Politics and ESG (environmental, social & governance) are natural bed fellows. But they are rarely treated as such, particularly in the diligence process.
GK Strategy is the only consultancy offering ESG due diligence (DD) services and political, policy & regulatory due diligence (PDD.)
Why do these disciplines belong together? And why should investors see them as two sides of the same coin? Why should companies consider their political and regulatory risks and opportunities at the same time as their ESG risks and opportunities?
We believe there are five key answers:
1. Politics and ESG often try to achieve the same ends
- Laws, regulations and public policy are often intended to direct business towards more beneficial behaviour and outcomes than they might do otherwise. Similarly, companies own ESG policies seek to do the same. And industry association codes of conduct and collective programmes seek to do the same, but at a sector-wide level.
- When we assess a company’s ESG risks we are inevitably looking at how well their ESG performance and approach meet the expectations of stakeholders. When we look at political risk, we are often assessing how some stakeholders – regulators and politicians, etc – view a sector or group of companies in terms of how well existing statutory and voluntary measures meet their expectations – and hence how likely they are to regulate further.
2. Political and ESG initiatives can be different routes to the same goals, but shouldn’t be equal
- A mature and responsible sector that understands, anticipates and properly addresses its challenges and opportunities at a sector wide and company level is less likely to be subject to regulation that seeks to achieve the same ends. Regulation is necessarily a blunter and less flexible instrument than voluntary measures.
- Many regulatory proposals often seek to address perceptions of widespread irresponsible practice, such as poor consumer information and communication by companies – leading to unsustainable borrowing or debt, for example.
- In these cases, there is an opportunity for leading companies to work with their peers and industry bodies to address these concerns, either through improved sector codes (e.g. responsible marketing and sales codes) and/or new statutory measures.
3. Commitment to ESG often requires quasi-regulatory and regulatory solutions
- A company has to get its own house in order first – with robust, policies, processes and governance to ensure responsible behaviour – but it should not stop there.
- Most companies recognise that many of their biggest ESG risks lie in their supply chain. They also know that there are limits to what their own pre-qualification assessments, contractual clauses and subsequent supplier management can achieve in isolation
- This is why many sectors now use third party supplier platforms or certification schemes. These are quasi-regulatory – to the extent that third parties (but not governments) set rules that require compliance and require evidence of compliance (e.g. through the reporting of external audits).
- But these quasi-regulatory initiatives will only be regarded as acceptable alternatives to statutory regulation where politicians, regulators and campaigners believe they perform a similar function and are similarly effective; do they secure the sort of sector-wide standards and levels of compliance they would seek with statutory measures.
4. Developing sector ESG initiatives needs political and ESG understanding
- In many cases, these third-party initiatives can achieve massive benefits, but their limitations can be exposed where a crucial regulatory or institutional element is missing.
- For example, the shortcomings of many UK recycling schemes were revealed when it became clear that there was insufficient infrastructure and enforcement to ensure that the waste plastic was recycled in many of the countries to which it was sent.
- Responsible companies and industry organisations need to identify regulatory or enforcement measures that can address issues that voluntary schemes cannot. This requires an ability to develop robust regulatory solutions and to advocate for them effectively.
5. Company ESG measures need to be informed by political and regulatory realities.
- It is not unusual for companies to develop ESG programmes that are based on and reference the latest international ESG best practice, as set out by international NGOs and advisory bodies.
- We do this ourselves, when advising investors and companies on how they can align with best practice and undertaking gap analysis
- But this alone is insufficient. Our gap analysis – in due diligence and in other assessments – also looks at the gap between a company’s ESG performance and policies, etc and the expectations of what politicians, regulators and consumer groups think in any particular jurisdiction.
- Understanding and addressing best practice and regulations is an important way for companies to establish market leadership positions, giving them a competitive edge in winning the business of retail, business and public customers and in shaping the political and regulatory environment.