What is ESG?
The acronym ESG (Environmental, Social, Governance) emerged during the early 2000s but the ideology originated much earlier.
In recent years, interest in the environmental part of the acronym has grown rapidly as a result of the increasingly tangible effects of climate change.
The social aspect of ESG, too, which concerns a company’s interaction with its employees and the surrounding community, has gained more visibility since the pandemic. For instance the increasing human rights legislation around the globe is creating regulatory risk in supply chain management for companies.
While this aspect can have a significant material impact on a company’s performance, it is much more challenging to measure because there is no single approach to measuring social risk.
Although ESG metrics have been an integral component of risk analysis for decades, increasingly vocal social and environmental activism, magnified by social media, has helped hype ESG reporting for companies, particularly over the past year.
The initiating factors are usually regulations or pressure from investors or other stakeholders.
As a result, ESG or sustainability reporting, also referred to as non-financial reporting, is becoming a common practice for most large companies across the world, and new regulations will soon extend that obligation to small, medium and large listed companies.
Meeting the reporting obligation yields a number of positives to companies, such as:
- improved identification and management of ESG risk ,
- a stronger foundation on which to base long-term strategy and objectives,
- more efficient organization of internal management structures,
- greater quantities of analyzed data,
- improved reputation.
The greater awareness of ESG’s importance to a company’s wellbeing and to the wellbeing of the planet means that many companies are recognizing the need to appoint a senior leader to oversee the area.
Corporate sustainability (ESG) reporting
ESG reporting, also referred to as ESG disclosure or sustainability reporting, communicates a company’s ESG undertakings to the public. Such public disclosure therefore helps hold companies accountable for their ESG strategies and performance.
While ESG reporting thus far has been voluntary, new rules and regulations are being introduced around the world to change that. In the USA, the Security and Exchange Commission (SEC) has proposed new rules requiring periodic reporting on climate-related risks and greenhouse gas emissions for listed companies that have significant consequences.
In the EU, rules now require large companies and listed companies to publish regular reports on the social and environmental risks they face, and on how their activities impact people and the environment.
Such new regulatory requirements almost certainly mean a change in how companies file reports and will involve investing in teams and systems to enable these changes and comply with the requirements.
Reliable ESG information starts with solid reporting by company management. Some ESG issues could have a direct impact on your balance sheet. For instance, environmental contamination could lead to reputational damage that reduces sales and would affect remuneration costs.
In applying financial accounting standards, you should consider the ESG impacts in the same way that you consider other changes in your business that have or could have a direct or indirect effect on your company’s financial results.
Inevitably, some industries are likely to be more affected than others by ESG issues, based on the accounting standards being applied.
ESG accounting: financial implications for CFOs
The changes to ESG reporting standards underway may mean extra hours on the job for the IT department, and increased tech spend on software and systems to enable your company to comply with the new regulations.
IT professionals will be needed to handle the data collection and analysis as ESG requirements are added to existing financial reporting. You will also need software tools to measure and compare all of this information, which will be particularly challenging for companies who still aren’t doing any of this.
Some of the new challenges you will face as CFO regarding ESG reporting include:
- the lack of universal standards for reporting,
- limited or poor data quality,
- the risk of producing sustainability data without any real relevance for business decisions
- the need to promote ethical behaviour through employee training to ensure long-term business success
- aligning financial decisions with long-term goals,
- identifying areas where investments can drive efficiency and innovation
- collaborating with other departments to develop strategies that promote transparency, accountability, and integrity.
At a more practical level, it also means a substantial change in working methods, targets, and internal and external reporting. For instance, information systems will have to be adapted to include many new numbers such as, but not limited to, the usual metrics such as CO2 emissions, or the type of packaging material used, to other more complex issues, such as your suppliers sourcing raw materials in countries with scant respect for the environment or for workers.
It behoves you as CFO to know what information is available and to extend your dashboard with ESG parameters. You will also need to ensure that people throughout the organization meet targets regarding climate impact and social factors.
The drive towards universal ESG standards
A uniform set of standards for measurement and reporting on ESG is necessary.
While there is a plethora of frameworks, processes and related acronyms, and service providers in the arena of sustainability reporting, a forerunner has emerged that promises to offer a single model for ESG reporting: the International Sustainability Standards Board (ISSB).
