The development, adoption, and implementation of regulation is an infamously slow process, but once complete, can significantly change how businesses are required to operate.
The Health and Safety at Work Act 1974, for example, established the legal requirement for companies to identify, assess, and manage potential workplace hazards, record and report data regarding work-related injuries and illnesses, and ensure adequate workplace facilities are provided for employees.
While such requirements may seem common sense today, there were likely a number of companies for which, in 1974, these new regulations required significant changes to be made. More recently, the General Data Protection Regulation (GDPR) 2018 almost certainly meant major changes were required for companies in certain industries, given the need to significantly alter how personal data is collected, stored, and processed.
In order for businesses to adapt to regulatory changes, they may be required to undertake a large programme of work, which of course means time, effort, and spending. For those companies that are well prepared for such changes, and especially those who seek to reach a state of compliance before any legal mandate to be so, transitions are likely to be much smoother, and any associated costs can be spread over a longer period. For those that aren’t, the opposite is true.
As such, a lack of preparedness to meet regulations can constitute an inwardly material governance risk (and also potentially an environmental and/or social risk, depending on what the regulations in question relate to) in that it may pose a threat to the profitability of a company in question. On the contrary, a strong approach to preparedness may give companies a competitive advantage, and thus represent an opportunity.
Companies that are poor at anticipating regulatory change, and those that fail to adequately prepare for such change, may face greater levels of operational disruption that those companies that do. Let’s take an example of a hypothetical regulation requiring manufacturing companies to capture and store any form of direct air emissions.
To ensure compliance, companies covered by the regulation would need to, for example, quantify their emissions, install any necessary equipment to capture and store said emissions (which may in itself require structural adaptations to sites and associated planning applications), and organise and pay for contractors to handle installation and construction.
If the work required to achieve these steps is left too late, companies will need to scramble in order to achieve them, if they want to avoid any revoked licenses, potential financial penalties, and/or reputational damage. This might mean large numbers of staff and resources being redirected from revenue-raising work at short-notice, and may also result in higher costs. More immediate access to capital may be more expensive, and companies ay lose the opportunity to effectively “shop around” and negotiate better prices with contractors. As a result, the cashflows and profitability of ill-prepared companies may be impacted to a greater degree, compared to those which were well prepared for this regulation.
For well-prepared companies, more advanced planning may allow for staff and resources to be spread over a longer-time period, and thus limit disruptions to regular operational activities. Alternatively, it may allow for the development of contingency plans, and ensure disruptions to operations are mitigated as much as possible. In terms of costs, these companies would be in a position to explore financing and work contracting options with less urgency, meaning cheaper rates (from both financiers and contractors) could be identified or negotiated. The most pre-emptive of companies may even be able to set aside financial reserves to prevent the need for finance to be raised, and thus limit costs further.
So, what should ESG investors do? In short, they may wish to incorporate regulatory preparedness into their risk assessments of potential investee companies, with additional emphasis on companies operating in sectors and industries more prone to increasingly complex or technical regulations.
With the growing global movement towards sustainability, it seems a fair assumption that increased levels of regulations will form part of this movement. As a result, companies which are better prepared to meet the requirements of regulations pertaining to environmental, social, and governance topics may have a lower risk profile than those that aren’t, and may even be able to achieve competitive advantages.
For those investors who wish to work with their investee companies to limit their risk, it could make for an ideal area for engagement. Investors have the ability to at least try to work with their investee’s, and therefore may be able ask companies about their preparedness, and push for improvements in their approach.