Investors are keen to understand the impact companies are having on the environment and society at large, but gathering and presenting that data remains a complex task. 

Glass

Most relationships function on the exchange of information. Banks, investors, employees and customers all take decisions concerning business – and each other – based on their knowledge of the other party. Providing that data in a meaningful form, of course, is important. Just as past crises led to a revolution in which that information is shared, so the pressures around environmental, social and governance (ESG) factors are creating new ways to present a broader, more impactful view of companies.

Ronald Cohen, chairman of the Global Steering Group for Impact Investment (GSG), notes how the US passed legislation to mandate the use of Generally Accepted Accounting Principles after the 1929 stock market crash and the Great Depression. He says that the uncertainties raised by the coronavirus pandemic have further highlighted the need for a better understanding of corporates’ role in society.

“Today, [...] investors are asking themselves: have we really been investing in companies and measuring only their profit, without measuring the impact on lives, and on the environment and the cost of all the damage that they’re inflicting, which governments then tax us all to try to remedy,” said Mr Cohen in a speech at a London School of Economics online seminar in July. After his pioneering work in venture capital in the 1970s with Apax Partners, Mr Cohen is now often referred to as the father of impact investing.

Time to get serious

He is not alone in believing in the need for a new revolution in corporate reporting. “If we really are serious about taking impact into account when we’re making decisions as a society, then we cannot just be optimising risk and return – we should be optimising risk, return and impact,” says George Serafeim, Charles M Williams professor of business administration at Harvard Business School.

“We need to create the infrastructure for us to really measure that.” Mr Serafeim is in charge of developing a methodology to create accounting statements that present a company’s financial, social and environmental performance as part of the Impact-weighted Accounts Initiative by the GSG and the Impact Management Project. 

Others are heading in the same direction. The Value Balancing Alliance, a not-for-profit organisation supported by business, the four big accounting firms (Deloitte, EY, KPMG and PwC) and the Organisation for Economic Co-operation and Development, is also working on a methodology to express companies’ environmental impact in monetary terms, building on the concept of natural capital by the Capitals Coalition, an organisation which is part of the same project.

No easy task

The revolution of accounting practises to incorporate ESG factors may be inevitable, but getting there remains a complex task.

While impact-weighted accounting aims at measuring the overall impact of a company on the environment and society, companies’ ESG disclosures have predominantly aimed to establish the impact of those externalities on them. For example, they would attempt to quantify the consequences of a global transition to a low-carbon economy for the oil sector and for the banks that finance them. Or they would consider the implications of discrimination on share prices.

After years of investor and policy-maker pressure, there is now enough data to begin to address those points. And Mr Serafeim’s impact-weighted accounting approach relies on those ESG corporate disclosures, which form the building blocks of the new methodology. But the issue of how to best use that information, of its meaning and its comparability, has yet to be solved.

ESG reporting is often a cumbersome and time-consuming exercise, which leads to companies creating multiple sets of disclosures to meet the requirements of multiple standards that serve a variety of users.

Since the late 1990s, a number of frameworks have developed to address various aspects of sustainability reporting. The Global Reporting Initiative (GRI) was the first of this kind and its standards remain widely used; they cater for a variety of stakeholders. In 2017, the Task Force on Climate-related Financial Disclosures (TCFD) released recommendations to explain how management’s strategy and risk oversight would work in different temperature scenarios, and to report on targets. The task force was created by the G20’s Financial Stability Board under the leadership of then Bank of England governor Mark Carney and businessman and former US presidential hopeful Michael Bloomberg. It is now the subject of a proposal by the Financial Conduct Authority that would impose TCFD disclosures on all companies listed on the UK stock market. 

Among the more widely used frameworks is also the Sustainability Accounting Standards Board’s (SASB’s), which focuses on the financial materiality of ESG factors and breaks it down industry by industry. 

Issues remain

So far, these are all voluntary measures. But issues remain even when disclosures are made mandatory, as legislators have discovered. Since 2018, EU companies with more than 500 employees must disclose additional information under the EU’s Non-Financial Reporting Directive. But because no specific framework is mandated, the European Commission has found the information to be of little use: it is not sufficiently comparable or reliable, it is not meeting users’ needs, and it is imposing unnecessary costs relating to disclosures and uncertainty over which data, standards and timeframe to adopt for their disclosures. The commission launched a consultation with the industry over a revision of the directive, which may be adopted by the end of 2020.

Others have called for harmonisation. The International Integrated Reporting Council, which has been promoting the disclosure of ESG factors alongside traditional financial statements, has also been encouraging a dialogue between standard-setters to ease off reporting pressures on companies and provide a clearer, more coherent picture to investors. This led to the announcement of a formal plan, in July, to better explain how the SASB and GRI standards interact and can work together.

Janine Guillot, CEO of SASB, says that a standardised approach to providing information to individual user groups would help and that this could materialise as early as in two years. But, she adds: “We don’t think that one single standard can meet the needs of such a broad breadth of users,” from providers of capital, to customers, employees, suppliers, policy-makers and non-governmental organisations.  

