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Focus on What Really Matters: Key Trends in Sustainability and ESG Reporting
by Stathis Gould, Head of Professional Accountants in Business, IFAC | February 10, 2014 | 2
Investor engagement, regulation, and societal expectations are driving increasing awareness and action on environmental, social, and governance (ESG) performance. These drivers challenge organizations and their chief financial officers (CFOs) to enhance reporting and disclosure, and address ESG factors as an everyday part of decision making.
But how should organizations provide meaningful and specific disclosures for ESG issues? What significant initiatives and frameworks are available to help and how might organizations use these to ensure that reporting and disclosure is useful for users?
Reporting ESG: Progress and Pressures
Investors continue to increase their engagement with ESG issues since IFAC published Investor Demand for Environmental, Social, and Governance Disclosures in 2012. Since then, the number of signatories to the UN’s Principles for Responsible Investment topped 1,200 with an increasing number of mainstream, US-based asset owners and managers onboard. Although the amount invested in assets governed by sustainable investing strategies is increasing substantially, increasing numbers of mainstream asset owners and managers are adapting their approaches and methods to integrate ESG into their risk, valuation, and performance analysis.
Furthermore, some investors directly engage regulators and companies on specific ESG matters. This, plus engagement with company management and proxy voting, is higher than ever before and frequently covers specific ESG matters, or addresses a general lack of publicly available information on ESG policies and performance.
Two examples in the US highlight rising investor concern and subsequent action.
Investors wrote to Chevron’s management to request additional information on preparations for potential scenarios where demand for oil and gas greatly decreases due to regulation or other climate-associated drivers. And a group of investors, concerned that misleading disclosures may be driving investment in unclean energy sources, wrote to the US Securities and Exchange Commission (SEC) to request that the Commission evaluate the disclosures of certain registrants in the bioenergy industry for consistency with the Commission’s disclosure rules and 2010 Climate Guidance.
Governments, exchanges, and regulators are also working to drive responsible business practices. The 2013 edition of Carrots and Sticks, Promoting Transparency and Sustainability highlights 180 national reporting policies and initiatives, two-thirds of which are mandatory and mainly affect state-owned enterprises (SOEs). Mandatory and voluntary approaches often overlap but work to create traction. This proliferation of rules and regulations spans many jurisdictions. In the last year or so, the US legislated the Dodd Frank Act to cover conflict minerals, safety disclosures, resource extraction payments disclosures, and the proposed rule for pay ratio disclosure.
In India, voluntary guidelines have been adopted to encourage responsible business; but the top 100-listed companies and state-owned enterprises are now required to report on sustainability as well as enacting a controversial 2% corporate social responsibility (CSR) spending requirement.
Policy drivers are also a key feature in China, where the government has set a tone for improving corporate responsibility. The rapid increase in China of company and SOE sustainability reports in recent years was driven by China’s efforts to develop their capital markets, which involved using exchanges as a mechanism to encourage sustainable business practices. The 2006 Social Responsibility Guidelines for Listed Companies of the Shenzhen Stock Exchange, the Notice of Improving Listed Companies’ Assumption of Social Responsibilities of the Shanghai Stock Exchange in 2008, and the CSR Guideline by the State-owned Assets Supervision and Administration Commission in 2008 all have led to more reporting in China.
So the good news is that mandatory and voluntary approaches have led to an increase in ESG disclosures across most jurisdictions. However, the big challenge remains providing meaningful and specific disclosures about material ESG issues. Increased reporting too often leads to boilerplate disclosure or too much disclosure on issues that are not central to the strategy and business model of an organization.
What Initiatives and Frameworks are Available to Help?
Three significant initiatives should help to deal with this challenge.
1. The Global Reporting Initiative’s G4 version of its Reporting Framework helps organizations provide greater clarity on material non-financial drivers and impacts, including those in the supply chain. Each organization determines its most material factors to be incorporated into both strategy and reporting. The emphasis on what is material encourages organizations to provide only information that is critical to their business and stakeholders.
2. The Sustainability Accounting Standards Board, a US-based initiative, is developing material sector-specific key performance indicators. It brings together experts in each and uses a public consultation process to develop standard material measures designed for disclosure in mandatory SEC filings, such as the Form 10-K and 20-F.
3. The International Integrated Reporting Council’s International Integrated Reporting Framework facilitates smarter reporting focused on how value is created over time, rather than on financial performance in the short term. The Framework covers a comprehensive range of capitals—or resources—an organization uses or affects.
