What do we mean when we talk about the significance of ESG reporting?
The significance of ESG reporting lies in the changes it brings to the substance and method of corporate disclosure as well as in what it intends to facilitate for a company and its internal and external environment. In our article, we try to deal with both these aspects of ESG reporting.
ESG reporting is poised to play an increasingly important role in the coming decades. At the recently-held COP26 climate conference, a number of countries pledged efforts toward creating net-zero economies in the next two to four decades. And the road to net-zero needs to be paved with sustainable practices spearheaded by governments as well as businesses.
ESG issues have caused a shift in investment patterns with inflows into ESG-focused funds increasing at a pace that’s quicker than anticipated. Recent research from Bloomberg pegs ESG investments at $53 trillion by 2025 – which is roughly one-third of the $140.5 trillion in global assets under management estimated by then. And as an indicator of how quickly ESG investments are growing, global inflows into ESG-based funds by Q3 2021 exceeded the entire 2020 inflows of $51.1 billion.
The growth in ESG investments must be backed by high-quality data for it to create the intended impact. That’s where high-quality ESG reporting comes in, revolutionizing the business of corporate disclosures. It is vital to understand the significance of ESG reporting, with a focus on the difference it would make to companies and their various stakeholders.
Significance Of ESG Reporting For Companies
A Difference in How ‘Value’ is Measured
For companies, ESG reporting represents a shift in the way they measure or interpret ‘value’. Companies now need to think of creating value not just for shareholders but for all stakeholders, including their customers, employees, the external environment and society, lenders, and credit rating agencies (mainly those focused on ESG performance).
Any business activity that is viewed as being harmful or exploitative of the environment and society stands the risk of being called out. There have been instances in the recent past of companies taking a stand against sourcing consumer goods whose raw materials are thought to be harvested in a region where human rights violations are allegedly rampant. Such measures came after the companies involved were called out by their customers and human rights activists.
When it comes to creating value for employees, the factors under consideration would be employee well-being, gender equality and diversity in the workplace, and the creation of a culture of openness. What would appeal to customers is products that emphasize quality over price, efforts towards a positive customer experience, a positive brand image, and rewards for loyalty.
ESG reporting also signals a difference in the aspects considered essential for business ‘value’. With the global economy long having moved away from a dependence on heavy industry to being one supported by services and knowledge, the investor focus is now on the value locked up in intangible assets rather than tangible.
There are numbers to back this up. According to a study by Ocean Tomo, a firm that provides financial, management, and advisory expertise on matters related to intangible assets, 90% of the S&P 500 companies’ market value today comes from intangibles, compared to less than 20% in 1975.
[Source: Ocean Tomo, LLC Intangible Asset Market Value Study, 2020]
The Incentive for High-quality ESG Reporting
Numerous studies have proved that robust ESG reporting has helped decrease companies’ cost of capital. In fact, there is a difference in the average cost of capital for companies with higher and lower ESG scores.
According to an MSCI study published in 2020, companies on the MSCI World Index with the highest ESG score had an average cost of capital of 6.16%, while those with the lowest ESG score had an average cost of capital of 6.55%. The same can be said of cost of equity and debt. MSCI also found that companies with a high ESG score are less prone to systematic risks that affect the broad market or sectors.
[Source: MSCI]
A McKinsey study from November 2019 has identified five ways in which companies benefit from ESG initiatives. They are as follows:
Rise In Revenues: Revenues rise when companies enter new markets or expand in existing markets on the strength of their ESG credentials. Moreover, supervisory bodies and regulators facilitate the growth of companies with a strong ESG performance – easily granting them the approvals and licenses they need. Such companies can also benefit from better valuation if they are being acquired.
Reduction in Costs: Costs reduce when ESG measures are implemented effectively. For instance, a company can improve its manufacturing processes to consume lesser quantities of a scarce resource, recycle waste material for reuse, and ensure that its processes do not cause pollution. Cost of capital is also known to reduce when companies have strong ESG credentials.
Reduction in Regulatory Interventions: Regulatory pressures ease and risks of adverse government intervention reduce when companies exhibit a stronger ESG proposition. On the contrary, governments may begin to support companies that are known to create sustainable value. This is true across geographies.
Increased Employee Productivity: Companies can benefit from increased productivity when employees believe their efforts are meant to fulfill a larger purpose. Employees can stay loyal to organizations with strong ESG credentials and there could be a constant inflow of fresh talent. Moreover, a rise in revenue due to greater productivity would mean more incentives.
Enhanced Investment Performance and Asset Utilization: These are achieved when capital flows into sustainable avenues. An ESG focus can keep companies from assets that harm the environment in the long run.
Significance Of ESG Reporting For Investors
What ESG reporting offers to investors is a measure of how a business is affecting its immediate environment and society, and how strong its governance practices are.
The environmental aspects considered for ESG metrics include climate change, use of natural resources, and pollution and waste management. Social metrics include human capital, product liability, stakeholder opposition, and social opportunities. The ‘G’ in ESG, or governance aspects, include corporate governance and corporate behavior.
ESG reporting that factors in all these aspects in a neutral and fair manner – without ‘greenwashing’ or the use of marketing or PR to gloss over ESG impact – would contribute to an ESG score by agencies such as MSCI ESG Ratings, Sustainalytics’ ESG Risk Ratings, and Bloomberg ESG Disclosures Score.
What would aid transparent ESG reporting is the use of sustainability standards that work in a similar fashion to accounting standards. The recent creation of the International Sustainability Standards Board (ISSB) will facilitate the creation of a globally-accepted baseline set of standards by consolidating the efforts of organizations such as the Value Reporting Foundation (VRF) and the Climate Disclosure Standards Board.
To tie it all together, transparent ESG disclosure on the basis of globally accepted sustainability standards that lead to a sound ESG score for the reporting companies would offer ESG-conscious investors the right platform on which to base their investment decisions.
Conclusion
ESG reporting represents a seismic shift in the way corporate disclosures are made and used. Moreover, the impact of ESG reporting is intended to be much wider than financial reporting. There is a larger stakeholder base that ESG reporting caters to, as well as a wider impact footprint that includes the environment, society, and governance metrics. A business entity is no longer focused on creating only financial value, but ‘value’ in a much broader sense. In a sense, a commitment to high-quality ESG reporting as well as investing is a commitment to build institutions that make a difference in their internal and external environments.