Sustainability and ESG risks are a pressing global concern. The environment, in particular, tends to be the area that is better documented and, perhaps, easier to articulate in terms of threats. According to the World Economic Forum’s 2020 Global Risks Report, extreme weather events, failure of climate change mitigation and adaptation, major natural disasters, major biodiversity loss, and human-made environmental disasters are the top five most likely risks according to respondents, who mostly come from business. Failure of climate change adaptation and mitigation is also the top risk by impact, with biodiversity loss, extreme weather events and water crises among the other top five.

In the dark

Yet, some warn these concerns still do not fully transpire in corporate disclosures, not even when they should, as requested by existing accounting principles.

Andrew Watson, co-founder of a network of experts in intangible assets, Rethinking Capital, has been looking into this subject and finds companies’ apparent lack of disclosures confounding. He points to the International Accounting Standards Board’s specific guidance on contingent liabilities: IAS37. As previously noted by The Banker, IAS37 sets the standard on provisions, contingent liabilities and contingent assets, which means that it deals with assets of which existence is not yet certain and with liabilities of an uncertain timing or amount or where obligation will be confirmed by uncertain future events out of the direct control of the reporting organisation.

Paragraph 20 specifies that although an obligation always involves another party to whom the obligation is owed, this does mean that the specific identity of the other party must be known, “indeed the obligation may be to the public at large”. TCFD does specifically refer to IAS37, and other standards, in its recommendations.

Mr Watson believes that there is a mismatch between corporate public statements of concern over climate change and what is disclosed in their reporting. Unless the liability is remote, corporate directors must either disclose a contingent liability in a detailed note, or recognise a provision. Yet, says Mr Watson, based on what his group is seeing, “organisations seem to conclude that climate risk is remote, and therefore neither disclose a contingent liability nor recognise a provision as they should under IAS37”.  

Other professionals believe that reporting is not always guided by the principle of that rule. “Theoretically speaking, more disclosure could be given on IAS37 than what is given today,” says Imre Guba, director and accounting specialist at Standard & Poor’s, who oversees the rating agency’s Europe, the Middle East and Africa coverage of around 2000 companies. “If some of the standards existing today were applied more consistently, and better, we would immediately have greater disclosure.”

He refers to supplementary information in footnotes and additional disclosure around, for example, risks related to transition to a low-carbon economy. “Strictly speaking, that kind of disclosure would be in the spirit of IAS37.”

Mr Watson warns that ignoring that spirit may lead to class action lawsuits against those companies that do not disclose such liabilities and recognise their responsibility toward the wider public, as happened with the tobacco industry.

The debate over sustainability disclosures can be elevated to accounting theory too so that a view on the ultimate goals of this discipline can more naturally seep into rules and practice. For example, if a company invests to transition to a climate neutral scenario or is paying “responsible tax”, any capital spent on those investments would reduce balance sheet equity, but “this is not a true and fair view”, says Mr Watson. If equity on the balance sheet is viewed as a store of fairness, he adds, “decisions made to invest into reducing environmental and social inequity must increase balance sheet equity”.

Based on the same principle, decisions that result in environmental and social damage should lead to a reduction in equity value. Following this theoretical approach, ESG factors could have direct implications for financial statements.

Making a difference

Intuitively, few would disagree on the business relevance of environmental and social issues. Research is beginning to show just how much they matter.

Harvard Business School’s recently released analysis of more than 13,000 companies found that 11 out of the 68 industries studied have a ratio of negative environmental impact to revenues of more than 10%: the environmental damage caused by generating a certain revenue equates to more than a tenth of that revenue. 

The university has also gathered examples of companies that have already adopted methodologies to share information about their impact on the environment and employees, as well as on the impact that their products have on society. The latter “is super important because most ESG measurements have been about operational impact, the types of impacts that you’re having through your operations, but very few metrics exist, actually, for the types of impact that the organisation is having through their products,” says Mr Serafeim. “This has been a huge blind spot for the industry and the data that we have right now.”

Looking at companies’ broader impact is leading to a very practical revolution, just as technology did before it. Technology has become “the water on which every ship sails: you can’t really set up a company and not think about technology,” noted Mr Cohen at the LSE event. “I think impact will do the same; it will be another layer of water on top of technology. And the companies that deliver impact are going to disrupt the model of companies that are not.”

Disclosures are essential to see that revolution through. Even environmental disruptors like Tesla, for example, have not necessarily made sufficient disclosures to allow an impact analysis. The company that helped push the automotive industry away from the internal combustion engine and towards electric cars has only recently released enough data to be included in Harvard’s next environmental research, which will help clarify whether the use of its vehicles outweighs the environmental damage of the production and disposal of their batteries. 

Investor, policy-makers and public pressure have built urgency around ESG disclosures. All the signs are pointing to this urgency leading to longer-term changes in what type of business information is publicly shared and how it is valued.

James Stacey, partner at consultancy ERM and co-author of the TCFD technical supplement on scenario analysis, says: “A company reporting [environmental and social factors] in 2030 will be doing it quite differently than now and, more likely, let’s face it, it will be mandatory.”

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