#DeloitteESGnow — Enhancing Trust in ESG Disclosures
Significant progress has been made in corporate reporting of environmental, social, and
governance (ESG) information, as evidenced by the rise in the number of S&P 500
companies that publish some form of a sustainability disclosure. At the same time,
institutional investors, asset managers, lenders, credit raters, and insurers are
increasingly relying on companies’ ESG disclosures to make important decisions regarding
the allocation of capital. Against this backdrop, there continues to be a growing call
for companies to enhance the quality, comparability, and usefulness of their ESG
disclosures.
A number of factors are driving this call to action:
- ESG investing continues to accelerate at breakneck speed. For example, UBS saw more than $71 billion of flows to ESG funds and pandemic bonds in the second quarter, bringing its ESG assets under management to $1 trillion for the first time. In addition, “[a] new record was set in 2019 for the volume of sustainable debt issued globally in any one year, with the total hitting $465 billion globally, up a remarkable 78% from $261.4 billion in 2018.”
- According to the Harvard Law School Forum on Corporate Governance, the role that sustainability and nontraditional metrics play in investment decision-making is growing. “Investors are seeking [quantitative ESG] metrics to evaluate a company’s approach to sustainability and its drivers of long-term growth.”
- Although investors are increasingly relying on ESG disclosures, they remain dissatisfied with the level of appropriate quantitative ESG information, lack of comparability over time, and questionable data quality. In 2019, only 29 percent of S&P reporting companies obtained external assurance on their sustainability information.
The lack of standardized investor-grade information in ESG reporting has become a
sticking point among issuers, investors, and standard setters. It is clear that
institutional investment decision makers and other capital market participants need
standardized and increasingly quantitative ESG disclosures that are assured and can be
used by investors to efficiently evaluate ESG information and integrate it into their
decision-making process.
What Is ESG
Investing?
ESG investing involves incorporating
nonfinancial factors related to the environmental impact, social
impact, and governance attributes of a corporation into the
evaluation of companies and affects the allocation of
capital.
“People may choose not to invest in a firm that
has poor ESG, thereby limiting its access to capital and raising
its cost of capital.”1
What Is ESG
Reporting?
According to the CAQ, “ESG reporting encompasses both
qualitative discussions of topics as well as quantitative
metrics used to measure a company’s performance against ESG
risks, opportunities, and related strategies:”
- “The E, or environmental, component of ESG information encompasses how a company is exposed to and manages risks and opportunities related to climate, natural resource scarcity, pollution, waste, and other environmental factors. “
- “The S, or social, component of ESG includes information about the company’s values and business relationships. For example, social topics include labor and supply-chain standards, employee health and safety, product quality and safety, privacy and data security, and diversity and inclusion policies and efforts.”
- “The G, or governance, component of ESG incorporates information about a company’s corporate governance. This could include information on the structure and diversity of the board of directors; executive compensation; critical event responsiveness; corporate resiliency; and policies on lobbying, political contributions, and bribery and corruption.”
This Heads Up discusses multiple ESG market developments and steps that companies
can take to enhance the quality of their ESG reporting.
ESG Information for Investment Decisions — Market Developments
U.S. Department of Labor Proposed Rule Related to ESG Factors in the Selection of Plan Investments
Institutional investors and asset managers are calling for enhancements in the
quality and comparability of ESG disclosures, and regulators in leading markets
around the world are moving forward with requirements under which investment
fiduciaries must consider ESG factors. Meanwhile, the U.S. Department of Labor’s
Employee Benefits Security Administration issued a proposed rule on June 30, 2020, that would steer policy in
the opposite direction by changing the “investment duties” regulation under
Title I of the Employee Retirement Income Security Act of 1974 (ERISA), as
amended, to confirm that ERISA requires plan fiduciaries to select investments
and investment courses of action solely on the basis of financial considerations
relevant to the risk-adjusted economic value of a particular investment or
investment course of action. This action would represent a dramatic shift in the
momentum across the globe and to current practices that asset managers and
financial advisers use to integrate ESG considerations into their investment
processes and selections.
There were 8,737 responses to the proposed rule during the
30-day comment period, and more than 95 percent of those comments opposed it. Some of the more common points raised included
concerns that the proposed rule ignores the material financial impacts of ESG
issues and is based on a flawed and unsupported assumption that ESG funds give
up financial returns in favor of “nonpecuniary” rewards.
Other Market Developments
Other developments are demonstrating the clear and compelling call to action by
the marketplace for companies to disclose certain ESG information in mainstream
financial filings as well as strong support for standardization and enhancement
of the quality of ESG disclosures, including strengthened requirements related
to assurance over that information. Some of these developments are summarized
below:
- On August 26, 2020, the SEC issued a final rule that modernizes certain disclosure requirements in Regulation S-K.2 Two SEC commissioners, Caroline Crenshaw and Allison Herren Lee, dissented to the decision and expressed concern that the final rule does not go far enough to adequately address climate change risk, human capital, and diversity. Commissioner Lee stated, “It’s time for the SEC to lead a discussion — to bring all interested parties to the table and begin to work through how to get investors the standardized, consistent, reliable, and comparable ESG disclosures they need to protect their investments and allocate capital toward a sustainable economy.”
- Other SEC activity:
- The SEC’s Investor Advisory Committee published a report encouraging the SEC to develop a framework for ESG reporting in SEC filings.
- The SEC’s ESG Subcommittee provided a report in May 2020 and an updated report in September 2020 to the SEC Asset Management Advisory Committee highlighting the need for certain ESG-related disclosures by asset managers including disclosure and independent validation of the degree of ESG compliance.3 The report also noted that the ESG subcommittee is studying possible enhancements to issuer disclosures.
