Building ESG credentials through better ESG reporting – a look at global trends in mandatory ESG reporting

Typically using a scale of 1 to 100 or a rating between AAA to CCC or D, the purpose of ESG ratings is to rank businesses by their performance in environmental, social and governance matters. Businesses with higher ESG scores are generally looked upon favourably by ESG investors as presenting a more sustainable proposition, with lower investment risk and distinct financial benefits. Indeed, according to McKinsey and Company, a strong ESG proposition links to cash flow in five keyways: 1) facilitates top-line growth; 2) reduces costs; 3) minimises regulatory and legal invention; 4) increases employee productivity; and 5) optimises investment and capital expenditure.¹

Shortcomings of the current ESG rating system

The OECD and others however are beginning to question the utility of ESG ratings for investors due to deficiencies in the methodology of their calculation as well as the quantity, consistency and quality of the data on which they are based.

On methodology, ESG ratings agencies have been criticised for acting fundamentally at odds with the objectives of sustainable investing (or socially responsible investing), by basing their ratings on traditional financial measures of whether a particular ESG issue impacts the profitability of a business, rather than measuring the positive (or negative) impact of that business on society and environment.²

On the underlying data, the issue boils down to the fact that in most countries, ESG disclosure is, by and large, not regulated. Most organisations can choose whether to report on its activities against an ESG reporting framework, and if so, which one (or more) of the myriad of frameworks to adopt. Therefore, the quality and quantity³ of the data on which ESG ratings are based can be highly variable.

According to EY, there are currently over 600 ESG reporting provisions across the globe, many of which apply a different lens to the interpretation and evaluation of sustainability.⁴ Some reporting frameworks, such as the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD Recommendations), are directed at climate-related issues only and seek to highlight how such issues could impact an organisation’s financial performance. Others, such as the 77 industry-specific SASB Standards developed by the Value Reporting Foundation, track a broader range of sustainability factors that are most financially-material to investors. While many of these reporting frameworks overlap in content, the varying formats of disclosure make it difficult for investors, other stakeholders and indeed ratings agencies to interpret and compare self-reported ESG data in a meaningful way.

International developments in mandatory ESG reporting

Fortunately, major steps are being taken at an international level to establish a quality, baseline global framework for the disclosure of sustainability-related issues.

The International Sustainability Standards Board (ISSB), established by the IFRS Foundation at COP26 in November 2021, is currently considering and seeking public comment on two prototype standards, one setting the general requirements for sustainability disclosure and the other focused on climate-related disclosures (see an outline of their key features at Table 1 below).

The prototype standards build on the work of existing investor-focused ESG reporting initiatives, including the TCFD Recommendations and SASB Standards mentioned above, as well as the World Economic Forum’s 21 Stakeholder Capitalism Metrics (SCM), which has gained great traction amongst the world’s largest companies since its launch in September 2020 (with over 70 companies including Dow, PayPal, Royal Dutch Shell and Unilever now committed to disclose against the SCM’s four pillars of “Governance”, “Planet”, “People” and “Prosperity⁵) and arguably marked the first major step towards building a universal set of comparable ESG disclosure standards.

While the ISSB does not have the power to mandate the application of its standards to individual jurisdictions or companies, the intention is that the ISSB’s standards will be designed in such a way that they can be mandated at the election of jurisdictional authorities, and can be combined with jurisdiction-specific requirements or requirements aimed at meeting the information needs of stakeholder groups other than investors.⁶ It is therefore encouraging to see the commitment and progress being made at a regional level towards mandatory ESG reporting frameworks, most recently by regulators in Europe and the United States (see Table 2 for an outline of the mandatory ESG disclosure rules that have been introduced or proposed by individual countries or regions), and the collaboration between ISSB and regional regulators, including the Chinese Ministry of Finance, the European Commission, the Japanese Financial Services Authority, the United Kingdom Financial Conduct Authority and the US Securities and Exchange Commission, to enhance compatibility between the ISSB’s standards and jurisdictional initiatives on sustainability disclosures.⁷

Where is Australia at?

