ESG stands for Environment, Social and Governance. Today, governments, regulators, lenders, investors, asset owners, employees, customers, ALL stakeholders, want to know more about companies than just their financial performance. They are interested in sustainability factors, such as carbon emissions, waste management, water consumption, employee health and safety, gender representation, diversity, wage equality, child labor, culture and ethics, and cybersecurity, to name but a few. Stakeholders want to know about these non-financial factors because they understand the effects they may ultimately have on companies’ financial performance, risk management profile, and long-term value creation.
Currently, California — as well as many international entities — require companies to disclose only certain ESG aspects of their businesses, leaving many corporations to “voluntary” disclose information. However, that is beginning to change, as many regulatory bodies including the EU CSRD and ISSB are starting to make more elements of sustainability reporting mandatory.
Even if it is not required by law, many see ESG disclosure as an intelligent business move that appeals to investors and stakeholders alike. As such, public and private corporations are beginning to understand how to measure sustainability performance, report on ESG and factor it into a company valuation. Increasingly, institutional investors are using ESG to evaluate a company’s risk exposure, long-term value creation prospects, and alignment with their corporate purposes.
ESG includes factors such as:
- Environmental: How will climate change and other environmental factors introduce risk into a company’s operations? Social: What are the company's relationships with stakeholders — which include its customers, employees, suppliers and residents of communities where it operates? Factors considered regarding social impact include inclusion, community relations, labor stands, and customer satisfaction.
- Governance: What is the company's track record regarding executive pay, shareholder rates, internal controls, and audits? Governance considerations include internal policies and controls, political contributions and lobbying, leadership and company board makeup, and shareholder rights.
1. Numerous SASB/ISSB metrics relate directly to these factors, which makes ESG reporting even more critical today.
Why Sustainability Matters
Some companies believe these factors matter on principle. Consider a B corp that has gone through high-level standards regarding social and environmental impact to obtain certification and is legally obligated to be socially responsible.
Other companies have historically been profit-driven but want to move toward higher levels of ESG accountability. In some cases, this is driven by the market. When it comes to ESG, investors are willing to pay a premium for products and services that align with their principles, so adopting ESG criteria is good for business. In some cases, companies may choose to report ESG ratings because they want to avoid additional SEC scrutiny.
What Is ESG Reporting?
When it comes to aligning with CDP, TCFD, GRI, IFRS and SASB standards, companies generally fall into one of three stages of maturity based on how well they tell their ESG story through disclosures.
1. Laggards
Companies that don’t have anything documented on corporate social responsibility, either in a report, on the website, or anywhere else. They haven’t identified material ESG topics. In addition, they have not taken into consideration insights from investors or other stakeholders and their views on ESG topics. Essentially, ESG efforts of companies in this stage of maturity may still be anchored in philanthropy efforts rather than incorporating a strategic business focus.
2. Middle of the pack
Companies that may be publishing a sustainability or corporate responsibility report or disclosing information on a webpage, but do not have a cohesive ESG strategy that is linked to their business purpose and embedded in their core operations. They likely do not have standardized ESG metrics to measure progress or the data gathering processes and controls required to do ESG reporting consistently and on a timely basis. Board oversight is scant at best.
3. Front runners
ESG strategy is regularly reviewed by board/committees and embedded in core operations. The company has adopted commonly accepted ESG/sustainability standards and reporting frameworks to guide their ESG disclosures. Robust processes, controls, and governance are in place to ensure disclosures are “investor grade.” Many of these companies increasingly are pursuing third-party assurance.
How to Report on ESG Information
In the absence of clear guidance from a standard, what is a company to do when it comes to an ESG report or ESG disclosure? This five-step approach can help boards of directors and executives understand how to report on ESG scores:
- Find a focus: Given the many details that ESG covers, it isn't practical to report on all of them. To start, come up with five to seven areas on which to report — such as sustainability, social impact, labor practices, energy efficiency and climate change.
- Identify a partner: Partners familiar with ESG standards and ESG disclosure can help companies identify the most impactful benchmarks to measure and how to measure them.
- Define what makes the difference: With any ESG element, there are many ways to move the needle. Using peer groups, drill down on what the company can do to make a difference and how that difference can be expressed in data.
- Pick talking points: With ESG initiatives, select three to five key themes that show what the business is committed to and why. This might be reducing a carbon footprint or committing to a livable minimum wage.
- Create content: Once you know what is important, how to measure it and how to communicate it, work with the chosen partner to create data and a narrative text for ESG reporting.
How to Measure ESG Performance
While the process of reporting on ESG in finance seems straightforward, a stumbling block can be the measurements themselves. How is ESG tracked and measured when it can refer to a broad arrange of initiatives?
This is a tricky question. To date, there is no single standard or methodology companies can use to measure ESG. Given the numerous taxonomies r, an omnibus approach would be too onerous. Different stakeholders have different priorities when it comes to ESG, which again complicates the measurement process.
This is where a partner can add value. The right partner will understand ESG reporting trends. It can work with the company to outline clear and measurable criteria that demonstrate sustainability activities. This is important because ESG indicators can be quantitative as well as qualitative. The former can be expressed in terms of measurable numbers, while the latter indicators are typically not as easily measured. For example, energy consumption in terms of kilowatt hours is an example of a quantitative indicator, whereas the contents of an energy conservation plan to reduce consumption would be considered qualitative.
Even the most precise measurement, such as the diversity of new hires, doesn't communicate what the effect of this practice is. There is an assumption that diversifying hires benefits the business, and there is data that suggests businesses benefit from a diverse pool of employees. Simply tracking the number of new hires by race or gender doesn't display impact.
It’s suggested that companies zoom in or zoom out to alter their analysis. Zooming in to look at insights might go beyond the hiring practice to see how diverse hires are treated on the job. Are they compensated fairly? Mentored? Are they contributing in meetings or being shut down when participating? These details give more context than raw numbers, painting a bigger picture.
Zooming out also enhances the picture, in this case by showing how the ESG measure connects to systemic issues and contextualizing the measure in time. With something such as climate change, zooming out places a company's ESG practices in context of how it can change the planet in decades — thus, what needs to shift now to reduce environmental impact.
Impact on Valuation
ESG has a demonstrable impact on business valuation and perception of worth, with these factors becoming increasingly important for equity pricing, M&A diligence, and index eligibility. Data shows companies that honor ESG commitments are proven to offer lower risk and greater resiliency during times of crisis. They also offer shareholders a higher return on investment.
ESG reporting requirements are always subject to change, but one thing is certain: consumers will continue to prioritize companies that are transparent and committed to long-term risk mitigation. . Reporting on ESG is about identifying your risks and opportunities creating a governance and oversight structure, providing decision useful data, aligned with long-term value creation. Over time this ESG governance and data may provide a lens into the company’s commitment to ESG, the quality of management and alignment with corporate strategy and executive compensation plans.
The Evolving Regulatory Landscape
As the global regulatory landscape continues to trend toward more mandatory ESG reporting, companies will need ready-to-file, assurance-ready ESG data. Adopting technology and automation to streamline these workflows will be critical for accelerating compliance adoption, and DFIN offers robust ESG reporting software to ensure companies are ready for the new normal. To learn more about how DFIN can prepare your company for the new ESG reporting environment, reach out and speak with a member of our team today to schedule a demo.
