ESG Due Diligence: Setting a High Water Mark

Refinitiv’s Wendy De Cruz talks to Regulation Asia about new supply chain laws reshaping industries and the challenges FIs face in enhancing due diligence practices.

ESG has become front and centre to strategy for financial institutions (FIs) globally. Amid increased regulatory pressure and heightened public awareness, banks have started to incorporate ESG considerations in their lending decisions, asset managers in their investment processes, and insurers in their underwriting practices.

Yet, the consequences for failing to account for ESG related risks associated with a loan, investment or asset, are still largely reputational, and companies continue to be benchmarked against profitability. It is no surprise, then, that FIs are often not thorough enough in conducting ESG due diligence to identify all possible threats, including risks associated with supply chains.

This will change with the emergence of new supply chain laws that will make it increasingly necessary for FIs to conduct more thorough ESG due diligence to comprehensively assess human rights and environmental risks in supply chains. In Germany, for instance, a new Supply Chain Due Diligence Act passed Parliament in June, and will come into force on 1 January 2023.

The German law establishes obligations for companies to conduct due diligence on both direct and indirect suppliers, requiring a risk analysis to be performed, whistleblower systems to be established, and immediate remedial action to be taken if human rights or environmental violations are detected.

The law will initially be applicable to all companies with more than 3,000 employees, including foreign firms with activities in Germany, and from 1 January 2024, it will expand to include companies with 1,000 employees or more. The law will penalise failures to comply with due diligence obligations with fines up to 2 percent of total worldwide annual group turnover, as well as potential bans on issuing public tender offers and securing government contracts in Germany.

Supply chain scrutiny

Germany’s new law represents only the beginning of a trend towards increased due diligence obligations for companies, and high penalties for non-compliance. A new directive on corporate due diligence and accountability is currently being discussed at the EU level, which will impose similar reporting obligations and duties to monitor supply chains.

Meanwhile, the US is becoming increasingly focused on modern slavery and forced labour in its policies, the UK government is considering the introduction of financial penalties for non-compliance under its Modern Slavery Act 2015, and Australia is considering implementing major updates to its own Modern Slavery Act 2018.

These new laws will require companies across a large swathe of industrialised nations to review and update their supply chain due diligence processes and systems to ensure they can identify, assess, prevent and remedy human rights and environmental risks and impacts in their supply chains, and in their own operations.

The impacts will be felt across Asia, where the majority of goods are produced for export to industrialised nations. Companies with extensive supply chains in Asia could suffer large scale de-risking due to questionable environmental and labour practices in some jurisdictions where their suppliers operate.

Germany, for example, imported about USD 1.16 trillion of goods in 2019, making it the number three trade destination in the world. Its largest trading partner is China, which outsources production lines to other Asian countries, and will increasingly do so as the Belt and Road initiative further develops.

Ahead of the curve

ESG data quality is still considered low, methodologies are opaque, and there is still some ways to go before companies have adequate oversight over their supply chains. However, ESG due diligence practices and disclosures will improve over time, resulting in increased transparency over poor environmental and labour practices.

To date, the financial sector has seen some firms get ahead of the curve when it comes to ESG due diligence. Already some FIs have implemented ESG screening processes into their due diligence, and some have even started to ask borrowers and new portfolio companies to monitor and report on metrics and progress.

Asset managers in particular have face intensified pressure to take a longer-term view when it comes to their investments, including to assess the environmental and social impact of their portfolios. As of Q3 2021, the internationally-recognised Principles for Responsible Investment (PRI) has over 4,100 signatories, representing USD 121 trillion in assets under management globally.

Wendy De Cruz, APAC Sales Proposition Director, Customer & 3rd Party Risk, Refinitiv

Wendy De Cruz, APAC Sales Proposition Director, Customer & 3rd Party Risk, Refinitiv

“Younger investors and consumers in particular are an important driver of these changes. They are increasingly making their choices based on ESG elements such as global warming, impact of plastics on the oceans and sustainability,” says Wendy De Cruz, APAC Sales Proposition Director for Customer and Third Party Risk at Refinitiv. “The new generation is really expecting companies to improve their practices, and to prove what they say they’re doing.”

Yet, according to De Cruz, many FIs have not yet ingrained ESG as part of their overall compliance frameworks. “There is still insufficient awareness at many firms. It is still very murky. Based on the economics, corporates – including banks – will continue to be benchmarked against profitability, and not so much around how they conduct their businesses sustainably and responsibly,” she said.

“There is going to be a time of building awareness, setting up the necessary due diligence frameworks, so that we can ensure sustainability of the FI, as well as sustainability of the client. The measurements are just not there yet – goodness is difficult to measure and the task will not get easier. But I think the conversation we are having five years from now will be quite different.”

High water mark

In the short term, De Cruz says a key challenge is the opaqueness in supply chains, particularly around the environmental ‘E’ and social ‘S’ pillars of ESG, due to a lack of data, oversight and monitoring. Smaller companies, for example, may not have formalised processes or metrics in place for supply chain due diligence or even a code of conduct.

To address this, De Cruz says FIs should start by setting their own “high water mark” and adopt a self-certification process for customers and investee companies, similar to how banks use the Wolfsberg Group’s questionnaire for correspondent banking due diligence.

“As a baseline, banks need to ask customers if they have a code of conduct in place, an up-to-date human rights policy which is integrated throughout all levels of the business. If not, ask them to self-certify their commitments under the bank’s supplier code for how it expects third parties to manage their businesses. Due diligence is not a check-in-the-box exercise.  Engage with them to take a genuine approach,” she says.

Some asset managers have indeed adopted screening processes that include a survey of questions for investee companies, covering everything from environmental policies, employee discrimination, supply chain risk management, anti-corruption measures, the existence of formal employment contracts, and the protection of customer and employee data, among other areas.

Others are taking this a step further, seeking to use the questionnaires to facilitate change at investee companies, continuing to invest in those that don’t currently meet the standards but which signal a willingness to work toward them and improve their practices.

In Singapore, a key feature of the environmental risk management guidelines for FIs, which will take effect from June 2022, is an expectation that banks, asset managers and insurers engage with customers and investee companies to help them improve their environmental risk profiles – an approach that is increasingly being emulated in other jurisdictions.

For De Cruz, however, the change will not just be driven by regulation. Rather, it will be a concerted effort involving NGOs, governments, regulators, the private sector and consumers. “Compared to three years ago, the private sector in particular has stepped up its efforts and momentum is building around responsible and sustainable investing,” she says. “I’m optimistic from what I’m seeing, because I do see cooperation to change.”

“Of late, we’ve witnessed a flurry of activity around refreshing company policy commitments, soft law standards, hard law obligations and NGO activism. The transition in the corporate space is absolutely happening. And on the consumer side, we’ve seen boycotts and lawsuits against companies over their labour practices using non-judicial resolution mechanisms. I am confident that ESG commitments and practices will not just be another new year’s resolution.”

To learn more about mitigating ESG risks through an ethical approach to due diligence, join this webinar.

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