Robert Kugel's Analyst Perspectives

The emphasis on environmental, social and governance (ESG) issues has been growing for some time. I participated in the development of the Sustainability Accounting Standards Board (SASB) as a software industry expert more than a decade ago. The rise of ESG’s profile in corporate reporting is the latest evolution of “responsible investing,” a topic that goes back centuries in the west. The modern era of responsible investing took form in the United States beginning in the 1960s and then elsewhere in the west as part of the social upheaval of the day. The efficacy of such investment has been hotly debated since then, both academically and politically. Regardless of how one feels about the pros and cons of these laws and regulations, organizations required to report on ESG topics must find a way to pragmatically address the issue of how to achieve compliance with laws and regulations. My focus here is on environmental reporting because this is the most complex and more difficult to manage. The move to codify environmental impact reporting by organizations gained ground because organizations were making public assertions about objectives and achievements that were difficult or impossible for outsiders to verify. The demand for environmental reporting has its roots in the notion that reporting based solely on financial transactions omits important costs to society rooted in the notion of externalities. This, in turn, is based on concepts related to “the tragedy of the commons”; that is, people and organizations can be counted on to economize and be faithful stewards of their personal assets but cannot be trusted to treat common property the same way. They will privatize their personal gains in the form of their fatter livestock but socialize the costs imposed on society in the form of overgrazed commons. When human populations were small, the impact of individual behavior on the broader environment was localized and could be controlled and mitigated locally. Today we live in the Anthropocene — the age of humans — and the collective impact on common resources from individual actions can be greater and more widespread than ever. And because of this, the demand for reliable accountability for these externalities has grown to the point where it has become part of the legal and regulatory framework in many countries. ESG issues have been closely aligned with investing, especially what is termed socially responsible investing. Doing well by doing good has its immediate roots in the 19th century, when the Methodists adopted a policy of not investing in companies that produce alcohol or tobacco. The recent development of standards for assessing environmental stewardship is an attempt to provide rigorous and objective benchmarks for measuring environmental impacts that coexist alongside market-based, monetary accounting frameworks. The point being that consumption of common resources such as the atmosphere, oceans and water is not explicitly accounted for in traditional accounting and investment performance measures and therefore requires a trusted method of making those assessments to guide investors. It’s also worth noting that, historically, those advocating ethical and socially responsible investing will claim that this approach provides better returns than those that do not take such measures into account, but decades of peer-reviewed research have consistently shown this is not the case, most recently in the Financial Analysts Journal. ESG reporting generally, and environmental reporting specifically, is a worldwide phenomenon. It exists or is pending in major economies such as the United States, the European Union and United Kingdom, as well as New Zealand, Singapore, Malaysia and Hong Kong. Some jurisdictions make this reporting mandatory while others are “comply-or-explain” regimes. The latter means either complying with regulations or providing considered and detailed reasons for not complying. In the past, these reporting requirements were not especially rigorous in terms of scope and specificity. Increasingly, though, the trend, especially with respect to environmental reporting, has been to quantify specific impacts so as to make them auditable. These mandates have the biggest impact on publicly traded companies but can also affect private corporations and other entities. Adding to the complexity of ESG reporting are the multiple frameworks that organizations can apply in creating disclosures. Some of the most widely used ESG reporting frameworks include: Global Reporting Initiative (GRI), one of the most widely adopted globally, which contains a comprehensive set of guidelines for reporting on a wide range of sustainability topics. Task Force on Climate-related Financial Disclosures (TCFD) which provides guidelines for disclosing climate-related financial information. It is particularly relevant for companies looking to report on climate risks and opportunities. International Sustainability Standards Board (ISSB): Seeking a single comprehensive approach, the International Accounting Standards Board (IASB) is consolidating the work of several investor-focused reporting initiatives, including: the industry-specific SASB standards for financial reporting, the Task Force on Climate-related Financial Disclosures (TCFD) and the Climate Disclosure Standards Board (CDSB) Framework. Carbon Disclosure Project (CDP) which collects and reports on environmental data, including carbon emissions, water usage, and deforestation. Organizations face multiple challenges with respect to ESG reporting, some of which are similar to those posed by all forms of regulatory reporting. There are three main differences between ESG and financial reporting: Accounting practices and standards have evolved over centuries, but the regulatory requirements are not well-established and are likely to evolve rapidly in coming years. Moreover, the structure of double-entry bookkeeping means data is recorded entirely in numerical terms thus simplifying calculations and auditing, and testing the validity of presentations in the context of those accounting standards. This is far more difficult for ESG if only because comparability and unit measurement are more complex. The data necessary for producing ESG metrics must be taken from a wide range of systems and sources, and these are likely to grow more complex as regulations evolve. As noted, there are multiple frameworks and approaches to analyzing and summarizing the data used in ESG reporting, depending on the regulatory authority or the information that the organization wants to convey. As is the case with financial reporting, organizations must be able to manage the complex processes associated with gathering data, employing frameworks and creating narratives as well as editing, reviewing and approving final reports. Reporting may involve dozens of individuals across multiple locations, with a specific structure and format required for each jurisdiction’s regulatory report. The process is ongoing, so the ability to automate repetitive tasks and reduce or eliminate the need for consistency checks is essential. Accuracy and auditability must be assured, which means that data used for all reporting must be traceable to an authoritative source, and data transformations must be highly controlled. The discussion about ESG reporting is now focused on high-level issues such as what data to gather, how to use it in reporting, and how to manage the disclosure process properly. While collecting ESG data is best done at the business unit level, responsibility for managing the data gathering and consolidation from these business units and performing the analysis is best done by a financial planning and analysis, or FP&A, group because it is uniquely qualified for this role and because of its existing role in managing external financial reporting. Ventana Research asserts that by 2026, more than one-half of corporations required to comply with ESG reporting will centralize responsibility with the FP&A group to achieve accuracy control and efficiency objectives. With most of the attention focused on what’s to be reported, very little attention has been paid to how ESG issues will be managed internally in the context of these external reporting mandates. That will quickly become an important issue because once company-wide objectives and measurements are in place, it will be necessary to devolve responsibility for meeting ESG-related targets down to the business unit level and even to individuals. Getting from current conditions to a future objective means assigning measurable goals and assessing performance in achieving them. This is another reason why the core responsibility for ESG analysis, planning and reporting will rest with the FP&A group in the finance department because it will be part of the planning process. Devolving enterprise ESG objectives also adds a further level of complexity to data acquisition, analysis and reporting: Management issues such as assigning targets, allocating indirect and company-wide ESG metrics, and measuring attainment will be challenging, especially when careers and compensation are at stake. How targets are set and measured internally must be transparent, those responsible for achieving targets must be able to control the forces that produce results, and the data used in the process must be credible. Moreover, ESG targets will only augment existing financial, customer and employee goals set by company executives and therefore will involve explicit trade-offs to achieve a reasonably balanced set of objectives. ESG compliance and reporting are complex topics confronting senior executives, especially with regard to the degree of uncertainty around pending legal and regulatory requirements as well as related internal objectives, methods and frameworks for assessing these non-financial elements of a company’s performance. FP&A groups need a strategy to enable their company to meet ESG reporting needs, especially in managing the process of devolving objectives across the organization. Technology is the key to achieving efficient compliance with ESG mandates. Regards, Robert Kugel

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