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Rotman Insights Hub | University of Toronto - Rotman School of Management

A global standard for ESG reporting is coming. Is your company ready?

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Sandria Officer

Worldwide focus on climate change, continuing disruptions from the pandemic, social movements and demands for equity have forced companies from every corner of the globe to act on their environmental, social and governance (ESG) initiatives.

The ESG acronym refers to the non-financial plans made by companies to measure their ecological footprint, equity and social impact. It covers the following metrics:

• Environmental indicators such as greenhouse gas emissions, waste generation, water security and climate change risk strategy.

• Social indicators such as employee and supplier diversity, data protection and privacy, community socio-economic outcomes, pay equity, worker health, safety, and human rights.

• Governance indicators such as board independence and accountability; board oversight of executive performance and compensation; and board oversight of company strategy, risk management, performance and disclosure.

Over the past two decades, issues related to ESG have impacted corporations’ profitability and long-term financial viability, as evidenced by the increase in severe weather events, dangerous infrastructures, and troubled world economies. In addition, the 2008 financial subprime crisis shed light on the relevance of investor decisions and the centrality of their role, the progression in public awareness as it relates to social responsibility, and the significance of good governance practices.

As a result, the financial sector and many corporations in other industries have taken steps to amend their strategy to reflect sustainable long-term value creation rather than short-term profit. Stock market and investor activity support this trend with investment in ‘intangible assets’, often in sustainable new technologies. Intangibles are non-monetary assets that cannot be seen or measured but have risen in value compared to tangible assets like cash. A 2021 report from the Royal Bank of Canada (RBC) found intangible assets comprised the majority of enterprise value for most companies. Nearly 70 per cent of Canada’s S&P/TSX Composite’s market value derived from intangibles, compared to more than 90 per cent of the United States’ S&P 500’s value in 2020.

 The RBC report’s findings show Canada lags behind the U.S. on this measure, with intangible asset allocation remaining largely flat for the past decade. In addition, the report reveals that Canadian corporations need to invest more into research and technological development by building their intellectual property and by finding ways to retain it within a global economy increasingly focused on sustainable development.

The fact is, many investors now make their financial decisions only after they understand a companies’ pledge to ESG. They realize that companies with good ESG metrics tend to outpace competitors. A 2022 global survey by Capital Group found steady growth in the adoption of ESG by investors. In 2022, 26 per cent of investors said ESG was ‘central’ to their investment decisions. This number was down slightly from 28 per cent in 2021. Europe is ahead of other continents with investors who say ESG is ‘an integral factor’ in their investment decisions (93 per cent Europe vs. 79 per cent North America, 88 per cent Asia-Pacific).

A growing number of companies have responded by issuing yearly performance reports on ESG to avoid both environmental and corporate brand damage and negative impact on financial earnings. Recent worry over companies shifting their focus from ESG to the financial market crisis has largely subsided as environmentally responsible companies have demonstrated that they are less exposed to systematic risks. Overall, studies show that companies with high ESG ratings earn comparatively higher stock returns and experience lower volatility than low-sustainability focused companies. Sustainable ESG investing is forecast to exceed US$41 trillion in 2022 and US$50 trillion by 2025, which is 30 per cent of the projected total assets under global management, according to Bloomberg. While ESG disclosure reports consist of the three ESG metrics, it can be observed that focus is mainly on the environment and social metrics and not on governance. The lack of attention to governance metrics likely stems from the broad availability of governance information in other disclosure documents such as proxy statements and investors’ justified focus  on the environment.

The Role of ESG Rating Agencies

Increased calls by stakeholders for accurate information to assess corporate performance on ESG issues has set off a new industry of ESG rating agencies that provide companies with quantitative evaluations of their ESG data, ratings and rankings. And faced with the growth in regulations and standards in the past few years, these agencies have intensified their demands for more comparable and consistent ESG metrics from companies.

Currently, ESG reporting is done on a voluntary, unregulated basis because the data is mainly nonfinancial information that is external to established auditor and regulatory oversight. Under these conditions, corporate executives have had the opportunity to take part in ‘greenwashing’ by overstating their sustainability records. Fully aware that this may be happening, ESG rating agencies often disagree among themselves over the quality and credibility of ESG reports issued by corporations.

These disagreements do not serve investors or corporations, because they undermine the reliability of valuations and create capital market uncertainty. This disunity has prevented the formation of something that capital markets and investors alike sorely need: a global standard that embraces the interrelatedness of ESG  data.

In addition to greenwashing concerns, inconsistencies in ESG ratings stem from six reasons:

1. Theoretical differences. Raters may have different beliefs about the idea of what constitutes ‘social responsibility.’

2. Commensurability. There is a need for across-the-board consistency in the ratings that ESG raters give when they measure the same metric such as employee health and safety for multiple companies.

3. Differences in the ESG raters’ perceptions of what constitutes exceptional ESG performance.

4. Different ESG rater indicators (e.g., supplier performance and employee management) and different rater weights (e.g., equal, back-test, industry-specific) have been used, which can influence a companies’ financial performance outcomes.

