Informed and flexible approach is vital in navigating ESG regulations

Risk managers are navigating a great number of emerging global ESG regulations, developing flexible strategies to avoid non-compliance and other risks that could have significant financial and reputational consequences if not properly managed.

While there are encouraging signs that standardisation and harmonisation could make it easier to monitor and comply with ESG regulations in multiple jurisdictions, this isn’t likely to happen soon. It is therefore critical that, in the meantime, insurers engage with their customers, regulators and policymakers to help with proper and consistent interpretation and the development of rules that effectively support the purpose of ESG, while they are easily understood and not cumbersome to follow.

Emerging regulation is prompting companies to pay more attention to ESG, according to BCG’s 2022 Global ESG, Compliance & Risk Report. A large majority of survey respondents (79%) said they have intensified their commitment to ESG as regulations and enforcement actions have increased, focusing particularly on companies that engage in greenwashing or fail to implement required changes to products, services, reporting mechanisms or organisational structures.

Despite this increased awareness, there is a growing tendency for some companies to become overwhelmed by the regulatory challenges and step back, perhaps from fear of greenwashing accusations. On the other hand, 76% of consumers say they will not do business with companies that poorly treat the environment, employees or the communities where they operate, according to research by PwC.

Rather than reducing their ambition and  applying ESG requirements conservatively, companies should focus instead on execution and take a proactive approach, albeit one that is sufficiently informed to deal with the rapidly changing landscape. Their strategies call for closely monitoring regulatory developments and engaging stakeholders through an in-depth assessment of risk and opportunity.

Sizing up the risks

Risk managers are aware that falling afoul of regulations can create a number of problems. Failing to meet obligations outlined in ESG rules such as the impending requirements under the European Union’s Corporate Sustainability Due Diligence Directive (CSDDD) and Corporate Sustainability Reporting Directive (CSRD) could lead to regulatory or legal penalties, while inconsistent reporting or disclosure also creates risks, and is made difficult by the voluminous and differing rules that companies are bound to abide by.

With the world not on track to meet the Paris Agreement’s long-term goals, including limiting global warming at 1.5 degrees, governments and regulators are increasingly pushing to accelerate the transition while also moving to actively address human rights regulation and growing concerns about nature and biodiversity. With so many projects on the horizon, regulatory frameworks are struggling to address the risks that can arise as companies transition to low-carbon operations, a process that can render assets that are heavily dependent on fossil fuels stranded. Regulators are working to understand the potential financial implications of this issue and how the effects can be minimised.

Transition risk can also arise if regulations create an atmosphere of uncertainty. Inconsistent or ambiguous regulations can hinder long-term planning and investment decisions related to transitioning to a low-carbon operation.

According to S&P Global Market Intelligence, 80% of the world’s largest companies are reporting transitions risks associated with climate change.

In addition to these risks, the constantly changing regulatory scene can lead to volatility and uncertainty in financial markets, which can influence investor expectations. Corporate insurance buyers, insurers, brokers and other insurance market participants are adapting to evolving regulations and ensuring that they are meeting expectations around disclosure and performance. Otherwise, it could be difficult to attract and retain investors.

Organisations may also find that an uncertain regulatory landscape can create barriers to market access and hinder international expansion. Alongside this concern, companies operating in regions with more stringent ESG regulations than those in places where competitors are located could find themselves at a competitive disadvantage. An example would be an automaker operating in California under the state’s Zero Emission Vehicle mandate competing against manufacturers in other states with less stringent emissions standards.

Reputational risk that could result if companies are found to be operating outside regulations is a particularly significant exposure. ESG issues have gained increasing attention and the public is highly focused on it. Any negative media coverage can quickly magnify and spread through multiple digital channels. The resulting damage could have long-lasting effects on sustainability and competitiveness, particularly for companies that are expanding into new markets. And a reputational contagion could spread to supply chain partners, investors and other associated entities, who could also face a backlash if they are linked to a company that falls afoul of regulations.

The risk management role

What can risk managers do to help their organisations keep up with the rapid changes in regulations, ensure that they remain properly aligned with requirements in multiple jurisdictions, and tackle other regulatory challenges?

The regulatory landscape and sustainability reporting frameworks and standards guiding companies and investors on ESG disclosure are constantly evolving and developing. It is important that businesses have the capacity to stay informed, closely monitor and analyse these requirements, and develop a proactive, adaptive strategy of advocacy, engagement and compliance to meaningfully engage relevant stakeholders. In this challenging environment you need to remain committed and accountable for delivering your overall objectives and sustainability goals. This includes integrating sustainability considerations into existing processes, both on implementation and disclosure, ensuring they are robust and can withstand internal and external scrutiny, and where and how to engage with stakeholders across the operations, supply and value chain.

It is vital that regional and operational functions work closely with a corporate team to ensure that compliance and sustainability efforts remain anchored to the company’s overall objectives and goals.

Having the right people in place with a mindset of being proactive and adaptable in the constantly emerging regulatory landscape is critical. Risk management can sometimes be quite binary. There will be deviations along the road, and that is why flexibility is a key ingredient in a successful ESG strategy.

Insurers bring data and expertise to the effort

First and foremost, insurers can help customers with risk assessment and risk transfer. With the expertise to evaluate and quantify physical ESG risks and their potential impact on operations, insurers can also provide in-depth insights on emerging trends and help risk managers develop strategies.

However, insurers also play a meaningful role by providing data and analytics that can help regulators and policymakers gain a deeper understanding around the financial implications of ESG risk. With vast amounts of data on climate change, natural catastrophes and other risk-related information, insurers can help inform evidence-based regulation while facilitating better risk management practices for their customers.

Utilising a broad range of insight and expertise, insurers are also able to develop specialised coverage that helps customers manage and mitigate ESG-specific perils. Insurers are well positioned to help customers adopt sustainable practices and invest in resilience. Such approaches complement ongoing regulatory efforts, making compliance a less arduous task.

Insurers are actively involved in advocacy as well, bringing expertise to regulatory discussions and working to help develop effective and consistent standards.

Inaction could be costly

In addition to the effect of positive implementation on brand and employee engagement, there is evidence that striking the right balance with an ESG strategy that aligns with your company’s financial objectives can have an impact on the bottom line of companies that adopt them. According to research by McKinsey, ESG strategies can affect operating profits by as much as 60%, providing incentive for implementing them. This means that more than just a standalone compliance framework is required, but rather an assessment of materiality and full integration into business strategy.

It is not inexpensive to put in place a sustainability framework and the processes needed to monitor and comply with all applicable regulations around the world. But it shouldn’t be a matter of cost; it’s a matter of doing the right thing. What is going to happen down the line if we don’t get a grip on this is quite clear. This is a business-critical concern that needs to be adequately resourced because the risks of not delivering will be severe.

Contributed by Andrew Myhill, head of climate & ESG policy, public affairs at Zurich Insurance Company.