It is frequently acknowledged that investors should identify and analyse any environmental, social, and governance (ESG) factors that could impact the value creation and risk profile of companies and integrate these factors into their investment process.
Evidence supporting the relevance of this type of information for investors continues to grow — see, for example, the Bank of America study ESG Part II: A Deeper Dive, Cornerstone Capital Group study At the Intersection: Where ESG matters to Factor Investing, or Accounting Review Journal article “Corporate Sustainability: First Evidence of Materiality.”
In tandem, the integration of ESG information into investment analysis depends on the extent to which companies’ disclosures effectively convey useful information (i.e., material for investment decision making, reliable and unbiased, accessible, comparable).
There is also a general acknowledgment that the current poor quality of reporting of ESG factors is an impediment to their use. In 2015, CFA Institute reported in Environment, Social, and Governance Issues in Investing: A Guide for Investment Professionals that there was limited use by investors of current disclosures related to “environment” factors.
In a similar vein, recent publications (Harvard Business School survey, Ernst & Young (EY) report, CPA Canada’s study on climate-related disclosures, US Sustainability Accounting Standards Board’s (SASB) State of Disclosure Report — 2016) elaborate on the gap that exists between information that can be useful for investors versus the state of existing company disclosures. These varied studies help build a strong case for improving ESG reporting, particularly considering, as pointed out in the EY report, that the annual report is the most important source of non-financial information.
Key ESG Reporting Developments
There are several global ESG-related reporting initiatives, including the International Integrated Reporting Council (IIRC) and Global Reporting Initiative (GRI) as well as the Climate Disclosures Standard Board (CDSB), which is associated with the Carbon Disclosure Project. The IIRC’s six-capital (financial, social and relationship, human, intellectual, productive, and natural) integrated reporting framework focuses on value creation and it includes sustainability reporting factors. GRI is primarily focused on sustainability reporting. The CDSB framework sets out principles and requirements for integrating climate change and natural capital information into mainstream reports based on existing accounting requirements.
There have also been a variety of country-specific ESG reporting requirements, including requirements from regulators and stock exchanges.
Sign up to Unpacking the Alphabet: Do ESG Reporting Initiatives Meet Investor Needs? on 19 September, a webcast hosted by CFA Institute.
European Union Non-Financial Reporting Directive (NFR): On 26 June, the EU issued the NFR, which has been described by some parties as the most important piece of EU legislation. Beginning in 2018, 6000+ companies must ramp up reporting of environmental and social aspects, including respect for human rights and action against corruption and bribery. The pivotal nature of the NFR was emphasised in the influential EU High Level Expert Group on Sustainable Finance Interim Report issued in July. The sustainable finance report calls not only for improved ESG disclosures but also for asset managers to consider the integration of these factors as part of their fiduciary duty.
That said, the jury is out on whether there will be a significant change in the quality of companies’ reporting of sustainability factors because the NFR is largely a principles-based reporting framework with no prescribed metrics. In addition, there is not yet a common framework to determine what is material information that warrants reporting. Hence, it is necessary to have ongoing development of best practise examples, as groups such as Accountancy Europe are doing.
Financial Stability Board (FSB) Task Force for Climate-Related Financial Disclosures (TCFD): The initial impetus for the TCFD initiative was the perceived failure to link climate change risk to financial stability and long-term risk of financial institutions, including insurance companies. This was described by the Bank of England Governor and FSB Chairman Mark Carney in a 2015 speech on tragedy of horizons. Climate risk has different yet ubiquitous impacts across different industries and the need to mitigate this risk extends beyond the financial sector.
The TCFD recognised the need to enhance climate disclosures beyond what is currently reported. On 29 June, the TCFD issued its final report with voluntary recommendations for better reporting and management of climate-related risk.
These recommendations are based on a distinction between risks related to (1) the transition to a lower-carbon economy and (2) physical impacts of climate change, as a basis of strategic decision making as well as on informing investors about the implications of climate-related risks.
Given that the TCFD recommendations are voluntary, there is an ongoing and complex challenge of ensuring these recommendations are implemented by a critical mass of companies across the globe. The CDSB has a critical role in aiding the rollout of the recommendations. It also helps the cause that the ‘EU High Level Expert Group on Sustainable Finance Interim Report’ has endorsed the TCFD recommendations.
Unpacking the Alphabet
We have highlighted the NFR and initiatives by the GRI, IIRC, CDSB, and TCFD. This is a large mouthful of acronyms, so it is not surprising that with the multiple initiatives involved in the ESG reporting space, it is challenging for investors to discern the similarities and differences across these varied frameworks. There is also the challenge of getting to a common and robust definition.
CFA Institute is hosting a webcast — Unpacking the Alphabet: Do ESG Reporting Initiatives Meet Investor Needs? — on 19 September that will bring together SASB, IIRC, GRI, and CDSB to discuss investor relevant ESG reporting, including similarities and differences across the different reporting frameworks. Register today to learn more.
If you liked this post, you can read more views on the integrity of capital markets on the CFA Institute blog Market Integrity Insights.