Why companies need to act now to get their ESG house in order

Environmental, social and governance (ESG) has rocketed up the corporate agenda in recent years, fuelled by more regulation and the twin pressures of consumer and investor demands.

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The UK Government is preparing to publish findings from a consultation launched earlier this year proposing mandatory ESG reporting in line with the Task Force on Climate-related Financial Disclosure.

The new rules, expected to come into force from 2022, will make ESG reporting mandatory for all private UK companies and limited liability partnerships with more than 500 employees and turnover greater than £500m, along with all publicly quoted UK companies, the professional services firm added.

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ESG encompasses a wide spectrum around sustainability. While many consider it predominantly related to the environment, ESG also covers areas under the “social” category, such as modern slavery and racial and gender equality, while the “governance” aspect covers how well a company is run.

The Task Force on Climate-Related Financial Disclosures (TCFD) has created a framework to help companies and other organisations disclose their activity around ESG.

Should reporting on sustainability become mandatory in the first half of next year, companies will be under the same obligations as they are to disclose their annual accounts.

TCFD reporting alongside regular company disclosures will be used by ratings agencies to build company ESG scores.

Jo Freeman-Young, sustainability actuary at EY, believes ESG reporting is crucial for the futureof firms. She explains: “Getting your own house in order is important because of the impact it has on investors.

“Most companies are not operating on the cash that they are sitting on, they are operating on debt. They issue corporate bonds or they issue equity and people buy it and they then use that cash to run their business. If investors come under pressure through regulation not to invest in companies that do not have good ESG credentials then they won’t invest.”

Reporting of ESG scores, however, is causing a headache for companies and investors alike, as there is a lack of standardisation amongst the main players in the ratings industry.

Freeman-Young says: “Ratings companies might choose different environmental factors, different social or different governance factors to build their scores and they might weigh each element differently.

“You have this real problem where there is a lack of standardisation across the ratings industry. An MSCI score will be completely different from an S&P [Standard and Poor’s] score. Whereas with credit ratings, people are comfortable using them because the correlation between different firms is like 98 per cent.

“This is a problem for investors, because they don’t know if they should buy into an individual company or not, and it is a problem for the individual company because they don’t know the best way to disclose to get the best possible rating.”

Another issue for directors when it comes to ESG reporting, is building up a true picture of their company’s impact on the environment.

The TCFD framework is split into three scopes, with one and two being direct emissions that come from a company’s operations, such as energy use in an office. Scope three covers more opaque factors, such as employees’ behaviour around commuting to work and financed emissions, which covers any investments the company undertakes.

Freeman-Young says: “A lot of the ESG scores are made up of scope one and scope two and not three. Scope three includes data which is difficult to collect, such as reporting on people driving to work. Financed emissions are also a significant part of the company’s footprint.”

The Global Reporting Initiative and the Sustainability Accounting Standards Board are working together on a single framework for ESG which should address the ratings issue. However, there is a clear opportunity for fintechs to address the gaps in reporting.

Jo Freeman-Young observes: “One of the big data gaps is how we standardise scope three emissions, such as people travelling to and from work.

“Most people have a mobile phone and you envisage a Strava-type app running in the background that tracks movement and if a person, walked or cycled to work or travelled by car.

“The technology is there to address these gaps and it will take people thinking about thisproblem in an innovative way to solve it. Who does that? Is itGoogle, Apple, or is it a fintech that develops an app?”

Gbenga Ibikunle, professor and chair of finance at the University of Edinburgh, highlights the fact that fintechs, like CoGo linking up with Natwest, are collaborating to provide customers with greater insight into their own carbon footprint.

He says: “There is a lot of enthusiasm amongst start-upsand established financial businesses to take the lead in addressing climate change by developing new technological applications.

“A good example is CoGo, which uses transactional data to estimate the carbon footprint of every person in the economy.

“This provides an incremental indicator to individuals and allows people to determine for themselves how much they contribute to the problem.”

Nicola Anderson, chief executive at industry body FinTechScotland, is confident that Scotland’s strength in asset management puts it in a strong position to develop new financial services around ESG.

She explains: “We have a very strong financial services heritage in Scotland which gives us a good foundation.

“We are seeing more and more fintechs think about that opportunity and how they can use data to support boards and executives in the decision-making process when it comes to sustainability.

“Seeing fintechs think about the risk and how regtech and risk modelling needs to change in the future. We are dealing with a community who want to see positive change and have real purpose and drive behind that.”

Caroline Stevenson, partner and head of the financial services regulatory team at law firm Burness Paull, says financial services firms should place transparency at the core of their activities: “Companies could be open to claims in the future if investments turn out to be not what they said they were.

“The Financial Conduct Authority is trying to discourage greenwashing, therefore if you say something is green then it genuinely needs to be.”

This article first appeared in the October 2021 edition of The Scotsman’s Fintech Focus supplement. A digital version can be viewed here.