What’s one of the biggest risks facing public companies today?
When it comes to providing adequate disclosure of sustainability activities with business impact, it seems companies are not doing enough. And regulators and shareholders are increasingly holding their feet to the fire, demanding more.
As we transcend from cookie-cutter programs to the age of social investing and shareholder activism, public companies are under pressure to demonstrate — in more than gestural ways — the impact they’re having on the environment, the communities they serve, the people who work for them and those with whom they do business. Being a good corporate steward means going beyond having a community investment program or using recycled paper — and sustainability is no longer just a buzzword; it’s an important financial indicator.
Gone are the days when an organization could simply record good deeds in a corporate social responsibility report or annual report. Today, ESG issues are prompting companies to integrate financial data with sustainability data to give investors a better picture of corporate risks and materiality, corporate strategy and long-term value. And early data shows that companies that embrace ESG are reaping real benefits.
Addressing the reporting gap
Back in 2015, DFIN and SimpleLogic conducted a Canadian investor survey in which we discovered 100 percent of investors said they consider either one or all three elements of ESG when assessing risk and deciding whether to invest in a company. We found even more evidence of this notion in a 2017 Morningstar study, in which 70 percent of investors consider ESG an important factor in investment choices. The urgency of reporting is becoming indisputable.
Still, investors and regulators aren’t yet getting what they need. Despite the availability of information from multiple third-party resources such as MSCI ESG Research, ISS and Sustainalytics, and from companies themselves, data is often incomplete, inconsistent and error-prone.
Indeed, the same DFIN survey reports that only 30 percent of investors say they find ESG information from companies helpful in determining materiality. Of the 75 percent of respondents who prefer third-party information, they too are not getting what they need to understand materiality.
And regulators are starting to come off the sidelines as well — becoming increasingly sensitive to ESG issues and leveling additional scrutiny against companies that fail to provide this information, as it has the potential to affect global markets and economies.
With this gap, it’s clear that companies must fill this need and ensure they’re providing investors and regulators with a holistic picture of how ESG efforts link to their strategy, risk management and operations.
John Truzzolino, DFIN’s director of business development, advises clients on the importance of presenting ESG information in such a way that investors find it useful for decision-making. It needs to be illuminating, rather than simply greenwashing.
“What matters today is providing a materiality assessment of industry-specific risks and opportunities, which are aligned with corporate sustainability ESG goals that can differentiate Company X from Company Y.”
“Vague commitments to reducing one’s carbon footprint are out,” Truzzolino says. ”What matters today is providing a materiality assessment of industry-specific risks and opportunities, which are aligned with corporate sustainability ESG goals that can differentiate Company X from Company Y — and can allow Company X to demonstrate progress on meeting its ESG goals year over year.”
So how can companies avoid inertia and get ahead of this? Let‘s dig into the concept of integrated reporting — all part of the growing demand for a broader range of measures that demonstrate long-term value for both shareholders and society as a whole.
Linking ESG issues to financial performance
Integrated reporting helps investors understand the materiality of ESG issues and links these to corporate performance through standard evaluation and reporting practices — managed by a system that can capture all of this data in one place.
However, the challenge facing companies is what to disclose and how to put it in a context that outlines risks, but also highlights business opportunities.
This has given rise to several reporting standards, including the Principles for Responsible Investing, which has over 1,800 signatories, and the emergence of organizations such as the Global Reporting Initiative, Sustainability Accounting Standards Board and Taskforce on Climate-related Disclosure, which have created ESG disclosure frameworks and brought them into the mainstream globally over the last decade.
According to Truzzolino: “ESG has come into its own as a set of investment priorities and criteria for decision-making, and investors and other stakeholders are demanding company-specific material risks, disclosed using a sustainability framework like GRI, SASB or TCFD.”
These standards and organizations help companies define what goes into ESG reporting. Factors such as the impact of climate change, human rights legislation, marketing practices, and corruption and governance practices are just some of the issues identified as risk factors and considered material. These are the kinds of things that should appear in corporate disclosure, to aid investors and boards in their decision-making.
Capturing this type of ESG data through integrated reporting enables ESG disclosures to evolve from qualitative terms to quantitative measures that guide understanding the materiality of risks.
So what’s material?
Distinguishing between materiality and what’s significant from a social point of view is key to effective integrative reporting. ESG factors can have financial impact, without being financially material. What distinguishes SASB standards is a focus on financially material information covering a range of industry-specific sustainability areas, including environmental and social topics and the governance of those topics. SASB focuses on financially material issues because their mission is to help companies around the world report on the sustainability topics that matter most to investors.
Materiality as defined by SASB aligns with terms used by the SEC, which defines it as information “to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered.”
But how does a CFO figure out what gets reported when there are differing views on what’s important?
One way is to look at the many factors in a company’s social environment. Where there is a social outcome, either positive or negative, these will have consequences on reputation and eventually, financial impact. And conventional wisdom around ESG says these should be disclosed as soon as they’re known.
Some of the types of reportable negative outcomes relate to negligence — including causing pollution, disturbing ecosystems, complaints or unrest related to low wages, lack of diversity and even not keeping employee practices and standards up to acceptable industry levels through lack of training.
