Internal Audit: Has ESG become a tick box exercise?

Earlier this year, I conducted a roundtable with fifteen senior internal audit professionals from financial services institutions in London. There were several key takeaways from the session, but the most startling one was that “ESG [environmental, social, governance] has become a tick box exercise”. This is surprising, as at the start of 2022, ESG was a key focus for many organisations. However, investor misbehaviour and the lack of coordinated and meaningful action by regulators have left a sour taste with many financial services professionals.

Marketing ESG financial services products 

When financial services organisations market ESG products, they are primarily marketing to investors. A key concern from one professional at the session was the marketing surrounding ESG-related products. They voiced that “everyone’s saying looking at my product, we are ESG compliant, but what are we actually doing to support this? Even just getting greenhouse gas exposure, is that really sustainable?”.

The consensus at the table was that companies rush off and label their products as “environmentally friendly” and “green”, but how many of their claims can be validated? One attendee added that “rather than us slapping everything with a green label, be cautious that we might be unable to verify it”. As a group, they agreed that this is something several organisations struggle with, especially from the investment perspective. 

According to Triodos Bank, a leading expert in sustainable banking, 26% of consumers that don’t invest in an ethical fund question whether many investments claiming to consider environmental and social impact are truly ethical – a figure that has risen from 17% in 2020.

 As Internal Auditors, they concluded they need to ask “how much due diligence is being done on the assets?”

The role of the Internal Auditor in ESG 

We’ve recently talked about the impact of Europe's SFDR on ESG and sustainable investment. And for some people in the room, ESG didn't factor into their role until earlier this year, when the SFDR regulations came into effect.  There was a lot of discussion about the firms, like BNY Melon, who have been hit with financial penalties as their underlying assets aren’t adhering to the SFDR and other ESG regulations. Moreover, firms are taking the decision to employ external ESG consultancies to implement a rigorous due diligence process and avoid these sanctions and any potential fallout.

However, people have had mixed experiences relying on external experts. Several people around the table highlighted the value of bringing ESG talent in-house or upskilling current employees to add talent who is not only able, but brought into your business. One attendee explained that some of their brightest ESG talent started their careers in internal audit, risk and governance. The participant also explained that those prepared to move into the function already have a natural interest in ESG outside their role.  

One senior internal auditor, from a leading bank, explained why internal audit and ESG don’t necessarily “gel as entities”. From his perspective, ESG is subjective and means different things to different businesses, people and regulators. The problem comes when you try to turn it into an objective and repeatable process. The participant explained that to make the ESG proposition a more coordinated entity, businesses need to identify data points. Whether that's surveys, interviews with employees review operational risk issues. It is only once you have this information can you develop your business' ESG function in a way which interacts meaningfully with other functions.

The Carbon Promise 

When financial service organisations discuss the carbon promise and reaching net-zero by 2050, we discuss the Net-Zero Banking Alliance. The industry-led, UN-backed Net-Zero Banking Alliance brings together a global group of banks, currently representing about 40% of global banking assets, who are committed to aligning their lending and investment portfolios with net-zero emissions by 2050.

The attendees discussed that, from an internal audit perspective, focus should be on where a physical statement or deadline has been made. The attendees agreed that focus should be on where there are concrete timelines, as there is opportunity for increased risk. Moreover, one attendee added that there is significantly more risk when considering the “environmental” component of ESG, and he has had minimal conversations regarding the “social” and “governance” components. The attendee said, from their experience, the “social” element isn't talked as often, as “environmental” is often at the forefront due to climate change being incredibly topical. 

Another attendee added that businesses may be reluctant to comment on the “social” component, as it is constantly evolving, and they "don't want to get it wrong".   

An example of ESG in Financial Services

This pension fund’s ESG journey is similar to many other financial services organisations. Like others, they hired an ESG Manager about three years ago, after working with several third-party consultants. Prior to this appointment, they “kept tripping up on ESG”. 

Being in the public sector, this pension fund found there’s more pressure to get responsible investment “right”. The appointment systematically developed a robust ESG arm of the organisation. From their experience, engagement was key to changing policy. Because this person was so capable, people listened.  Additionally, the CIO who changed from being a diehard ‘do what we have to do’ to being a tremendous advocate for ESG and the service the ESG manager provided. 

The attendee from this pension fund did add that ESG has yet to have a big impact on internal audit. “We haven’t done any audit work on it, as it's only emerging so not much to audit”. Another attendee from the organisation added that for internal audit to have a meaningful impact in the space, the risk and compliance functions must be leading the way.  However, the attendee added that the ESG team is growing, which signals its importance to the business.

ESG as a business culture 

Despite the discussion surrounding the success of ESG in the pension fund above, some attendees still felt that ESG was a tick box exercise. One attendee challenged this perspective by explaining that their organisations experience with ESG markedly improved when they moved away from working with third party consultancies. They found that once they hired an internal ESG specialist, transparency increased and policies became much more authentic to the brand.

However, one participant expressed concern with the potentially detrimental impact “green washing” could have on business culture. He argued that green washing is dangerous, as the “spin” takes people away from “all sense of proportionality and truth, creating some potentially uncomfortable questions”.

Mostly, the group agrees that honesty is the best policy when it comes to business culture and ESG. However, one leader questioned whether employees even care about their organisation’s stance on ESG.

Meaningful ESG activity must come from the top

A survey conducted by PwC found that 83% of consumers think companies should be actively shaping ESG best practices, 91% of business leaders believe their company has a responsibility to act on ESG issues and 86% of employees prefer to support or work for companies that care about the same issues they do.

Meaningful ESG activity and policy must come from the top of an organisation. All attendees agreed that if senior management and business leaders aren’t passionate about ESG or don’t appreciate the seriousness of it until the regulator fines the business, then people will not engage with it meaningfully. Beyond the roundtable, I've had conversations with ESG professionals who feel their function isn't taken seriously by business leaders. Ultimately, this makes it even more difficult to implement ESG.

Our network of internal audit and ESG professionals 

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