Mandatory ESG reporting will change the market. Is your company ready?

Despite the very provocative and polemic Economist’s article on the flaws of the corporate’s sustainability efforts, ESG is not going away. On the opposite: the tide is turning, and obligatory ESG reporting is on its way across the World.

The Securities and Exchange Commission (SEC) in the US issued new environmental, social, and governance (ESG) disclosure rules for firms in March of this year. These new guidelines require public firms to improve and standardize their climate-related disclosures. Additional climate risk disclosures, such as the effect of extreme weather occurrences and risk management process governance, are also needed. 

Similarly, the Corporate Sustainability Reporting Directive was amended to require firms to provide quarterly standardized reports on their environmental and social impact actions beginning in the fiscal year 2023.

Mandatory ESG disclosure standards will provide stakeholders with comparable and targeted ESG data across companies to model effect, predict trends, identify risk, and make everyday sustainable decisions. Requiring companies to disclose ESG performance represents a tectonic shift in sustainability regulation. It will open many new opportunities for innovation, impact studies, and societal change while strengthening the resilience of companies and the welfare of workers and communities across vast corporate value chains.

From the investor's perspective, ESG disclosures have provided a new source of information for identifying risk, increasing prospects for returns, and serving as the foundation for new financial instruments such as ESG indexes.

The focus on increased transparency, intentional reporting, and financially relevant information regarding how ESG variables affect financial reporting and an organization's results of operations is shifting dramatically.

Measuring and managing

In a recent Deloitte survey of 300 finance, accounting, sustainability, and legal executives at public companies with more than $500 million in revenue, 57% said data availability (access) and data quality (accuracy or completeness) are their most significant challenges when it comes to ESG data for disclosure.

The growing number of environmental, social, and governance (ESG) ratings, standards, methodologies, frameworks, conventions, associations, and policies has made it difficult for investors, consumers, academics, and regulators to gain a thorough understanding of what ESG metrics are essential and how to measure corporate impact.

The Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), Task Force on Climate-Related Financial Disclosures (TCFD), CDP (formerly Climate Disclosure Project), and other major voluntary sustainability reporting frameworks have served as platforms for companies to disclose their ESG performance in a concise, structured manner. Each of these frameworks takes a different approach and serves a different goal. Still, they all provide some degree of similar openness about the company's corporate sustainability activities for investors, customers, and other stakeholders to assess.

The end of WASHING?

According to the Edelman Trust's 2021 Barometer Special Report, 86% of the 700 US investors polled feel firms regularly misrepresent or exaggerate their ESG progress when releasing results, and 72% of investors worldwide do not trust companies will meet their ESG pledges. 

The SEC is developing new regulations to prevent fraudulent ESG claims made by investment funds and to require corporations to report how climate change impacts their operations. According to Bloomberg News, the SEC examines charges that the banking giant's funds did not correspond with ESG parameters mentioned in marketing literature. 

A new SEC task force is progressively strengthening enforcement of corporate environmental, social, and governance disclosures, putting corporations on notice. A year and a half ago, the Securities and Exchange Commission established its Climate and ESG Task Force. The unit has generally remained in the background. However, according to agency data, it has assisted in prosecuting at least three enforcement actions in the previous four months.

What should boards do?

What role does the board of directors have in developing and implementing ESG strategies? Who has supervision responsibility for ESG risks and opportunities? What impact do ESG disclosures have on the company? When is climate-related data organized and reviewed?

Regulations and procedures governing the involvement of finance, audit committees, and boards of directors; current climate-related data being collected and the associated level of assurance; process for evaluating the materiality of climate-related disclosures; and the resources required by an industry to meet proposed reporting deadlines are some of the significant concerns that organizations must address concerning sustainability reporting. 

The buck stops with the board; according to Edelman survey respondents, 71% of US investors believe the board of directors must be held responsible for maintaining a healthy business culture. At the same time, 86% agree that a workplace culture that encourages employee empowerment is vital for developing trust. Three-quarters of global investors believe that employee activism signifies strong workplace culture.

The SEC has suggested governance and risk management disclosures in both financial and nonfinancial statements. According to the SEC's proposed regulation, public businesses must declare if any board members have climate-related knowledge and, if so, what that experience entails. Companies must also identify how active board members and senior management are in managing a climate risk program and creating and implementing ESG initiatives. The benefits of enhanced transparency do not end there. The proposed regulation from the SEC would also require corporations to disclose how they identify, analyze, and manage climate-related risks, including establishing their relative severity and materiality.

The activist shareholder pushback against greenwashing has progressed from corporate criticism to actual action against directors. Directors should meet with investors ahead of proxy voting, listen to their recommendations, and provide well-thought-out initiatives to address climate-related risks, social justice concerns, and diversity and inclusion at all levels of the organization.

Given that most US investors polled predict an increase in ESG-related litigation, the demand on boards to scale up their assurance operations is increasing. Boards must demonstrate that their ESG figures add up to something substantial to avoid' greenwashing' charges and create confidence with investors.

Directors should carry out ESG supervision with different experiences and skill sets. So far, most institutional investors and proxy advice companies have been non-prescriptive in this respect, recognizing that relevant skills vary by sector and size. Some demand boards offer unambiguous transparency on the ESG competencies mirrored in their ranks. 10 Glass Lewis, for its part, clearly considers environmental and social abilities and health and safety skills in its board review. It feels demonstrated expertise in global environmental management, experience in leadership with workforce participation, and applicable degrees in an environmental or social sector, among other material elements of the company.