How to Build Sustainable Businesses - The Hunt Report (Vol 15)

Organisations need to embrace Environmental, Social and Governance (ESG) demands, but can such initiatives improve on the widely criticised CSR of the past? Professors Nada and Andrew Kakabadse of Henley Business School in the UK, consider the challenges and solutions.

Very few companies give due consideration to environmental [E] or social [S] issues. In fact, the majority of their attention is focused on the organisation’s purpose and how it is governed [G]. Collectively these matters are known as ‘ESG.

Throughout the COVID pandemic, the growth in ESG investment and the pressure on asset managers to integrate ESG risk-factors into their portfolio has triggered a high demand for businesses to provide shareholders with comparable data, ratings and rankings through consistently applied and easy-to-understand metrics.

On the back of this rising demand as to how businesses should behave, companies must rebuild, reinvigorate and abide by a form of capitalism that is acceptable to the majority. This means the growing investor community interest in ESG funds and statistical measures will only increase during 2022. All of this has led to a new industry, led by agile agencies specialising in a variety of ESG data and ratings, intended to benefit investor decision-making. Further to this, the addition of numerous standards and guidelines for corporations have sprung up, which some observers view as a near-impenetrable alphabet soup of questionable regulation.

The problem with current reporting metrics is that they often detract from pertinent disclosures regarding management capability and intentions that could otherwise provide invaluable information for investors.

This is essentially a repetition of the now outdated days of Corporate Social Responsibility (CSR) reporting, which similarly displayed strong potential at its outset.

In effect, the pooling of responsibility for CSR, standardising its definitions, the casual and ambiguous glossing over of objectives and its ultimate beneficiaries provided a distorted view, which made it difficult to evaluate whether any corporation was in truth upholding its stated responsibilities.

ESG, when effectively utilised, should and can inspire significant change that remoulds business activity and societal expectations for the better.

Unfortunately, the current metrics mania actually detracts from pertinent disclosures regarding management capability and intentions that would provide invaluable information for investors.

These measurement failures are centred on a lack of reliable and appropriate corporate data detailing company ESG adoption. Insufficient transparency and a failure to fully disclose firms’ ESG activities present ongoing challenges for asset managers seeking conscientious investments, as does the difficulty in assessing links between long-term value creation and non-financial performance.

Although climate change may pose an existential issue for many companies and humanity itself, other environmental challenges such as biodiversity, drinking water contamination, domestic and agricultural water shortages, air pollution, deforestation and land degradation from mining and waste disposal are also critical.

Similarly, social issues including boardroom diversity, equal pay, human rights, health and safety, consumer protection, animal welfare, income and wealth distribution, terms and conditions for ‘gig’ workers and minimum pay are all topics requiring serious consideration.

Although it is a management task to address these issues, the board holds ultimate responsibility to ensure these objectives have been achieved.

More recently, ESG has become closely associated with expected investment returns, particularly in the long-term, in the same way as other financial and analytical factors.

Despite the existence of several non-financial reporting frameworks utilising elements of ESG reporting — such as those promoted by the United Nations and the International Integrated Reporting Council — there is a lack of unity that makes it challenging to draw comparisons between various firms and industries.

Neither the International Financial Reporting Standards (IFRS) nor the Generally Accepted Accounting Principles (GAAP) have developed the necessary methodologies to assist enterprises in accounting for ESG initiatives from a financial perspective.

The IFRS considers materiality in financial terms, when ‘Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions.’ However, environmental and social materiality is about the impact of a company on the environment and society.

While the main objective for investors, up until recently, has been to understand possible degrees of warming around financial performance, it is increasingly being recognised that ESG perspectives have an impact on enterprise value.

As a result ‘non-financial information,’ used by analysts trying to value a company, is not currently recognised in financial statements, but is nevertheless useful in analysts’ and investors’ decision-making.

While this detail can be useful to a wide range of stakeholders, non-financial information is specifically designed for the benefit of investors. Moreover, the expression sustainability-related financial disclosure is being increasingly used to reflect the material importance of such disclosures to providers of financial capital such as equity, bonds and loans.

The European Securities Market Authority (ESMA) stresses the need to rely on a broad notion of ‘double materiality,’ meaning two types of regulation or directive. One is aimed at corporate disclosure (NFRD and CSRD), while the other, such as Sustainable Finance Disclosure Regulation (SFDR), serves asset owners and managers.

The EU Commission has been concerned with both perspectives and social factors in corporate behaviour and decision making. This has been put into effect in their Non-financial Reporting Directive (NFRD), soon to be updated and become law, at which point it will be titled the Corporate Sustainability Reporting Directive (CSRD). This will also provide the background for introducing the EU Sustainable Finance Disclosure Regulation (SFDR).

In addition, last November, the IFRS announced the formation of a new International Sustainability Standards Board (ISSB) to provide a comprehensive global baseline of high-quality sustainability disclosure standards. This will be published in June 2022 and is a significant step forward in achieving a globally-unified standard for sustainability disclosure. It is notable that the US has not announced a similar initiative for GAAP.

If both IFRS and GAAP move forward to establish a standard framework for ESG reporting and corporate boards strategic lever for company success, then, and only then, does ESG have a better chance of success than its predecessor CSR in the minimisation of ‘greenwashing’.

Click on the link to read the entire report: The Hunt Report (Vol 15)