- The International Business Council (IBC) of the World Economic Forum (WEF) published a report that includes a set of core ESG metrics designed to enable companies to measure and report on sustainable value creation. Facilitated by the Big Four accounting firms, the publication helps advance the momentum toward global ESG standards by establishing a coherent and comprehensive corporate reporting system. The WEF-IBC report includes references to the separate WEF, Impact Management Project, and Deloitte’s facilitated efforts to align global standards and frameworks, which culminated in the issuance of a joint statement by the five major ESG standard-setting institutions of a shared vision of what is needed for progress toward comprehensive corporate reporting and their intent to work together to achieve it. At the same time, the International Federation of Accountants launched its consultation for the IFRS Foundation to create an authoritative nonfinancial standard setter.
- The Commodity Futures Trading Commission, an independent U.S. federal agency, issued a report calling for regulators to actively promote, and in some cases require, better understanding, quantification, disclosure, and management of climate-related risks.
- The Financial Accounting Foundation sent a survey asking the public about what the group’s future priorities should be, including whether it should explore nonfinancial accounting standards such as those related to ESG issues.
- Large investors, including CalPERS (the largest U.S. public pension fund), are calling for mandatory reporting by companies and auditors on climate risk.
- Asset managers continue to focus on ESG within investment decisions. BlackRock published a special report highlighting its increased engagement on ESG and actions taken against companies deemed to be making insufficient progress. State Street issued a letter to board chairs requesting that companies provide enhanced disclosure about diversity, specifically racial and ethnic diversity, including communication related to strategy, goals, metrics, the board, and board oversight.
- The European Commission’s upcoming revisions to the European Union Non-Financial Reporting Directive, which, on the basis of consultation responses received, could expand the scope of the directive to more companies and could require companies to provide additional disclosures of (and assurance over) ESG matters in annual reports.
As these actions indicate, ESG disclosures are critical to institutional
investment decision makers and other capital market participants. The section
below explores how the quality of ESG disclosures can be improved and how
assurance over ESG information is an effective means of enhancing such quality
and trust.
Improving the Quality of ESG Disclosures
The manner in which investors are analyzing a company’s ESG disclosures is similar to
how they assess financial information because performance on ESG
metrics can affect financial performance. Evaluating ESG
information at the onset of a potential investment can help investors better
determine and understand the investees’ governance and short- and long-term
strategies related to addressing material risks and opportunities. Once an
investment is made, investors use ESG information to monitor performance, much in
the same way they use financial information. However, the critical element of the
financial reporting process that is still largely missing and needs to be
institutionalized in ESG reporting is external assurance.
Sustainability Assurance as a Tool to Enhance ESG Disclosure Governance and Quality Reporting
Improving the quality and consistency of ESG disclosures will enhance
transparency, which will enable and enhance investing decisions and potentially
reward more sustainable businesses and strategies by unlocking capital. Using a
recognized standard for disclosure of ESG information and obtaining
sustainability assurance are key steps toward improving the quality and
consistency of ESG reporting. The AICPA and the Global Reporting Initiative
(GRI) published FAQs in response to an increasing number of inquiries
related to sustainability assurance. The FAQs explain that assurance on ESG
information is designed to enhance the degree of confidence of decision makers
that use that information. The FAQs also address why organizations choose to
have their sustainability information assured. For example:
[O]rganizations determine that the reporting of sustainability
information may not be enough, and decision-makers desire further
confidence in its reliability. Assurance can increase the confidence of
decision-makers in the accuracy and reliability of the reported
information.
It can also support organizations in:
- signaling to their stakeholders the importance the organization places on sustainability reporting,
- strengthening internal controls and reporting systems relating to sustainability reporting,
- raising awareness of the importance of sustainability information at Board and C-suite level, and
- driving better decision-making based on higher quality sustainability information.
Furthermore, the Sustainability Accounting Standards Board’s (SASB’s)
Implementation Primer (“a reference document for companies
that have chosen to integrate SASB standards into their core communications with
investors”) indicates that assurance is a signal that the information is
reliable. The Implementation Primer also illustrates how external assurance
provides internal benefits for companies, including enhancing a company’s rigor
and internal quality control processes that pertain to measuring and disclosing
ESG information.
Practical Considerations for the Board and Management Related to Integrating ESG Into the Business and Preparing High-Quality ESG Disclosures
The ESG integration maturity model below shows the stages of ESG maturity and
describes common attributes associated with those stages.
As companies navigate societal and environmental trends and changing stakeholder
expectations, they need to establish a systematic approach to sensing rapidly
changing disruptors that affect external reporting. Actions management can take
now in connection with providing ESG information that is more standardized and
reliable are illustrated in the graphic below.
Conclusion
Growth in public and investor demands for ESG accountability is compelling companies
to pay closer attention to expectations and enhancements related to sustainability
disclosures. Developing a robust governance structure, integrating internal audit
and the board of directors into such structure, and obtaining external assurance
(i.e., the three lines of defense) can enhance public trust and improve a company’s
ability to meet investors’ and other stakeholders’ expectations related to the
disclosure of accurate and reliable information. It may also reduce risks related to
misleading or omitted disclosures. Implementing the three lines of defense will
promote high-quality, relevant, and meaningful nonfinancial disclosures, enhance
investors’ reliance on reported information, permit better analysis of such
information, and promote ESG investing.
Footnotes
1
ESG Matters (Harvard Law School
Forum on Corporate Governance).
3
See also Drumbeat Grows Louder for SEC to Take Action on ESG
Disclosures (Latham & Watkins
LLP).