In an earlier post, we discussed some typical difficulties in ESG reporting for large complex corporate entities:
- Identifying metrics
- Collecting and consolidating information
- Data quality and accuracy
- Resource adequacy
In this next post in our series, we will delve a little deeper into addressing the difficulties. Let us begin with identifying metrics ESG performance metrics.
The ESG in ESG reporting stands for environmental, social, and governance. The terminology has widespread popular usage, but the meaning remains open to interpretation as businesses, governments, standard setters, and the public have different ideas of what the concepts represent. ESG reporting involves metrics that are not necessarily commonly used, nor widely understood (for example – the weight of end-of-life materials recycled); – unlike financial reporting metrics such as revenue, or net income.
Factors to Consider When Identifying ESG Performance Metrics
- Regulatory environment
- Other stakeholders (employees, suppliers, customers, governments)
- Materiality (or double materiality)
Let’s dig in.
The first consideration for organizational reporting is the regulatory environment. In various parts of the world, there are regulations that exist, are proposed, or are being considered, that will establish the rules for reporting ESG matters under specific frameworks. As a result, an organization needs to make a careful assessment as to what regulations apply.
There is the obvious consideration as to where its securities are traded. But there can also be national and transnational regulations, which cover organizations who carry out business activity – for example when a US-based company has its securities traded in NY but also carries out activities in Europe. Some of the more prominent frameworks, and their regulatory applicability:
- Corporate Sustainability Reporting Directive: regulation that covers EU companies; non-EU companies that have certain thresholds of business in the EU; and companies with securities listed on an EU-regulated market. The standards to be followed will be European Sustainability Reporting Standards (ESRS).
- US Securities and Exchange Commission: regulations that have been proposed but not yet finalized and in force – for companies with US-listed securities. It is widely expected that regulations will be released soon.
- Task Force on Climate-Related Financial Disclosures: began as a voluntary set of recommendations for organizations to communicate their climate-related risk, and is beginning to be adopted by some national regulators, including the UK and Canada.
- Global Reporting Initiative (GRI): a voluntary set of standards, focused on creating a common global language for organizations to report their impact. They report that the standards are used by more than 10,000 organizations in more than 100 countries.
- International Sustainability Standards Board (ISSB): established by the IFRS Foundation to form a global baseline of sustainability reporting. International Financial Reporting Standards are widely adopted as the reporting framework by regulators around the world, and therefore it seems likely that the sustainability standards when released will be widely adopted.
A clear understanding of the regulatory environment will go a long way to determining the framework(s) to follow, and therefore the probable metrics. Depending on the organization there may be more than one framework that needs to be followed.
How Debt & Equity Investors Use ESG-related Information
Debt and equity investors are significant users of ESG-related information, which they use to inform their investment decision-making. Some of the information may be used in assessing risk, or in determining alignment with their investment strategies. For example, with the requisite ESG information at hand, a company can ensure the funds they invest align with their carbon reduction strategies or strategies that may avoid investments in oil and gas production.
Engagement with investors is useful for management to understand the investor’s interests and priorities. Many of the investor’s information needs may be addressed by following the regulatory reporting framework. However, in the ESG sphere, we see that the investor community tends to be leading the way in having organizations improve their ESG reporting. Regulators are far behind (for example, the SEC has not issued definitive guidance).
ESG for Diverse Stakeholders
Other stakeholders, can be a diverse group with varying interests in transparency and disclosure of ESG matters. Employees have an interest in diversity information. Environmentalists are also stakeholders who want information about pollution or water, as referenced previously. Additionally, customers are stakeholders who wish to know more about a supply chain’s characteristics. Finally, governments are stakeholders who want to identify economic impacts by region.
Engagement with a wide variety of stakeholders will inform the organization about matters which should be considered for measuring and reporting as ESG metrics.
How Industry Norms and Business Models Dictate Metric Types
Industry norms and business models will further inform the types of metrics to be considered. An organization should consider other businesses in similar industries and the types of information that are communicated. In addition, the nature of the industry will help define many of the metrics that organizations are expected to report. Some standards, such as SASB, which is now a part of the IFRS Foundation, have industry-specific standards for 77 industries. These standards are designed to enable comparability to enterprises in similar industries.
Materiality (and Double Materiality)
Materiality has long been an essential principle in financial reporting. In general, something is material to a user if it is likely to influence decision-making. Materiality should be considered from both a quantitative and qualitative perspective.
An organization begins by understanding any regulatory requirements for ESG reporting, along with the informational expectations from investors, other stakeholders, and industry norms. These considerations are then assessed through a materiality lens – to assess whether they are material to the organization, and potentially to the users. For ESG, materiality can be considered as matters that are significant for the organization, and which could lead to significant consequences for the organization.
Materiality in ESG will be defined in the frameworks. Generally, materiality will follow a similar principle as in financial reporting – it is material if it is likely to influence decision-making. In some of the standards, materiality for ESG information can be more expansive than traditional financial drivers.
There are two main directions that are emerging: materiality and double materiality.
Materiality typically refers to financial materiality; qualitative and quantitative assessments focused on the likelihood and scale of potential financial impact. Benchmarks are often used as reference points for quantitative assessment. For example, if the potential impact of an item is less than 5% of the net profit, it might be considered not material. Qualitative assessments involve far more judgment, usually involving a solid understanding of the expectations of the user groups. An item can be quantitatively not material, yet qualitatively material, for example, work-related fatalities.
Double materiality combines financial materiality, with the impact of the organization. The impact can refer to the environment, society, and workforce. It may also encompass impacts on the organization to external events such as changes in climate, legislation, and trends in society. The impact is far broader than financial materiality and leads to far more information being disclosed.
Materiality and double materiality assessments require substantial knowledge and experience. In this regard, expert input is invaluable to support an organization in assessing materiality, and the impact that has on applying materiality to the selection of reporting metrics.
How to Start the “Which Metrics Matter” Conversation
The most important step is to get the conversation started. Here are some things to consider:
- Have a clear understanding of the regulatory reporting environment, and any resulting reporting framework – legal.
- Read the reports of your competitors, or other businesses in similar industries
- Talk to your investor base – investor relations teams will have input
- Engage in a healthy debate with leaders in the business – HR, supply chain, procurement, and operations, all of whom will have valuable input.
- Make a list of what might be included, and why.
There is a lot of judgment and knowledge needed to come to a good answer, so reach out to those in and out of the organization who can support you.
Get started with identifying ESG metrics today
The ESG journey is only just beginning and most organizations are in the earliest stages of their journey. Organizations are being pushed by investors and other stakeholders, with regulators trying to catch up. The best time to get started was yesterday. The second-best time is today. When you are looking for an ESG reporting solution, consider r4apps’ ESG solution and get in touch today.