ESG risks – time for clarity
Financial Reporting Brief: September 2020
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.
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.
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.
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.
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.
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.
Monthly Reporting Pack - August 2020
Irish/UK GAAP and related developments
- FRC and IASB release joint webinar on General Presentation and Disclosures Exposure Draft
- FRC issues statement on application of Accounting for Lease Modifications (Amendment to IFRS 16 - Covid-19-Related Rent Concessions)
- HM Treasury publishes 2020/2021 sustainability reporting guidance for public sector annual reports
IFRS and related developments
- IASB finalises phase 2 of its IBOR reform project
- Consultation paper on a new ESG disclosure standard
Previous Financial Reporting Briefs
- August 2020 – Robust financial system – key to survival
- July 2020 - Goodwill - Sustainable in the current environment?
- Quarterly Financial Reporting Brief: July 2020
- June 2020 - A Tale of Two Crises
- May 2020 - Covid-19 The Epic Battle Continues
- Quarterly Financial Reporting Brief: April 2020
- April 2020 - Covid-19 - The New Normal
- March 2020 - Sustainable activities - A need for Transparent Reporting
- February 2020: Corporate reporting - delivering the message
- Quarterly Financial Reporting Brief: January 2020
- January 2020: ESG Risks - The reporting challenge
- December 2019: Financial Reporting – Promote Public Confidence and Trust
- November 2019: Regulatory Environment - Lessons for All
- Quarterly Financial Reporting Brief: October 2019
- October 2019: Taxation - A Financial Reporting Challange
- September 2019: Corporate Reporting – A Continuing Challenge
- August 2019: Climate Change – Planet Earth does not have time for excuses!
- Quarterly Financial Reporting Brief: July 2019
- July 2019: Integrated Reporting – Corporate Strategy and Long-Term Value
- June 2019: Lease accounting - IFRS 16: A new age
- May 2019: Corporate Balance Sheets – The Full Picture?
- April 2019: Sustainable Development – A Goal for All
- Quarterly Financial Reporting Brief: April 2019
- March 2019: Reporting on Success - Getting the Balance Right?