ESG Oversight: Walking the Tightrope Between Promise and Peril

Environmental, social, and governance (ESG) factors have become increasingly important in today’s investment environment, moving from being a minority interest to a common mandate requirement. For senior executives, risk managers, and compliance specialists, this development presents both great potential and significant challenges. In this context, the issue of greenwashing and the requirement for strong ESG supervision have become important areas of focus.

ESG investing has become mainstream as it has the potential to both improve society and provide investors with a strategic advantage in terms of long-term financial performance. Companies with strong sustainability practices should be better positioned to manage risks and seize opportunities, which translates into more sustainable long-term results, according to research and market trends. But there are several nuances in this world of ESG investing, the most important being the problem of greenwashing.

Overstating or misrepresenting one’s dedication to, and accomplishments in sustainability standards is a practice known as “greenwashing,” and it has grown to be a serious concern. Indeed, a recent ESG Global Study from Capital Group included the survey result that “50% of investors think that greenwashing is prevalent within the asset management industry”.

Whilst many cases of financial greenwashing are unintentionally caused by inadequate monitoring and processes, there have also been several high-profile cases where certain funds have turned to inflating their sustainability credentials to attract capital, since investors are beginning to consider environmental and social impacts more and more when making decisions. In addition to misleading investors, this disparity between commitments and actual practices compromises the credibility of the firm. Greenwashing has far-reaching consequences, such reputational damage, dissatisfaction among investors, and likely legal, regulatory and financial ramifications.

Investors who deal with fund-of-funds structures or who depend on external asset managers have an even greater issue when it comes to visibility of their environmental and social risks. In these cases, the oversight process becomes more complicated due to their distance from the underlying assets. Such investors, and even the fund-of-funds operators, may find it difficult to determine if the ESG mandates are being fulfilled. Relying on underlying investment managers and aggregating multiple disclosures from different sources becomes an impossible task due to different data sources, calculation methodologies, scoring standards and quality of reporting.

This emphasises how important it is to have strong sustainability oversight procedures integrated into the firm’s processing capability. A thorough, auditable and regular examination of the individual metrics of the underlying instruments, as opposed to a cursory and sporadic review of high-level ESG ratings and reports, is essential to effective monitoring. It calls for an exacting, data-driven methodology built into the core business processes that can separate fact from fiction to ensure that words are matched with deeds when it comes to ESG compliance.

Nevertheless, conventional approaches to ESG supervision frequently fall short in negotiating these complexities. They are often unable to keep up with the changing ESG regulatory landscape, and they frequently do not have the granularity necessary to uncover the truth about greenwashing. As a result, the industry requires more stringent monitoring procedures that use technology and analytics to provide a more complete and transparent picture of ESG practices.

Specialised ESG oversight solutions, as opposed to legacy systems with manual, spreadsheet-based workarounds, are needed to provide investment institutions the clarity they need to make informed decisions. An important requirement is the ability for investors to ‘look-through’ multi-tiered portfolios and monitor ESG metrics in a way that goes beyond simply checking boxes. Given the scale and depth of investment hierarchies, this is a deceptively very complex, costly, error-prone and time-consuming task when done manually.

Furthermore, effective ESG supervision is essential to risk management. It assists in identifying possible dangers and areas of non-compliance before they develop into more serious problems by giving a comprehensive picture of ESG practices over time. An “ESG Book of Record” is required to validate and maintain a history of the portfolios’ adherence to its environmental and social mandates. In a time when ESG variables can have a big impact on reputation, regulatory compliance, and ultimately financial success, this proactive approach to risk management is essential. Furthermore, given the ever increasing regulatory and investor scrutiny of a firm’s sustainability credentials, a scalable oversight solution can help turn compliance into a competitive advantage with the resulting transparency becoming a selling point for attracting new business. With the UK’s forthcoming SDR guidance expected to be published before year-end, now is an important time for firms to prepare themselves for the future.

In conclusion, the investing community needs to adopt improved, automated supervision systems that provide accurate, detailed, and transparent ESG reporting and analysis. Having a scalable solution is a must in a future where the capacity to efficiently monitor and validate ESG criteria will be essential.

James Pearce, Co-Founder, Know Your Funds

james.pearce@knowyourfunds.com

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