The ESG Risk Series: Why ESG Risk Should be Top of Your Due Diligence Agenda

Regulators increasingly require corporates and financial services firms to incorporate Environmental, Social and Governance (ESG) risks into their due diligence and reputational risk management processes. ESG also brings opportunity: asset managers and investment banks have enjoyed significant returns by moving assets into sustainable funds, while companies who are transparent about their ESG commitments have been profitable. But ESG is often poorly defined, and acquiring the right data to uncover these risks is difficult. In this series of four blogs, we explore the trend towards ESG risk management; break down the factors companies should consider when trying to assess ESG claims; and explain how Nexis® Solutions can help to identify these risks.

Expanding regulations mean ESG compliance is no longer optional

Until a few years ago, ESG was recognized as a worthy aspiration for companies but rarely prioritized at the expense of profit. Today, mandatory human rights and environmental due diligence has become a regulatory expectation for financial services companies and other firms. It is no longer enough for them to limit their monitoring of third parties to long-standing risks like creditworthiness or exposure to money laundering.

Numerous jurisdictions have brought in–or are planning–legislation requiring companies to demonstrate that they are carrying out due diligence on the ESG record of suppliers, agents and joint venture partners. For example:

• European Union: The European Commission recently published its draft Corporate Sustainability Due Diligence Directive, which sets out mandatory human rights and environmental due diligence obligations for companies and a new enforcement regime. It would likely be adopted and implemented into member states’ laws from 2027.
• Netherlands: The Child Labour Due Diligence Act 2019 mandates all companies that sell or supply goods and services to Dutch consumers to investigate whether these have been produced using child labour. It comes into effect later this year.
• Germany: The Supply Chain Due Diligence Act, which comes into force in January 2023, requires large companies to carry out risk management to ensure there are no human rights violations in their supply chains.
• France: The Corporate Duty of Vigilance Act 2017 requires large French companies to publish and implement a plan to identify, and prevent and mitigate human rights and environmental violations, among other issues.

Another important development is the EU Sustainable Finance Disclosure Regulation, which has been introduced to improve transparency around sustainable investment products. It requires asset managers across EU member states to disclose whether they have considered ESG factors in their company’s portfolio and their own funds.

ESG brings reputational risk and financial opportunity

Failure to properly consider and manage ESG risks poses a reputational risk to companies. Activist investors are moving money away from firms with poor records, while consumer campaigns boycott products with unethical sourcing in their supply chains. ESG failures put companies and their third parties in the spotlight with negative press and social media commentary, leading to a loss of consumer confidence and revenue.

Carrying out ESG due diligence is not simply about managing risk, but also a financial opportunity. Reuters reported that a record $649 billion was invested in ESG-focused funds in 2021, meaning they now account for 10% of worldwide assets. These investments have generally outperformed the market averages. For example, the MSCI World Index gained 15% last year, while its equivalent for companies with high sustainability ratings rose 21%.

Companies that demonstrate a positive ESG commitment are also enjoying more sustainable profits setting them up for long-term success. Customers, investors and employees increasingly want to buy from, invest in and work for firms that can demonstrate a positive ESG impact. Increasingly, businesses are recognising the concept of a "double bottom line"–that their performance should be measured in terms of positive social impact as well as profit.

How should financial institutions and other companies respond?

Companies of all stripes can mitigate the reputational, regulatory, financial and strategic risks posed by ESG–and exploit its opportunities–by taking the following steps:

• Incorporate ESG risk assessment into their due diligence reporting, including mandatory human rights due diligence.
• Examine suppliers, agents and joint venture partners for potential ESG risks, preferably using reliable sources that don’t require costly questionnaires or in-person audits of every company.
• Ensure assets under management that claim to be sustainable genuinely meet ESG criteria.
• Share insights around ESG risk with other stakeholders in the company to enable data-driven decisions that make ethical profit possible.
• Invest time and resources into accessing to high-quality data covering different aspects of ESG risk, including news sources, company data, PEPs and sanctions lists, and more. Data analytics technologies can be applied to this data to find relevant insights.
• Set expectations with third parties, customers and employees that trust and transparency over ESG is required for an ongoing business or employment relationship.

Compliance teams face challenges to understanding ESG claims

It is undeniably important for companies to monitor for ESG, but it is not a straightforward task. Challenges include:

• Greenwashing: Many investment funds and companies have been accused of exaggerating their ESG performance. In a recent survey of around 1,500 US executives, 58% admitted their company has “overstated” their sustainability efforts, while only 36% said their company has the tools to quantify their efforts to improve sustainability. This should concern asset managers who are deploying huge sums into funds branded as ESG compliant.
• Legacy processes of due diligence and reputational risk management: Financial services firms are used to screening third parties using traditional credit risk assessments. But they now need to monitor for all aspects of ESG, which involves subscribing to multiple solutions. This leads to more costs and inefficiency in their processes.
• Defining ESG: ESG is an extremely broad term covering a wide range of activities, which leads differing and often conflicting assessments of ESG compliance. In the remainder of this series, we will release three blogs which dive into each area of E, S and G in turn.

Nexis Solutions: cutting through the noise to surface ESG risks and insights

Nexis Solutions helps firms to tackle the challenge of assessing ESG risk head on and surface insights related to ESG risks across our broad range of data, from our news archive to company data to PEPs and sanctions lists. This supports companies’ reputational risk management, due diligence, and data-driven investment decisions.

In addition to our existing data, we have recently added ESG content to Nexis Diligence™ that enables users to confidently incorporate an ESG risk assessment into their due diligence research and reporting workflow, within a single interface of content chosen specifically for fast, cost-effective, and comprehensive due diligence:

• ESG Ratings is a new content type in Nexis Diligence, which displays an at-a-glance view of a company’s ESG These ratings, provided by CSRHub, help customers understand a company’s reputational or ethical business risk. The ESG Ratings break down ratings for each ESG category into further sub-categories, as well as providing an overall rating for the company.
• ESG Custom News delivers users a set of predefined search terms, enabling them to carry out ESG research within our extensive set of news sources, customized to their preferences.
• ESG Factors Power topics allow users to post-filter all their news results using ESG specific topical indexing.