Why ESG Risk Should be Top of Your Due Diligence Agenda

Regulators increasingly require corporate and financial services firms to incorporate Environmental, Social and Governance (ESG) risks into their due diligence and reputational risk management processes. The year of 2023 alone has seen massive increases in corporate responsibility in this area; for example, the European Union’s Corporate Sustainability Due Diligence Directive (CSDDD) requires companies with 250 or more employees to comply to unprecedented environmental standards.

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 blog, 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

At one point, 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–ESG legislation requiring companies to demonstrate that they are carrying out due diligence on the records of suppliers, agents, and joint venture partners. For example:

• United Kingdom: The U.K. spent the first half of 2023 conducting checks on its Companies Act 2006 and policies around the gender pay gap, minority equity, and environmental protections.
• United States: The S. Securities and Exchange Commission (SEC) has tightened up its due diligence laws in 2023, with a heavy focus on requiring climate disclosures.
• European Union: Acts like the Green Deal Industrial Plan and Critical Raw Minerals Act aim for net zero carbon emissions in the EU and are being heavily enforced throughout the region.
• Australia: According to the PWC, Australian businesses are uniting toward a “green hydrogen export industry” for the country’s future.

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.

MORE: How financial services can keep up with ESG regulations

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.

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 recognizing the concept of a "double bottom line"–that their performance should be measured in terms of positive social impact as well as profit.

MORE: Gaining executive support from ESG communication initiatives

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.

MORE: Key trends in risk and compliance

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. Done inefficiently, this could lead to more costs and be less efficient overall.
• Defining ESG:ESG is an extremely broad term covering a wide range of activities, which leads differing and often conflicting assessments of ESG compliance.

MORE: How to deal with political pushback to ESG initiatives

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. Get started with a free trial today!