[co-author: Catherine Musulin]*
In our previous alert, we discussed the evolution of the ESG (environmental, social and governance) landscape and how it is imbedded in or distinguished from various investor and business approaches such as impact investing and B Corp Certification. At the beginning of 2018, investors directed $30.7 trillion in ESG investments in the US, Europe, Japan, Canada, Australia and New Zealand, according to the Global Sustainable Investment Alliance. Representing a 34% increase over 2016, this marks a significant shift in the importance of ESG considerations for investors. In parallel, the ecosystem for evaluating, rating and ranking company ESG efforts has also increased, illustrating a push for companies to become more transparent through public disclosure of ESG impact areas and reflecting the shift to stakeholder capitalism.
The public sector is also creating pressure as disclosure of various aspects of ESG are either mandated or encouraged in many jurisdictions. These include, for example, the UK with respect to mandatory gender pay gap reporting, France pursuant to Grenelle II, and modern slavery disclosures for certain companies under California, UK and Australia laws (to name a few). However, there is currently no common government regulated standard for comprehensive disclosure or measurement that allows for comparable, useful and verifiable information.
In the US, the SEC has been reluctant to shape the ESG disclosure conversation. Despite this, on May 14, 2020, the SEC’s Investor Advisory Committee, heeding the investor calls towards more ESG disclosure, recommended the SEC take a leading role in establishing a framework for ESG disclosure to investors. And, following a July 2020 US Government Accounting Office report evaluating the ESG disclosure arena, Senator Mark Warner called upon the SEC to create a task force to establish an ESG disclosure framework for reporting companies. Given the current administration and the election year, it’s unlikely there will be any movement by the SEC any time soon.
Because disclosure is largely voluntary, the sustainability ecosystem is made up of (1) organizations that provide different sets of disclosure frameworks and standards for ESG self-reporting and (2) organizations that rate and rank company ESG efforts by aggregating publicly-available data, sometimes confirming findings with organizations and sometimes not.
As discussed in our first alert in this series, the current business climate highlights that reputational and operational risks are on par and are interrelated to financial risk. In the Fourth Industrial Revolution, more than 80% of a company’s value is made up of intangible assets, including intellectual property, market share, brand awareness, good will and perceptions of a company’s effect on society and the environment, according to Ocean Tomo. This is the reverse of almost 40 years ago when tangible assets comprised more than 80% of a company’s value.
This fact bolsters investors views that ESG considerations are necessary to evaluate all elements of risk in their investment decision. It also frames the basis for the increased pressure by customers and consumers to be transparent and accountable on ESG elements, like climate and labor rights. For business to consumer corporations, in particular, reputational risks are now strongly grounded in how a company manages its role as a corporate citizen.
Regardless of the particular stakeholder’s perspective, ESG has become a matter of risk management, and disclosure is the means for stakeholders to evaluate all types of risk. Internal business conversations that weigh disclosure are not always straightforward as there is a tension between making the financial business case for disclosure and the calls for transparency, accountability and shared value creation. This has also contributed to a fragmented ecosystem that caters to disclosure for different purposes and different audiences.
According to the Investor Responsibility Research Institute, in 2018, 78% of the S&P 500 companies issued a sustainability report covering various environmental and social metrics. Companies take a variety of approaches for shaping their ESG disclosure from broad frameworks that drive global commonality in reporting to specialized disclosures that target specific stakeholders.
The main players in the ESG disclosure realm have created frameworks that are accepted and endorsed by the major financial institutions, most notably BlackRock.
Materiality is generally defined with reference to the significance of a company’s impact on and for internal and external stakeholders. GRI defines impact as the effect an organization has on the economy, the environment, and/or society, which in turn can indicate its contribution (positive or negative) to sustainable development. In this regard, the UN Sustainable Development Goals serve as an important guide towards identifying a company’s sustainable development.
In the spirit of advancing stakeholder capitalism and harmonizing the disclosure ecosystem, earlier this year, the World Economic Forum’s International Business Council, a critical player in the global ESG discussion, proposed a common set of ESG metrics for disclosure in annual reporting.
Notably, human rights is not just forced labor. Human rights is a broad arena capturing diversity and inclusion, gender equality, land use, income inequality, and a host of other rights keyed to the International Bill of Rights. For more information on this topic, please see our blog series on the landscape for addressing modern slavery by business and framing a human rights due diligence strategy that allows for the policies and checks and balances needed for appropriate disclosure.
In April, the EU announced an intent to legislate mandatory human rights due diligence in 2021, signaling a shift from voluntary disclosure to a “know and show” approach for human rights.
If a company undertakes ESG disclosure, it is also critical to understand the various misconceptions.
The sustainability ecosystem also includes a plethora of organizations that are ranking and rating companies on their ESG performance and risk. Sustainalytics, now wholly owned by Morningstar, and MSCI are the two main rating agencies. A host of others include, but are not limited to: Bloomberg, Dow Jones Sustainability Index, Institutional Shareholder Services (ISS), Thomson Reuters, and countless others. In general, these companies collect data on companies via questionnaires, surveys, and publicly available information to rank and rate companies.
In addition, organizations within the ecosystem partner with other organizations to benchmark companies on specific issues. For example, Know the Chain, a partnership between Sustainalytics, Humanity United, the Business & Human Rights Resource Centre and Verité, benchmarks companies on their human rights efforts, primarily forced labor. It recently published its rankings in the Information and Communications Technology (ICT) sector, a high-risk industry for forced labor, and serves as an example of how players in the space collaborate to aggregate data and use it to influence behavioral changes.
The raters and rankers can be criticized for moving ESG to a check the box endeavor and/or compliance type exercise instead of a mechanism to drive genuine engagement, education and overall shared value through collaboration and continuous improvement. ESG disclosures are already met with a suspicion of greenwashing and if the ratings and rankings are dependent, in large part, on public disclosures, a loop of mistrust can be created.
The ESG reporting space is incredibly fast-moving as the definition becomes more inclusive, raising a challenge for companies to sift and organize the macro frameworks and adapt to the tension of varying disclosure guides that may not reflect what is material for the company or its sector. Companies also experience fatigue and a resource drain as they respond to questionnaires that may have the effect of companies focusing on non-material factors to their business.
If companies choose to disclose, disclosure should be approached carefully and cautiously. When deciding where and when to disclose, consider the following:
With all the eyes on ESG, particularly the social factors, disclosure is almost never without litigation risk. In our next post, we highlight the current theories being advanced in the space, lessons learned and best practices for disclosures.
*Sr. Manager, Sustainable Development & B Corp, Danone North America