ESG, sustainability initiatives, and financial reporting

Acknowledging the growing prominence of ESG as a lens through which investment decisions are determined, in March 2022, the SEC proposed new climate-related disclosure rules. With this move, the SEC began to formalize its position that sustainability information is a critical input that affects investor decisions. That is a massive shift in perspective that might change the landscape of ESG sustainability reporting.

ESG reporting must be consistent, timely, data-driven, and audited. In recent years, the SEC has taken enforcement actions against specific companies based on alleged false claims or false reporting about ESG-related issues, and in March 2021, the SEC launched a specific Climate and ESG Task Force to proactively identify ESG-related misconduct.

Growing investor interest and emerging sustainability reporting standards mean it is not enough for companies to say they have great environmental protection or human resources (HR) programs in place. Investors expect to see much more concrete information backed by verifiable and comparable data as they consider how to direct funds.

Previously, any information on sustainability initiatives in financial disclosure documents would largely be qualitative in nature and only appear in the management discussion section of corporate filings. The SEC’s new rule could require the companies to establish an entirely new section within their disclosure document dedicated to climate risk. The guidelines for this section are prescriptive and data-driven, so companies will need to invest significant effort in taking ESG out of its silo, assembling a team to pull this information together, and locating and collecting data that can be used in formal reporting.

The amount of lender and investor capital that is tied to ESG metrics continues to grow. Large private equity groups have been vocal about using certain ESG metrics – everything from diversity in the C-suite to greenhouse gas emissions – as investment criteria.

Risk mitigation is a critical concern. Companies with strong ESG-related programs in place signal to investors that they will be sensitive to the types of risks that could affect the business. Emerging ESG risks that need to be mitigated include climate risk, HR policies, governance and board oversight, board structure and diversity, and executive compensation, among many others.

There are also many opportunities in ESG, and investors want to see that companies are capitalizing on them. A stronger ESG commitment, backed by measurable performance, can yield several benefits, including reduced energy and water consumption, improved insurance rates, and even enhanced hiring and retention of personnel, to name a few.

ESG can have a direct, positive impact on cash flow through top-line productivity growth, cost reductions, and operational improvement. Research suggests that better performance on the ESG front correlates to higher equity returns and improved credit ratings. “Green” lending can also present new opportunities, lowering the cost of capital when borrowers can show a financial commitment to ESG metrics.

One change that will be important for companies to make is to keep sustainability initiatives and their outcomes top of mind throughout the year – not just in the lead-up to reporting deadlines. In addition, voluntary sustainability reporting has historically been about creating a selective narrative to share positive stories, but as it is brought under financial reporting, companies will be required to tell the whole story. In reporting comprehensively about ESG issues, companies are likely to find that some parts of the story are positive while also identifying opportunities for improvement. Where there are challenges, companies will need to articulate measurable plans for how they will improve.

By assembling a team that represents a cross section of disciplines, companies can benefit from in-house guidance on SEC regulations, financial reporting, risk and compliance, HR, legal, operations, information technology, information security, and other areas to think proactively about what regulators are requiring and what investors are demanding. A cross-functional team is important as it might take more than one person to see the full picture, and each perspective can help identify where the company has had success and where more work is needed. Evaluating ESG risks and mitigating factors by a cross-functional team can also expedite the launch of a new product or service and help predict its impact on ESG-related financial reporting.

If a company has great HR benefits, for example, that story should be told, as it demonstrates leadership and could help the company attract and retain talent. Alternatively, if a company has technology or processes that are reducing its carbon emissions, the team should consider what data is available to show the progress that has been made and tell that story.

Indeed, establishing a new regime for sustainability reporting will require the identification of additional data streams to collect and track. To establish a company’s carbon footprint, for instance, leaders might look to existing data on utility expenditures. But to assess climate risk and track trends over time, that data will need to be converted to reflect emissions. Some of the data might also lie outside of the organizational boundaries and might be available from national or international organizations.

Companies must take the rigor of financial reporting and apply it to these new data streams, looking at where the data is coming from, who is validating it, and assessing whether it can be tested for completeness. Underscoring the need for cross-functional teams, data will likely be housed in different systems within different departments, so involving specialists across the company is essential.

Many organizations are subject to risks due to climate change and greenhouse gas emissions, and they also must grapple with risks related to diversity, equity, and inclusion (DE&I). Other issues that investors are paying greater attention to include energy efficiency, water security, board diversity and governance, and executive compensation.

Beyond those, hundreds of additional unique risks exist that companies in different industries face. The Sustainability Accounting Standards Board has created standards that establish metrics by industry and subindustry, and companies can download information that breaks down the most important topics, along with key performance indicators. Companies that are getting started with the process of sustainability reporting can use these standards to understand what topics are of interest to investors. Insights gained through materiality assessment exercises can guide the strategy and communication development within and external to the company.

Investors have a growing interest in pursuing opportunities that are positive for the environment, sustainable, resilient to ESG risks, and that incorporate principles of DE&I. Accordingly, they increasingly expect to see much more from companies about how they are handling climate risk, what they are doing to support greater DE&I, and what approach they are taking on executive compensation and board oversight. Performance related to ESG topics will continue to be a point of comparison as investors evaluate companies for investment opportunities.

Final climate-related disclosure guidance is still forthcoming, but companies that prepare today can be better prepared when the rule is in force. By reporting sustainability information that is timely, measurable, consistent, and verified, companies can compete more effectively in the global market.