSR alone is no longer enough in a new era of purpose-led business.^9,10,11 While it opened the door to measure an organization’s non-financial contribution to the world and was a step in the right direction for corporations taking responsibility, many CSR programs’ statements on what the companies intended to do were simply policy statements lacking the ability to chart progress and impact. ESG, on the other hand, identifies environmental, social and governance as three key factors to measure the sustainability of an organization or investment.

For example, a company’s internal water preservation program that is disclosed and measured appropriately year-on-year to meet targets for progression. It would also be important in third-party risk management to not only know a supplier’s policy on environmental responsibility but also how they are changing their actions to meet a target. This could extend to business’ preparedness for resilience and long-term planning.

ESG-specific research seeks to identify references to the third party’s material involvement in activities considered as high risk or non-compliant by a range of ESG global standards, frameworks and publicly available data sources.^10,11

ESG is Complimentary to Business Plans, Not Competitive to Them

Kroll recently spoke to Stephen Ban, CEO and Co-Founder of GreenCat Advisors, on how ESG is quickly moving from words to action in the U.S. He elaborated on how ESG should be viewed as complimentary and necessary to business plans.

Stephen Ban (SB): Large company CEOs have had to embrace ESG because equity and debt investors are asking questions, asking for reporting and even making extreme requests and demands. I think we’re at an important inflection point now—and one that is catalyzed by the current issues facing our country and the world. That will only accelerate CEO’s needs to pay attention to—again, it comes back to clients, company, community and capital.

Kroll: How do you convince your customers that ESG factors impact their long-term business plans?

SB: This is so obvious when you think about it. Let’s start with economics. Being more energy efficient saves money. If you buy a building and can reduce its energy consumption, it becomes more profitable.

If you are more socially engaged, you can attract and retain a broader set of employees. Turnover is an enormous expense. I’ve read different studies that suggest employee turnover can cost a business between $15,000 and $35,000 (or more) per employee.

Then we get into the notion that business is competitive. There’s a “shop local” trend that I think will accelerate in the aftermath of our current crises. If you show people you care about your community, they’re more likely to patronize your business, all else being equal. We all know how expensive it is to attract a customer. Make it easy for them.

For bigger businesses that need to attract some form of institutional capital—whether from the public markets or from PE—the G factors (and the E and the S, frankly) are going to affect their access and cost. Investment in ESG strategies has tripled in the last year in the U.S. More than half of institutional RFPs ask questions about ESG practices.

This is all about capitalism beginning to correct itself. Clients, company (employees), communities and capital are going to reward good behavior and punish bad behavior.

Kroll: What is the first step to correcting past issues found within your third parties?

SB: It starts with asking the questions. If you are a business with profit and values at your core, then you must ask third parties about theirs. Then it depends on whether they can be addressed. No business is perfect; embracing ESG is an ongoing process—a journey and not a destination. Much as your own businesses can improve, so can third parties’. Are they working to improve their environmental footprint? Workforce diversity? Employee engagement? Client loyalty? That’s a right step. On the other hand, there are some things that can’t be fixed. If I see a long pattern of bad behavior (high turnover, hostile workplace) warning bells go off.

There are some challenges, though. Sometimes different companies (or investors or individuals) have different definitions of what responsibility means and that may be insurmountable. The other is that life is full—and capacity to evaluate businesses is limited. So, as much as there is an opportunity for large investment companies to say “here’s how we define it” and make it easy for individual investors to invest and say “at least it’s a step in the right direction, even though it’s not perfect or directly in alignment with my values,” there’s probably a market for an objective party to come in and rate companies so that it’s easy for the time and capacity starved businessperson or purchasing person to say “someone has made an objective assessment that this business is moving in the right direction.

Kroll: What sort of ESG due diligence do you see currently conducted to identify issues?

SB: Most businesses don’t have the bandwidth to do deep due diligence to ensure third parties are adhering to ESG measures.

