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ESG risks – time for clarity

Financial Reporting Brief: September 2020

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Three out of five of the top economic risks are environment-related.

The above was highlighted at The World Economic Summit that took place in January at which the overall position was made clear regarding the significance of environmental, social and governance (ESG) risks. Climate change has been a significant focus of attention in recent years, but there is a broader spectrum of ESG risks which are of major concern, including biodiversity, waste management, water management and a wide range of others.

The enormity of the worldwide Covid-19 pandemic had not become apparent in January but in recent months has become the challenge that dominates globally and will continue to until eliminated. We must not lose sight of the ESG risks, they have not gone away, and strategies and business models must take them fully into consideration.

Company law requires companies, with the exception of small and micro companies, to provide in their annual reports a fair review of their business and a description of the principal risks and uncertainties faced by them. This review should, inter alia, provide an analysis of key non-financial indicators relating to environmental and employee matters, and an indication of likely future developments in their business. For many larger public interest entities, EU law imposes additional requirements under the ‘Non-Financial Reporting’ Directive 2014.

Is disclosure by corporates and other entities informing investors and other stakeholders of ESG risks and responses proposed in a manner sufficient to enable appropriate decision making and allocation of resources? There is ample evidence that this is not the case and most entities need to renew their efforts. It is clear that the framework for reporting needs to be addressed and the EU is taking action regarding the need to improve non-financial reporting.

 

Developments in court

The escalating significance of environmental concerns was highlighted by a recent Supreme Court decision which could have major implications for environmental policy in Ireland and elsewhere in Europe. The Supreme Court made the ruling that the Irish Government’s 2017 National Mitigation Plan does not provide enough detail about how the State will reduce carbon emissions and provide for an environmentally sustainable economy.

The Government’s Climate Action Plan 2019 contains much of the detail, but the target of an annual cut of 3.5% in emissions continues to be controversial as many consider it will not achieve the overall objectives for our environment. EU Member States are required under the Energy and Climate Plan to set out how emissions will be reduced up to 2030, and beyond.

Similar cases of climate-related litigation are in train in many countries and are likely to increase in light of verifiable proof of climate disruption caused by human activity, big corporations – especially fossil fuel companies – and the policies of governments.

 

Responsible investment

ESG risks are closely linked to the concept of responsible investment (RI), commonly referred to as ‘green’ or eco-investments. In recent years RI has become an increasingly significant focus of investment markets. There is an expectation that ESG risks and opportunities will be part of the overall analysis of companies in their investor relations.

There is every possibility that over the long term companies will face greater scrutiny from consumers, investors, and governments alike over their ESG management and reporting practices. ESG investing can be an effective way for investors to align their portfolios with their values. ESG isn't just about values, it's about long-term risk management that affects all investors and other stakeholders.

With growing evidence that the global economy is moving to being stakeholder-led, rather than shareholder-led, asset managers that focus only on short-term financial measures and ignore or pay little attention to longer-term, sustainability-related risks and opportunities will risk not being considered attractive for investment.

The financial community has also seen sustainability-linked ‘Green’ loans becoming increasingly popular in recent years, replicating the rapid growth of the green bond market. More recently, loans and other financial instruments – whose terms depend on the borrower hitting certain targets linked to their environmental or social performance – have also appeared.

 

Falling short

In recent months, the Climate Disclosure Standards Board (CDSB) published a report ‘Falling Short – why environmental and climate-related disclosures must improve’. It is based on a review carried out of the non-financial information published by the top 50 European listed companies. The CDSB found that 78% of those companies fell short of reporting environmental and climate-related risk information at an appropriate level.

Major findings include:

  • Only fifteen companies fully disclose the environmental and climate-related aspects of their business models;
  • One in five disclosed no operational, strategic or financial impacts related to environmental and climate-related principal risks;
  • Overall implementation continues to lag behind the five-year implementation path set out by the Task Force;
  • Forty-two percent of companies omitted potentially material climate-related or environmental information for their sector.

