For hedge funds not already thinking about ESG strategies, the COP26 global climate summit in Glasgow last week should serve as a wakeup call.

ESG has become the world’s latest flashpoint, pitting activists, shareholders, and lawmakers in a tug-of-war over climate change, greenhouse gas emissions, diversity, and equity. Just as the pandemic and the worldwide social justice protests heralded a sea-change in public sentiment and corporate reaction over the past two years so will renewed urgency over the climate crisis create a perfect storm for accelerated change. COP26 was just the latest indication that ESG risks are taking center stage and companies should be prepared.

To be fair, ESG standards have been under development for the last two decades leaving many firms to come up with their own interpretation and rules in the absence of a globally accepted framework for disclosures. To put this fragmentation in perspective, consider that there are currently more than 600 ESG reporting provisions globally, according to one Ernst & Young study. However, this year we’ve seen a shift in how companies are thinking about and addressing environmental, social and governance issues driven in large part by shareholder activism.

We took one step closer to global standards with the announcement of the IFRS Foundation’s International Sustainability Standards Board at COP26. Endorsed by the World Economic Forum and the Group of Five, ISSB’s mission is to develop global sustainability reporting standards, providing that long sought-after baseline for consistent and reliable data. The ISSB action comes on the heels of other regulatory activity signalling that the time to get prepared is now.

Whether the financial industry is ready for sweeping scrutiny into investment holdings through the lens of ESG depends on who you ask. Investment giants like BlackRock have challenged companies its funds invest in to deliver greater value to stakeholders with better ESG profiles while others such as Goldman Sachs have pledged to spend $750 billion on sustainable finance by 2030. Hedge funds, by contrast, are lagging their peers when it comes to integrating ESG factors into their investment process. Forty-seven percent of hedge fund managers polled by Hedge Fund Research haven’t yet incorporated ESG factors into their investment process even as 75% said they engage with their portfolio companies on ESG issues.

Fund managers shouldn’t wait for reporting mandates. It’s crucial to begin identifying risks and areas of focus for disclosures across a range of ESG topics. Now is not the time to play fast and loose with investment oversight and alignment with ESG.

ISSB Standards are a Game Changer

The ISSB’s mandate is to develop a comprehensive set of sustainability disclosure standards for the 144 jurisdictions that fall under the purview of the International Accounting Standards Board. Two prototype standards debuted as part of the announcement cover climate-related financial information and sustainability related risks requirements.

• The Climate Prototype – applies to physical risks stemming from climate change and risks associated with the transition to a low-carbon economy. The standard will assess the impact these risks have on an organization’s financial position and performance, cash flows and enterprise value and strategy and business models.
• The General Requirements Prototype – looks at climate, labor practices, human rights, and community relations as well as water and biodiversity. This standard is aimed more closely at investors with the objective being to provide information to help asset managers determine which companies meet the approval of their investment remit.

What does this mean for fund managers? While the prototype standards are not considered exposure drafts at this point, it is likely the ISSB will move to formalize that process in early 2022 with eventual standards following close behind. The ISSB’s approach to establishing global reporting could spur the pace of adoptions for its standards across jurisdictions.

EU and U.S. Actions Usher in Stricter Regulatory Environment

We may indeed be entering the Hunger Games of ESG reporting as jurisdictions race to become the global standard-setter. The European Commission’s proposed Corporate Sustainability Reporting Directive (CSRD) extends sustainability requirements to all large companies and all listed companies in the EU. Roughly 50,000 companies could fall within the scope of the CSRD’s reporting standards by the proposed effective date in January 2023.

Similarly, the EU’s Sustainable Financial Regulation, which took effect in March, aims to stem the use of exaggerated ESG claims such as “ESG integration” by requiring asset managers to document their ESG figures, requiring asset managers in member states to make sustainability-related disclosures in financial product documents and on their websites.

Although Europe’s more prescriptive approach has taken the spotlight thus far, the U.S. isn’t far behind. In the U.S., the SEC in recent months has made ESG an “enhanced focus” of its inspections of firms. The regulator has also set up an enforcement task force to crackdown on the prevalence of “greenwashing” or using inflated or misleading language around ESG allocations. Alongside this it is collecting additional information from market participants through it’s own consultation process “…with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change.”

In this new paradigm of scrutiny, companies should consider and evaluate the potential impact or liability of statements made about their efforts to deal with ESG-related issues and climate change across all their communications, including channels not subject to traditional disclosure controls. It is therefore incumbent on hedge fund managers to verify that the ESG information in their portfolios is reliable. Hedge funds need to decide what’s important to them based on the needs of stakeholders, including investors, and be able to continuously monitor and track progress across key areas.

Hedge funds may be somewhat later to the party, but it’s imperative that managers understand the importance and challenges of implementing an ESG program, as well as the possible pitfalls if they don’t. Among the potential downsides of an absent ESG program is the inability to attract capital from an investor base hungry for responsible investments.