Navigating ESG: Forward Thinking

Environment, social and governance disclosures for companies lurk just around the bend, either directly or via business they conduct in other regions, according to speakers at PLANADVISER’s Navigating ESG Livestream on November 8.

Corporate sustainability regulations coming to Europe next year will be relevant for both domestic companies and those operating in the countries, meaning a number of large U.S. firms, according to Mirtha Kastrapeli, executive director of ESG Corporate Ratings in the ESG practice of Institutional Shareholder Services Inc., which also owns PLANADVISER.

This year, the EU passed deforestation regulation that seeks to ensure companies are not using materials in their supply chain that come from deforestation or breaches of local environmental laws. Separately, the EU’s Corporate Sustainability Due Diligence Directive, while details are still being negotiated, is slated to go into effect at the end of 2024. It calls on companies to identify actual or potential risks to human rights and the environment and to try and mitigate those risks.

“It’s really going to require European companies, but also companies that are doing business in Europe under a specific threshold, to consider their social and environmental impacts of their operations across the supply chain,” Kastrapeli said. “These future regulatory risks are now a real risk. It’s a risk that is coming in the next few years that is going to impact companies and investors.”

Allison Itami, a principal in Groom Law Group, Chartered, said U.S. companies are likely familiar or already working with such ESG disclosures. In California, in particular, a law going beyond Securities and Exchange Commission disclosure rules will be going into effect in 2025 that mandates corporate climate and climate-related risk disclosures.

“Companies who have a European presence, who have a California presence, are already working on this,” she said. “I also think that none of these are particularly new in concept. How it’s put together, how it’s disclosed might be new, but investors who are already doing their due diligence are asking questions about resiliency and all of these things.”

Mitigating Risk

Kastrapeli said investors should think about ESG as a “risk mitigation tool,” ranging across “operational risk, regulatory risk, reputational risk and, potentially, litigation risk with some of the new regulation.”

The sustainability expert believes there is “good news” for companies and investors in the form of established frameworks for how to report on ESG issues, both regionally and globally.

She noted disclosure methodologies created by the International Sustainability Standards Board, as well as the European Sustainability Reporting Standards in Europe, that are providing clarity on how to consider and report on ESG factors.

There are some differences between the European and ISSB approaches to ESG disclosures, Kastrapeli noted. The EU is focused on a “double-materiality” approach in terms of both “how the world affects a company and how the company affects the world.” Meanwhile, the ISSB is more focused on the financial materiality on the company itself in terms of long-term impact.

Kastrapeli recommended that U.S. investors start with the ISSB standards when approaching ESG disclosure standards.

Retirement Investing, Litigation Risk

When it comes ESG investing in qualified retirement plans, Itami referred to the “all things being equal” test. When used under the Employee Retirement Income Security Act, the test provides the baseline that if an investment is equal in all pecuniary factors, then it is allowable to consider a “collateral” benefit for inclusion.

“That has fundamentally been the test for decades,” Itami said. “I don’t expect that test to change going forward.”

What has changed, Itami said, is that ESG investing in retirement plans has become “highly politicized,” including multiple lawsuits, creating risk beyond the ERISA framework.

“Even if the legal risk is very clear, that doesn’t prevent someone from suing you over your decision, and it does not prevent that lawsuit from driving up costs,” she said.

That litigation risk is causing “folks to be reluctant to jump in” to implementing sustainable investing in retirement plans, Itami said. For plan sponsors to feel comfortable implementing ESG investing factors, they should seek expert advice that can guide them on the legal standards that already exist under ERISA and through the “all things being equal” test, Itami said.

When it comes to investors considering ESG factors in decisions overall, however, Kastrapeli said the “train has left the station.” A combination of the regulations with demands of investors and companies means it is hard to “disconnect” ESG from the markets.

She noted that ESG analysts are no longer “off in a corner” of an asset manager or pension firm, but part of the core analysis around investment decisions.

“I cannot imagine a world in which we start taking information out when making an investment decision,” she said. “You can call it whatever you want, but [ESG factors] are fundamental to the work.”