And where there have been positive outcomes on the flip side of those issues, these should also be captured, as often they signal opportunities when it comes to creating long-term value.
Evidence of the growing urgency to disclose ESG issues for regulators is the SEC’s Regulation S-K, which states that all material information should be in the 10-K, but that it need not be financial. However, these issues need to be accompanied by metrics to understand the size and scope of impact and risks.
In more practical terms, CFOs need to be able to talk about material issues and explain how they affect financial performance. And these should be part of analyst calls, investor communications and the general ongoing dialogue on how the company is doing, to provide a holistic look at how people are making investment decisions.
So what’s the secret to materiality?
When figuring out what to include as part of integrated reporting, a good rule of thumb is to stick to values-based information and activities that minimize risk or create opportunity.
This means moving away from short-term quarterly results as the sole predictor of long-term value and reporting on the things that matter — not just to company stakeholders, but to society.
Look no further than the rise in the number of ESG shareholder proposals, which paint a compelling picture of why reporting is important, particularly in the proxy. According to DFIN, so far in 2018 shareholder proposals relating to environmental and social issues comprise 58 percent of the total. And that number is likely to rise by year end.
“With shareholder proposals taking over conversations in annual meetings everywhere, the momentum for ESG in the investor market is going to continue to be a powerful force.”
“Companies need to act now by taking a longer-term view of ESG — incorporating practices and measures into their businesses and reporting on these regularly,” says Truzzolino. “With shareholder proposals taking over conversations in annual meetings everywhere, the momentum for ESG in the investor market is going to continue to be a powerful force.”
Smart companies are housing ESG information under one roof as part of a standardized integrated reporting source, and making that information available to investors. This ultimately increases long-term value for companies and their shareholders.
Leaders in ESG reporting
The Governance and Accountability Institute research team has published a report that shows that 85 percent of the companies in the S&P 500 Index published sustainability or corporate responsibility reports in 2017. Five years ago, just over 50 percent were producing these reports.
“One of the most powerful driving forces behind the rise in ESG reporting is an increasing demand from all categories of investors for material, relevant, comparable, accurate and actionable ESG disclosure from companies they invest in,” says Louis Coppola, EVP & co-founder of G&A. “Mainstream investors constantly searching for larger returns have concluded that a company that considers their material environmental, social and governance opportunities and risks in their long-term strategies will outperform and outcompete those firms that do not. It’s just a matter now of following the money.”
In fact, ESG-savvy companies are giving themselves a competitive edge in capital market appeal over their peers. They’ve figured out that investors are using their role in capital markets to influence businesses and governments towards a more sustainable society. At the same time, they’re looking to investor cohorts such as millennials who are said to value a healthy environment, responsible government and open and inclusive companies, and are therefore willing to take action on the issues that matter to them.
In DFIN’s white paper, “Disclosure of Environmental, Social and Governance (ESG) Risk Factors,” Eric Hespenheide, chairman of GRI, indicates that leaders typically use GRI disclosures to guide their sustainability reporting and understanding of materiality. It involves using a robust and inclusive stakeholder process enabling companies to understand various perspectives and classify what is material from an investor perspective.
Unfortunately, companies that ineffectively report ESG issues — or avoid them altogether — believe that taking a position and committing to it means having to invest money in it, rather than its core business.
But this thinking ultimately backfires. Investing in an ESG-integrated reporting system is simply the price of doing business and a worthwhile endeavor that pays dividends. At the end of the day, effective reporting of sustainability activities equals positive financial impact. A study of ESG research reports by the University of Oxford and Arabesque partners found that it lowers the cost of capital, results in better operational performance and positively influences stock price.
Still, with all of the buzz around ESG reporting, adoption differs around the world. A 2017 survey of IR professionals that appeared in IR Magazine revealed that 40 percent of those in North America were not providing ESG, compared with seven percent of European respondents and eight percent in Asia.
But this is set to change — and quickly. According to Truzzolino: “Too often in the past, discussions of ESG factors have been check-the-box exercises, with management and IROs disclosing boilerplate ESG or CSR disclosure, hoping to say whatever would mollify the investment community. As someone who’s been tracking this phenomenon since 2015, I can attest that gone are the days when such a strategy will work. If companies are not already on, or about to get on board, they will be left behind their peers in terms of performance and recognition on an industry and global scale.”
Integrated reporting is clearly a way for public companies to solve the issue of inadequate sustainability data, and in doing so they will get ahead of the curve in addressing coming regulation and standardization.
Investors are clear in what they want: ESG data that has a clear link to corporate strategy, risk and risk management and operational context. They need this data in standardized format to aid in transparency and comparability. Finally, sustainability reports should integrate with financial and non-financial data to help tell the holistic company long-term strategy.
Going forward, clear and robust ESG reporting will become a normal requirement and an operational part of financial disclosure. Investor and regulatory pressure is mounting to ensure this happens.
As companies continue to be expected to disclose their material exposure to ESG issues, CEOs and CFOs should start explaining and presenting ESG information in a clear, accessible form now.
Adopting an integrated reporting solution will help companies prepare for what’s coming, as investors increasingly embrace ESG data as part of their investment decisions.