The CDSB warns that current reporting practices could fall short of delivering on the objectives of the European Green Deal and the 2050 climate neutrality objectives.

If Europe’s top companies are not getting it right, the conclusions to be drawn about the overall population of companies seem apparent.

 

European framework

There is recognition of the shortcomings at EU level and the need to take action.

The European Commission (EC) has launched a consultation on its renewed sustainable finance strategy in the context of the European Green Deal. The proposals include amending the Non-Financial Reporting Directive (NFRD) to renew the principles for high quality non-financial information and some specific disclosure requirements.

The EC has launched a separate consultation on the NFRD as it is considered that there is inadequate publicly available information and that any information made available by companies falls short of standards considered useful to investors. Common failings identified are consistent with those highlighted in the CDSB report.

The consultation raises questions about whether there should be common standards for European companies and what the relationship between financial and non-financial information should be.

Responses to the consultation show strong support for a mandatory reporting standard for non-financial information and for strengthened audit/assurance requirements. This gives the EC backing to propose these measures in the draft legislation it is expected to issue in Q1 2021.  

The EC has mandated the European Financial Reporting Advisory Group (EFRAG) to carry out preparatory work with a likely outcome being to provide recommendations on European non-financial reporting standards.

 

Current position

The United Nations Sustainable Development Goals (SDGs) are intended to be the blueprint for all to achieve a better and more sustainable future. There are 17 SDGs, with 169 targets.  SDGs include those in respect of poverty, inequality, climate change, environmental degradation, peace, justice and many more.

The UN Global Compact, the world’s largest corporate sustainability initiative, and the Global Reporting Initiative (GRI) have formed a platform to tackle the challenge of reporting on the SDGs – ‘Business Reporting on the SDGs’. The platform has created three SDG reporting tools:

  • Analysis of the Goals and Targets: provides a list of indicators to help companies understand how they are impacting the SDGs and their targets for rectification and improvement;
  • Integrating the SDGs into Corporate Reporting: a practical guide that outlines three steps for companies to embed the SDGs in existing business and reporting practices, as follows:

   o   Define priority SDG targets;

   o   Measure and analyse – collect and analyse data and select appropriate disclosures;

   o   Report, integrate and implement change.

  • In Focus: addressing investor needs in business reporting of the SDGs to provide additional information about investor-relevant aspects of corporate SDG reporting.

A recent survey of over 1,000 CEOs from around the world by the UN Global Compact found that 87 per cent “believe the SDGs provide an opportunity to rethink approaches to sustainable value creation.” 70 per cent of those CEOs “see the SDGs providing a clear framework to structure sustainability efforts.”

Currently, two of the main organisations involved in sustainability reporting and non-financial reporting in general, are the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI).

  • SASB’s industry-specific standards identify the subset of substantially related risks on an industry-sector basis;
  • The GRI standards focus on the economic, environmental and social impacts of a company and hence its contributions – positive or negative towards sustainable development.

They have recently announced a collaborative work plan which should identify opportunities to consider how the SASB and GRI standards may be developed in the future.

 

Conclusion

The call for improved non-financial reporting grows louder and comes from a variety of sources. Notable examples include the published letter from the CEO of the world’s largest asset manager in January emphasizing that improved ESG disclosures are of fundamental importance to whether companies are ‘properly managing and overseeing their risks within their business and adequately planning for the future’ with the conclusion that where this is not so, ‘it will increasingly conclude that companies are not managing risk’. These comments are representative of what market views and practice are and are clearly indicative of the influence of ESG on investment decision making.

While there is work to be done on non-financial reporting by regulators and standard-setters, companies should not use that as an excuse for inadequate reporting. Time and resources must be committed by entities to providing information in their corporate reports on how they create long term value and how their business plan addresses ESG risks and opportunities.

For further review of this topic, our website provides a wealth of articles and insights.

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