Demystifying the conflict and often confusing lanscape of ESG measures and standards
by Patty Mah
The value and potential profitability of being environmentally conscientious has placed more accountability on corporations to be transparent about how they get to their bottom line. Consumers and investors, and increasingly, younger investors are wanting to align their investment choices with their own values of environmental sustainability, equity, and human rights.
“There is a heightened awareness of environmental, social, and corporate governance (ESG) factors that has led to a heightened demand for ESG investment products,” states Professor Elizabeth Demers (MAcc – Waterloo, MSc, PhD – Stanford), who recently published research on the resiliency of ESG investments during the global pandemic.
Originally coined in 2005, ESG factors have changed the financial reporting and investment landscape. Gone are the days of simple profit maximization. An organization’s performance is tied to factors that score how well an organization responds to, for example, climate change, how they treat their employees, and how they manage their supply chain, creating a bottom line that’s tied to the environment, social responsibility, and corporate governance.
STANDARD SETTING - ONE FRAMEWORK TO RULE THEM ALL? PERHAPS NOT.
Measuring non-financial factors, such as the ESG impact on an organization’s bottom line, is challenging enough but not having one globally accepted and adopted standard for measurement has made reporting and investing even more confusing. Accounting and finance (A&F) professionals, as well as consumers and investors, are navigating a multitude of reporting standards and measurements that differ in both perspective and criteria.
The Global Reporting Initiative (GRI) measures an organization’s impact from environmental and societal perspectives. Adopted by thousands of reporters in over 100 countries, the GRI, formed in 1997, covers ESG measurements important for a broad set of stakeholders, including those who may not have a direct interest in the firm. On the shareholder side, Sustainability Accounting Standards Board (SASB) was founded in 2011 to provide investors with insights on the impact of ESG on the firm. Throw into this mix the Sustainable Development Goals (SDGs) adopted by all United Nations member states and the Taskforce for Climate-related Financial Disclosures (TCFD) framework, both introduced in 2015, and it’s clear that there isn’t one reporting framework that is ideal for both investors and other stakeholders.
“All these frameworks help measure the performance of ESG or sustainability performance of corporations, but there are too many frameworks and too many indicators,” notes Dr. Amr ElAlfy, a Post-Doctoral Fellow with the School of Environment, Enterprise, and Development (SEED).
This past fall, the International Financial Reporting Standards (IFRS) Foundation stepped into the game to propose standardizing sustainability reporting as they had done previously for accounting standards. IFRS is adopted in 166 jurisdictions globally and is recognized by the International Organization of Securities Commissions (IOSCO), which may make them the ideal choice to find common ground, at least for the frameworks that cover investor perspectives. The IFRS Foundation proposed an ambitious goal to potentially announce the establishment of a sustainability standard board governed by the IFRS Foundation at the meeting of the United Nations Climate Change Conference COP26 in November 2021.
Where the IFRS Foundation may fall short will be setting reporting standards as it pertains to social and societal impact. This would be true for European Union (EU) countries, which are mandated by the European Commission’s Non-Financial Reporting Directive (NFRD) to report on the social and environmental impacts and risks related to their activities. The NFRD is expected to be replaced by a proposed Corporate Sustainability Reporting Directive (CSRD) that will provide more explicit reporting requirements and significantly broaden the number of firms required to report ESG information (i.e., from approximately 10,000 to 55,000). Initially announced in April 2021 and similar to its predecessor, the CSRD will adopt a broader stakeholder, rather than an investor, perspective.
As reporting standards evolve and are defined in the next few years, we can hope for a more streamlined set of frameworks, but perhaps it is too optimistic to assume one framework will rule them all.
ANOTHER LAYER OF CONFUSION
“There have been numerous standards and they’ve been competing, and now we might be moving towards one common global standard [with IFRS], for corporate sustainability reporting from an investor perspective. But corporate ESG performance is also being scored by commercial databases,” states Demers who acknowledges that this adds confusion to the reporting and rating landscape for ESG.
In addition to a multitude of reporting frameworks for ESG factors, there are just as many differing commercial databases that rate companies on ESG factors. A lack of correlation and compatibility between reporting frameworks and standards exists but the level of correlation across the larger, more credible databases that provide ESG scores “is disturbingly low. So, an organization can do really well when evaluated by one data provider and not so well on another,” notes Demers. “What are companies that are trying to do the right thing supposed to prioritize when weightings being applied to their activities are different across the rating agencies? From an investor’s perspective, which rating do you rely on?”
EARLY ADOPTION
On the bright side, although confusing, many organizations have been voluntarily reporting and following one or multiple reporting systems for years. Driven by public interest to demonstrate their corporate social responsibility, Demers attributes competition between companies to their early adoption of a reporting framework, “you’re competing for capital, so leading companies disclose their ESG-related activities in accordance with one of the recognized frameworks in order to a get a lower cost of capital, and from this, eventually best practices in ESG reporting will naturally emerge.”
CPA Canada, the governing body for the Chartered Professional Accountant designation has embarked on an enhancement project to embed sustainability throughout the CPA accreditation competency map. ElAlfy is optimistic that IFRS will find the synergy between the reporting systems, “it’s a pivotal moment for the standardization of reporting. We’re moving from ESG reporting to comprehensive reporting where every aspect is related to the financial statements.”
Anticipating the integration of ESG factors into financial disclosures and reporting, the School of Accounting and Finance (SAF) has enhanced and introduced new courses this past year and a new undergraduate program, Sustainability and Financial Management (SFM) in Fall 2022, to train a new breed of accountants and financial experts. “It’s an extraordinary paradigm shift for most accountants in practice,” notes ElAlfy, where they’ll be required to integrate ESG into how they report, interpret, and act on financial and non-financial factors.
“We are definitely ahead of the game with this degree [SFM], so it’s exciting that we’re in this space and already enhancing accounting education,” states Demers who anticipates other accounting, finance, and business programs, as well as organizations, will be scrambling to implement and integrate ESG into their curriculum once ESG reporting becomes a mandatory reporting requirement for companies.
“I believe that we are in a time of structural change in terms of how we think about environmental and social responsibility and corporate governance, how we think about investing, how we think about doing business,” says Demers. “And definitely, the accounting profession is about to change.”