How Can Organizations Get the Most Out of These?
The key question for organizations is how to use these initiatives and frameworks to ensure that reporting and disclosure is useful for users. A starting point is to recognize that the management filter for materiality in terms of what is driving sustainable organizational success is not the same as the materiality concept for financial disclosures. As Eric Hespenheide and Dinah Koehler of Deloitte put it, “The traditional interpretation of financial statement materiality does not adequately capture non-financial business drivers.”
The management filter requires applying the collective mind of the governing body and management to focus on those significant and few issues that really matter. This is done in respect to the legitimate and reasonable needs, interests, and expectations of the organization and its stakeholders. As Professor Mervyn King, a leading figure in global move toward integrated reporting, puts it “In making a decision on behalf of the organization, while taking account of these expectations, the governing body is guided by the principle of acting in the best interests of the company for the maximization of the total value of the company.”
Significant and material issues will affect, or be affected by, the organization’s strategy and its business model. These issues are material impacts on the organization, stakeholders, and society that the organization must address and communicate clearly and concisely to external audiences.
In some instances, significant issues can be linked to cash flow and other measures of financial performance. But the link is not always clear due to uncertainties in timing, magnitude, etc. However, a well-managed organization should identify and understand these significant issues recognizing that some may not have an immediate impact. Investors and other stakeholders are looking for meaningful information on these significant matters and how the organization is dealing with them as it is these issues that will ultimately determine how the organization will continue to deliver sustainable value over time.
What are the biggest challenges you have faced to communicating clearly and concisely how your organization creates sustainable value?
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February 27, 2014
Thanks Linda, pertinent and timely questions indeed. The IIRC has picked up materiality in its technical agenda for 2014 as something that needs further consideration, and supplementary practical guidance. I hope IFAC will be involved in this work when it progresses. Some of our members have also reported to us that materiality in the context of IR is a continuing challenge for preparers.
For now, I will not pass judgment on the IR Framework. I think it is conceptually sound but clearly there are practical issues in its application. I would welcome a broad debate on what these issues are, which would be particularly helpful in developing practical guidance. I think some implementation issues include:
Is IR materiality focused on applying a materiality process to decide what information should be included in an Integrated Report, or should it be applied more broadly from a management perspective (i.e., is it about management and those charged with governance identifying those material issues that affect or have the ability to affect the organization’s strategy, business model and or the capitals it depends on)?
This might be an important distinction to make because not everything that is important may have to go into an Integrated Report. Indeed the Framework states that not all relevant matters will be considered material.
I think materiality from a management perspective should not be confusing as the Framework says that ordinarily, matters related to value creation that are discussed at meetings of those charged with governance are considered relevant (and I would argue most likely to be of interest to stakeholders and report users). The process of identifying relevant matters is carried out in conjunction with stakeholders with relevant matters being those that have an effect on the organization’s ability to create value over time.
A “sub-level” of materiality requires identifying what information about a matter needs to be disclosed in the Integrated Report. What information and indicators are required to adequately describe the issue? Answering this question requires engaging directly with users as part of the process.
The challenge of balancing conciseness and completeness with materiality then comes up. Integrated Reports are intended to be concise, so the narrative has to be tight and the indicators, where used, support the description and analysis. A practical way to avoid cluttered disclosure is to provide supporting detailed information in other forms, such as on the website, or to direct people to other reports.
I think future work will need to examine whether there are additional concepts that can help implement IR, such as relative materiality. A materiality threshold perhaps does not need to be absolute, and various reports and disclosures can provide useful information on relevant issues.
The responses to the proposed IR Framework in 2013 highlighted concern on how the IR materiality definition relates to those materiality definitions already in use. In practical terms, for some folks a key question is how can it be reconciled or used in conjunction with the materiality definitions in other reporting standards, regulations and frameworks? We need to give this question more thought involving different stakeholders and professionals. In the meantime, I think the answer to this question will be different depending on whether an organization uses an Integrated Report, or applies the IR principles to other forms of reporting. Ultimately, preparers will have to be pragmatic in their approach to implementing IR.
LINDA LOWSON, ESQ.
February 19, 2014
Stathis, excellent article. You are right that the management filter is a critical part of the materiality determination process. Do you think the IIRC Framework (i) provides a clear and viable template for this materiality process, or (ii) reduces the difficulty of this task for corporate management, or (iii) makes this task more difficult for them?
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