5.  Discrepancies in ESG rater data imputation methods that are used to replace missing data with substitute values. When the data gaps involve a variety of companies and times for different ESG metrics, big disputes occur among ESG raters with different gap methods. For example, the demise of Lehman Brothers in 2008 marked the start of the global financial crisis and revealed the limitations of traditional measurement models on corporate performance and risk analysis. After 2008, the ESG rater agency industry began to consider ESG information as necessary in providing a better assessment of corporate performance and, in place of traditional measurement models, used a content analysis method. If ESG rating agencies compared different companies’ sustainability data in 2008 and 2009, different methods would have been used in each year, resulting in incomparable data, which would not have accurately reflected the issues being measured.

6. Benchmarking based on how corporate data providers define their ‘peer group,’ which can be key in determining their performance level.

The Dawn of Global Standards in Canada

Debate remains over the details of what standardized ESG disclosures might feature and include. The root of this challenge is that, given ESG’s broad scope, it affects every business in unique ways, and the particular issues companies face can differ vastly from within their industry, geographic location, culture, and life cycle, among other considerations. To reduce market confusion and compliance costs in ESG reporting, global and Canadian monitoring and regulatory bodies have intervened in an attempt to unify ESG disclosure standards around the world. In June 2022, the Independent Review Committee on Standard Setting (IRCSS) in Canada recommended the Canadian Sustainability Standards Board (CSSB) be set up and operational by April 2023 to manage ESG reporting amidst calls for better transparency and comparability of ESG data from companies. The CSSB arose alongside the global effort to standardize ESG reporting metrics, and as a result it works with the new International Sustainability Standards Board (ISSB).

The ISSB launched in June 2021 to develop a global baseline for sustainability disclosure standards, and to help consolidate the plethora of existing standards. When the global standard is finalized, the CSSB will review it before endorsing it to ensure that the global standard is suitable for the Canadian economy’s high number of resource-extraction companies and small- and medium-sized businesses.

As Canadian companies await the implementation of global standards, they cannot remain idle. Following are five recommended actions leaders can take in the meantime.

1. Expand your ESG disclosure strategy to address ESG materiality in your sector

Material ESG issues include the governance, environmental, or social issues that can impact the financial condition or operating performance of companies. Refer to the existing standards (e.g., SASB or GRI) for insight. For example, SASB will inform a company in the chemical industry (e.g. Dupont) that chemicals, water and labour practices are among the material topics that need to be managed.

Critical stakeholders such as employees, investors, local community members, regulators and the public should be consulted for their insights to identify business priorities that leaders may overlook. The company assessment and stakeholder assessment can then be combined to prioritize topics that are important to both — which can lead to a corporate competitive advantage.

Companies that have built sustainable operating procedures into their practices have already established a competitive advantage.

2.  Implement a strategic PESTLE & SWOT analysis through an ESG outlook

Conduct a sustainability-based PESTLE (Political, Economic, Social, Technical, Legal and Environmental) and SWOT (Strengths, Weaknesses, Opportunities, Threats) assessment. The PESTLE analysis helps to uncover ESG trends linked to material issues. For example, a question to consider might be: What type of political regimes in supplier regions might affect supply volatility, ethical challenges or our corporate reputation?

The SWOT analysis helps companies assess their current position in managing the material ESG issues that the PESTLE analysis identified, directing them to matters that need attention. For example, if an oil and gas company wants to assess its rank, the SWOT analysis will identify competitors who use micro refineries to remediate and transform waste oil into usable diesel fuel as well as the stragglers who do not remediate, among other issues.

3. Use key performance indicators (KPIs)

Companies should be using KPIs to guide them in the right direction and also to divert their attention when needed. For example, when ‘product availability’ is a top challenge in the retail and consumer sector, KPIs can be used to assess the risks in the supply chain and potential solutions.

4. Develop an ESG governance structure

Companies can create an ESG committee that is cross-divisional and focused on ESG best practices with access to the most recent news, technologies and tools. The ESG committee should work with other board committees (e.g. audit), human resources and executive leadership across corporate divisions to build a sustainability culture, which research has shown improves employee recruitment, retention and productivity.

5. Track the return on sustainability investment (ROSI)

Companies that use the Return on Sustainability Investment (ROSI) methodology link their sustainability strategies and financial performance to create stronger business cases for current and future sustainability initiatives.

The move towards a global baseline standard for ESG disclosures has accelerated in recent times, but companies that have built and implemented strategic, sustainable operating procedures into their practices based on ESG standards have established a competitive advantage in the global marketplace. Oversight from their boards of directors will ensure that their ESG performance measures remain on track — and profitable — over the long term.

This article originally appeared in the Spring 2023 issue of Rotman Management magazine. Published in January, May and September, each issue features thought-provoking insights and problem-solving tools from leading global researchers and management practitioners. Subscribe today.

Sandria Officer is a research officer at the David & Sharon Johnston Centre for Corporate Governance Innovation at the Rotman School of Management.