It is hoped that the ISSB will do for sustainability reporting what the International Accounting Standards Board (IASB) is doing for financial reporting — develop a common set of standards for companies to report their performance to investors. Both will fall under the IFRS (International Financial Reporting Standards) Foundation.
The ISSB was founded in 2022 when the Sustainable Accounting Standards Board (SASB) merged into the International Financial Reporting Standards Foundation (IFRS). The IFRS is one of the industry’s two major global accounting standards, the other, mainly used in the USA, is GAAP (Generally Accepted Accounting Principles).
The Sustainable Accounting Standards Board is particularly relevant for CFOs because it focuses on the data that is most relevant in determining the value of a company. It covers over 70 industry sectors incorporating industry-specific standards and metrics that reflect the issues most relevant to the financial health of companies in that sector.
Corporate Sustainability Reporting Directive (CSRD)
In April 2021, the European Commission adopted a proposal to amend the reporting requirements of the Non-Financial Reporting Directive (NFRD).
- The new Corporate Sustainability Reporting Directive (CSRD) will:
increase the number of organizations obliged to provide ESG reporting beyond just the largest companies - require external auditing of ESG reports
- implement mandatory standards with more detailed reporting requirements
The Corporate Sustainability Reporting Directive (CSRD) forms part of the European Green Deal and updates the provisions of the existing Non-Financial Reporting Directive (NFRD) which only applied to large EU-listed companies, banks and insurance companies.
When will the CSRD come into effect?
The CSRD will be applied in four stages and will affect:
- 2025 reports (on the previous financial year) for those companies already subject to the NFRD;
- 2026 reports for other large companies;
- 2027 reports for listed SMEs,
- 2029 reports for non-EU organizations that have a net turnover above €150 million in the EU or if they have at least one subsidiary or branch in the EU exceeding certain thresholds.
European Financial Reporting Advisory Group (EFRAG)
The European Financial Reporting Advisory Group (EFRAG) was jointly established by the EU and the private sector in 2001 to provide technical advice to the European Commission on accounting issues.
Its mission is to promote the European point of view on sustainability issues. It also recommends technical standards to the European Commission that can then be transposed into law through a ‘delegated act’ becoming directly applicable in all EU member states.
EFRAG has approved the European Sustainability Reporting Standards (ESRS) and has also been mandated to provide input into the development of the International Financial Reporting Standards Foundation’s sustainability standards.
EFRAG has drawn up comprehensive reporting rules covering all aspects of ESG that will be mandatory for large European companies with effect from the 2024 financial year.
This means that many companies will have to comply with the EU rules ahead of the global rules that are being drawn up by the International Sustainability Standards Board, which will cover far fewer topics.
On April 29, 2022, EFRAG released initial drafts of the European Sustainability Reporting Standards (ESRS) which outlined 13 ESG issues categorized into four areas as follows:
Cross-cutting:
- General principles;
- General, strategy, governance, and materiality assessment.
Environment:
- Climate change;
- Pollution;
- Water and marine resources;
- Biodiversity;
- Resource use and circular economy.
Social:
- Own workforce;
- Workers in the value chain;
- Affected communities;
- Consumers and end-users.
Governance:
- Governance, risk management, and internal control;
- Business conduct.
The future of ESG regulations
In response to this regulatory push on ESG reporting, organizations are increasingly evaluating their internal processes and assigning new specific roles.
For financial teams, this means that increasing collaboration will be required with other business areas in future because ESG information is the responsibility of different departments. Collaboration will facilitate the collection of data and clarify the reason for its collection.
Multinationals will have to produce their first ESG reports in 2024 and 2025. It is imperative to prepare in time by
- Making the right investments in both personnel and the best tools to collect and analyse the information
- Create the processes and identify the teams that will be responsible for collecting and analysing the information
- Begin assessing, modelling and forecasting the likely financial impacts of the different reporting areas so you can identify where you need new or better data.
- Train your teams and have them begin to gain practical experience in this data collection, analysis and reporting and identify where you need to do further training or modify your tools so that you can reduce the friction in the process before it becomes mandatory.
- Keep abreast of new regulatory developments and deadlines in this rapidly changing area.
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