Other Professionals Agree^12,13

Nigel Topping, CEO of We Mean Business, a coalition of 889 companies with $17.6 trillion in market capitalization, commented: “If these challenges are tucked away and approached solely for compliance reasons, they are not being integrated. And if businesses aren’t incorporating them into financial decisions and long-term planning, then they are not being taken seriously—which leaves the business poorly prepared for the future.”¹⁴

In Morgan Stanley's latest poll of 800 individual investors, 85% said they are interested in sustainable investing and adopting its principles as part of their strategy, and 86% believe companies that focus on the environment and social goals can earn better returns.

How Do You Create an Effective ESG Program? ESG Due Diligence Helps

Marketing and communications used to be the departments responsible for CSR. Now with the shift to assessment, ESG is moving into the risk and compliance departments of companies since unmitigated and unmanaged ESG risks can result in: reputational and public relations issues, the loss of potential buyers, regulatory action, significant commercial losses, possibility of extortion, disruption of business operations, the damaging loss of trust among customers and suppliers, negligence claims, and the inability to meet contractual obligations.

Best Practices for Integrated ESG Due Diligence Services

While most corporate ESG programs are forward-looking, it’s important to identify issues from the past, especially when it comes to onboarding third parties or assessing whether prospective investments meet your firm’s ESG standards and criteria. Including ESG assessments in the compliance due diligence process doesn’t necessitate a rewrite of the onboarding process. These risks can be mitigated through targeted research to understand your third parties’ ESG policies, to identify red flags before onboarding, and to assess specific ESG challenges when operating in unfamiliar jurisdictions.

There are steps that can be implemented within the framework of an existing compliance program, including these best practices:

• Keeping compliance and monitoring programs up to date with the latest changes
• Appoint ESG advisors early and have those inner discussions on the scope of assessment
• Transparent procedures are key in addressing corruption in procurement processes
• Effective control mechanisms 
• Centralization of procurement processes

Despite the absence of regulations at the federal level in the U.S., momentum continues to build among investors towards developing and implementing programs to mitigate ESG risks, which are of importance to their firms, investors, employees and the wider community. 

Contacts
Matt Fournier
Vice President, Compliance Risk and Diligence
T   +1 312 697 4690
M   +1 312 919 5249
[email protected]

Mallory Smith
Commercial Operations Associate, Compliance Risk and Diligence
T +44 20 7029 5030
M +44 7392194901
[email protected]

Sources
¹ https://www.bofaml.com/content/dam/boamlimages/documents/articles/ID19_1119/esg_matters.pdf
² https://www.cnbc.com/2019/08/19/the-ceos-of-nearly-two-hundred-companies-say-shareholder-value-is-no-longer-their-main-objective.html
³ ESG Needs its Own Due Diligence, April 2019 FT Adviser
⁴ Private Equity Giants Vow to Show their ESG Credentials in 2020
⁵ https://www.cbsnews.com/news/goldman-sachs-diversity-ipo-women-minorities-david-solomon-davos/
⁶ https://oag.ca.gov/SB657
⁷ https://www.kirkland.com/publications/article/2019/10/states-take-lead-on-esg-investment-regulations-whi
⁸ Private Equity Giants Vow to Show their ESG Credentials in 2020
⁹ ESG: Impact on Companies Doing Business in America and Why They Must Care
¹⁰ https://arabesque.com/research/From_the_stockholder_to_the_stakeholder_web.pdf
¹¹ Why ESG is Replacing CSR—and What This Means to Your Business, April 2019 
¹² ESG Needs its Own Due Diligence”, April 2019 FT Adviser
¹³ Integrating ESG: It’s Just Good Business, RBC Global Equity Team 
¹⁴ Global Sustainable Investments Grow 25% to $23 Trillion, Bloomberg Briefs 2017
¹⁵ https://www.morganstanley.com/press-releases/morgan-stanley-survey-finds-investor-enthusiasm-for-sustainable-