Have you ever heard of Engine No. 1? A few weeks ago, most hadn’t. It was a little-known hedge fund with a 0.02% stake in Exxon. Now, though, three seats on Exxon’s board of directors are occupied by candidates nominated by the fund. Engine No. 1’s cause-driven strategy aims to push Exxon’s investments well beyond oil — and it’s backed by behemoths like BlackRock and two of the largest pension funds in the U.S. Eyebrow-raising as this news is, it shouldn’t come as a shock.
Environmental, social and corporate governance issues, especially climate issues, and strategies for addressing them, have claimed increasingly large roles in businesses' decision-making processes; in fact, ESG investing is expected to reach $1 trillion by 2030. The climate crisis has significantly accelerated that trend, moving the environmental criteria in particular to the foreground as investors and management assess a company's direct and indirect impact on the environment, and its ability to manage and mitigate these risks.
This will present a particular challenge for lenders. As ESG risk grows, banks need not only to understand the underlying issues — from global warming to diversity to board structure — but must also satisfy themselves that borrowers have a real understanding of the risks they face and are reporting them accurately.
To date, there are a number of ESG frameworks meant to standardize reporting and disclosure; however, a lack of consistency and comparability across those frameworks leaves too much variability in regard to areas of focus and recommended metrics. This variation makes it exceedingly difficult for most organizations to fully grasp the context or strategies to address ESG risks, leaving money on the table for investors and business leaders alike.
Rest assured — or be warned — that regulation is coming. The U.S. the Securities and Exchange Commission is considering required ESG disclosures, starting with climate disclosures, and naming any funds with ESG-investment mandates. Adding to the momentum, President Biden recently issued an executive order that directs federal agencies to identify climate risks and set disclosure rules for private industry and finance. Focal points range from exposure to extreme weather events, to infrastructure and supply chains, to the “transition risk” for things like fossil fuel investments.
Savvy leaders will embed ESG criteria into their organizations now — voluntarily and at their own pace — before regulatory mandates force their hand. ESG reporting will and should follow the same level of rigor and scrutiny as any financial reporting; without investor-grade disclosures, there is an unacceptable risk of ESG reporting misstatement, either by fraud or error. Though the quantitative portions of the environmental standards will be relatively easy to upgrade, there are numerous qualitative metrics that will undoubtedly produce stumbling blocks.
The deepest complexities are rooted in assessing “impact” of an organization’s own products and services and that of their network of partners. For example, to measure “biodiversity impact,” one has to ask to what extent an organization's goods or services influence the variability of living things at an ecosystem level — and for how long, to what end and whether those impacts are reversible. It is a metric that will require nuanced, expert-led reporting that likely falls outside of an organization's core competencies.
Meanwhile, measuring impact for products and suppliers is equally complicated (if not more so) as organizations will need to dive deep into their own value and supply chains as well as those of their partners. For instance, understanding the carbon or water footprint of a given product or service — and, more important, organizing a path to redress pain points — becomes unruly without foolproof reporting mechanisms; the same can be said for assessing essential supplier operations. And these examples only scratch the surface of the full ESG context.
This level of scrutiny is not some far-flung possibility. Just look at the European Union — demand for ESG disclosure, ratings, funds and investment has led to an increased appetite for ESG methods that are robust and comprehensive to capture growing expectations on risks as well as to maintain trust. The EU is outpacing the U.S. on this effort — Europe has built a booming $40 trillion sustainable finance industry and accounts for almost 70% of global ESG mutual fund assets, according to a recent 2022 outlook study from PwC.
With this in mind, U.S. businesses must prioritize ESG reporting now, especially climate disclosure. This will give them a leg up on competitors in the likely event the SEC mandates ESG disclosure. Even without regulation, ESG reporting will position companies to better attract sustainable investment.
Despite its name, Engine No. 1 is not the first organization to fight for a low-carbon future — nor will it be the last. While this might seem alarming to some CEOs, businesses should be aware, but not fearful; when engaged meaningfully, ESG provides a mechanism to manage risk in the business and supply chain as well as measure and communicate progress and success. Transparency — and progress — in environment metrics in particular will equate to better performance and a long-term approach that drives growth, innovation and transformational change as we collectively transition to a low-carbon economy.
