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Does ESG Reporting Enhance the Understandability of Sustainability?

The Challenges of Reporting

ESG reporting provides a specific framework for evaluating and measuring a company’s sustainability performance. It assesses a company’s ESG-related risks and opportunities by providing a standardized approach for stakeholders, including investors, creditors, regulators and society in general, to assess corporate sustainability.

The Purpose of ESG Reporting

The goal of reporting on ESG (Environment, Social, Governance) is to use data to measure how a company’s ESG initiatives compare with industry benchmarks and targets. It also provides stakeholders with valuable insights that can inform decision-making, highlighting potential opportunities and risks that might affect the valuation of a company.

Sustainability and ESG are similar, yet differences exist. Sustainability is an overarching principle, while ESG provides a practical approach for evaluating and reporting on sustainability performance. Sustainability reporting communicates an organization’s non-financial performance to its stakeholders by disclosing relevant information about environmental, social, and economic impacts, as well as its governance practices.

One of the main differences between ESG and topics like sustainability or corporate social responsibility (CSR) is the notion of motivation versus outcomes. Sustainability and CSR function as the business model or methodology that motivates a company and its employees to act in the best interest of civil society. ESG reporting, on the other hand, is the outcome of those initiatives and provides stakeholders with the ESG data needed to inform decision-making.

ESG reporting is becoming increasingly important to companies, not just to comply with regulations, but to respond to the demands of stakeholders. The EU’s new Corporate Sustainability Reporting Directive (CSRD) affects approx. 60,000 EU and non-EU companies who will have to meet the European Sustainability Reporting Standards (ESRS) for financial year 2024. On a global level, the inaugural IFRS Sustainability Disclosure Standards (ISSB) will require companies to communicate the sustainability risks and opportunities they face over the short, medium, and long term.

Given the changing state of ESG reporting, it’s little surprise that companies differ greatly in how they organize ESG reporting responsibilities for gathering, processing and disclosing their ESG performance data. Depending upon the company, the organization of ESG reporting may vary in terms of organizational structure, company statement, and the distribution of tasks – as well as varying sizes of teams responsible for disclosure. 

The ESG Reporting Challenge for Companies

KPMG addresses the reporting challenge for companies. According to its report, the arising challenge is twofold. On the one hand, companies are obliged to report on ESG at ever-increasing levels of detail across a widening range of areas. As a result, metrics and targets are likely to stretch to the hundreds. On the other hand, similar to financial reporting, the CSRD expects companies to offer independent assurance over their ESG reporting. This places considerable pressure on companies to produce a fluid process for setting targets and measuring performance, to meet appropriate standards and adapt to the new requirements coming down the line. Meeting these extensive and growing requirements is a major, complex challenge that makes it imperative to transform ESG reporting, according to Jan-Hendrik Gnandiger, Global Head of ESG Reporting for KPMG International,

KPMG’s 2022 Global Survey of Sustainability Reporting found that 78% of the 250 world’s biggest companies by revenue (G250), now adopt GRI Standards for Reporting (up from 73% in 2020).[1]

Deloitte reports in its December 2022 Survey Findings on ESG Disclosures and Preparedness the following findings:[2]

  • As companies begin to prepare for the U.S. SEC disclosure requirements, they are beginning to shift from commitment to action to address evolving stakeholder expectations. They are starting to see the strategic benefits that can be realized through enhanced ESG governance, controls, and disclosure.
  • While most companies are taking meaningful steps towards enhancing their ESG disclosures, they continue to face challenges with data accuracy and availability.
  • Rather than waiting to react to future disclosure requirements, many companies are proactively implementing changes to help accelerate readiness. This includes creating new roles and responsibilities and plans to invest in more technology and tools over the next 12 months.
  • Companies utilize a range of frameworks and standards for ESG disclosure.
  • Chief sustainability officers (CSOs) are primarily responsible for managing ESG disclosure.

One problem with ESG reporting is the information may not be comparable and consistent between companies and industries. Moreover, transparency may be lacking. This is due in large part to the challenges in adopting one generally accepted method to account for and report non-financial information related to sustainability in the global environment. The result is that investors may have problems evaluating the information and making investment decisions.

ESG2

Frameworks for ESG Reporting

The Deloitte report identifies five frameworks for reporting ESG data as follows:

  • Task Force for Climate-related Financial Disclosures (TCFD)  56%
  • Sustainability Accounting Standards Board (SASB)                    55%
  • Greenhouse Gas (GHG) Protocol                                                     50%
  • International Integrated Reporting Council (IIRC)                      48%
  • Global Reporting Initiative (GRI)                                                      47%

Sustainability reporting continues to accelerate globally, and it is a growing requirement for large and listed companies around the world. The two comprehensive and internationally recognized sustainability standard-setters for corporate reporting—GRI and SASB—provide standards that are complimentary and help organizations meet stakeholder needs.

Transparency is the best way to create trust among organizations and their stakeholders, including investors. For this reason, companies focus on disclosures that assist these user decision-making needs. Companies can use both the GRI Standards and SASB Standards. The latter are evolving and should be carefully monitored by organizations to ensure they meet both the form and spirit of non-financial requirements.

ESG data is important not only for CSOs but also the following: chief operating officers (COO), who need to know how the reporting requirements might affect operational decisions; CFOs, who oversee financial reporting and disclosures; internal auditors, who evaluate reporting systems and whether they are operating as intended; and external auditors, who often are called upon to provide assurance that the systems are working in accordance with internal control requirements. The audit committee also has a key role to play.

ESG and Financial Performance

A study by the NYU Center for Sustainable Business examined the relationship between ESG and financial performance as reported in more than 1,000 research papers from 2015 to 2020. Because of the varying research frameworks, metrics, and definitions, the study divided the articles into those focused on corporate financial performance (e.g., operating metrics such as return on equity or return on assets or stock performance for a company or group of companies) and those focused on investment performance (from the perspective of the investor). The authors found a positive relationship between ESG and financial performance for 58% of the “corporate” studies focused on operational metrics, or stock price with 13% showing neutral impact, 21% mixed results, and only 8% showing a negative relationship.

The study provides the following conclusions:

  • Improved financial performance due to ESG becoming more marked over longer time horizons.
  • ESG integration as an investment strategy seems to perform better than negative screening approaches.
  • ESG investing appears to provide downside protection, especially during a social or economic crisis.
  • Sustainability initiatives at corporations appear to drive better financial performance due to mediating factors such as improved risk management and more innovation.
  • Studies indicate that managing for a low carbon future improves financial performance.
  • ESG disclosure on its own does not drive financial performance.

Another research study examined the impact of ESG performance on firm value and profitability. The authors found that individual Social and Governance scores have a positive and significant relationship while Environment score does not have a significant relationship with firm value. On the other hand, ESG combined score, Environment, Social, and Governance scores have positive and significant relationships with firm profitability. These findings suggest that investing in high ESG performance promises financial return for the firm in terms of both value and profitability. A materiality assessment can help an organization determine which ESG issues matter most to its stakeholders. The usefulness of ESG data should also be viewed based on a risk analysis.

Companies should gather ESG data and, I believe, report to investors. Many want such data because of their commitment to sustainable business practices. The decision shouldn’t be made from an investment perspective but an operating one, which means CEOs, CSOs, CFOs, internal and external auditors, and the audit committee all have a role to play in ensuring the data is accurate and reliable and will meet stakeholder needs now and into the future.

Posted by Steven Mintz, Ph.D., aka Ethics Sage, on May 6, 2024. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/.

 

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