In Australia, mandatory ESG disclosure requirements currently exist for select issues viewed as more ‘high profile’ or ‘high risk’. This includes reporting requirements under the Modern Slavery Act 2018 (Cth), Workplace Gender Equality Act 2012 (Cth) as well as the Corporations Act 2001 (Cth), which requires issuers of financial products with an investment component to disclose in their Product Disclosure Statements:

“the extent to which labour standards or environmental, social or ethical considerations are taken into account in the selection retention or realisation of the investment.” (s 1013D(1)(l))

The conversation about mandatory ESG reporting has also started in the context of climate-related disclosure, with a plan put forward by investor groups (led by CDP, the Investor Group on Climate Change and the Principles for Responsible Investment) for Australia to adopt a mandatory TCFD-aligned disclosure for climate change risks by 2024/25. The plan contemplates:

• coordinated regulatory efforts to establish a clear regulatory expectation on market participants to deliver TCFD-aligned disclosures;
• progressively extending mandatory disclosure requirements across all major financial institutions and companies, starting with the ASX300 and large unlisted entities as a priority; and
• increasing the minimum expectations for climate-related reporting over time, on issues like scenario use and reporting metrics, backed by regulator guidance on specific aspects and ongoing review.⁸

While the Government has not formally responded to this plan, it seems that Australia is reluctant to adopt too prescriptive an approach to climate-related reporting and would prefer to leave the decision-making power and accountability with the private sector for assessing and managing the risks that they face.⁹

Practical guidance for Australian businesses and investors

So where does this leave Australian businesses looking to differentiate themselves to potential ESG investors and ESG ratings agencies?

A useful source may be the joint publication by the Financial Services Council (FSC) and Australian Council of Superannuation Investors (ACSI) titled “ESG Reporting Guide for Australian Companies” (Guide), available from the ASX website. The Guide is specifically designed to assist, on the one hand, ASX-listed companies with addressing institutional investors’ expectations regarding the disclosure of material company-specific ESG risks and opportunities, and on the other, investors to better understand and compare company level information.¹⁰

The Guide sets out a base level of ESG information that investment analysts require to make stock selection decisions. It explains why each ESG issue identified in the Guide is important from an investor perspective and sets out a list of commonly reported indicators that investors look for in assessing the business’ performance against that ESG issue.

For example, on the issue of environmental management, the Guide notes that “entities with a lack of commitment, capacity or track record in the management of environmental considerations presents a higher risk for investors”, and directs investee companies to provide evidence of their track record of environmental incidents (such as fines and sanctions for non-compliance with environmental laws and process safety incident reporting), policies and systems related to environmental management (such as biodiversity impact management, water management and hazardous waste management) and energy/water consumption data.

On the issue of human capital management (HCM), the Guide explains that HCM “is central to execution of business strategy, expansion, innovation, and business continuity, and is therefore a key area of investor attention”, and lists a set of qualitative and quantitative indicators that investors look for as evidence of strong HCM controls and practices.

Concluding remarks

The Guide, although by no means comprehensive, provides useful guidance to Australian businesses to what information to provide investors, asset managers and ESG ratings agencies that are actually meaningful to their assessment of the business’ ESG performance.

However, until such time as Australia takes positive steps towards establishing its own mandatory ESG reporting framework (or until a global disclosure standard is established and adopted by Australia), the lack of consistent ESG data regarding Australian businesses may place them be at a significant disadvantage vis-à-vis foreign businesses that operate within a regulated ESG disclosure framework, which may be viewed more favourably by ESG investors and ranked more highly by ESG ratings agencies.

Table 1: ISSB Standards – Exposure drafts in public consultation until 29 July 2022

Table 2: Developments in mandatory ESG reporting