ESG ratings have become an increasingly important metric used by investors to assess the potential risk and return of investing in potential investee businesses.
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.
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
|Draft Standard||Key features|
|IFRS S1: General Requirements for Disclosure of Sustainability-related Financial Information|
|IFRS S2: Climate-related Disclosures|
– use of climate-related scenario analysis to assess risks and opportunities, where possible; and
– disclosure of a company’s gross Scope 1, Scope 2 and Scope 3 GHG emissions, calculated using the GHG Protocol, and the intensity of those emissions.
Table 2: Developments in mandatory ESG reporting
|Jurisdiction||Scope of reporting||Rules / Proposed rules||Key dates||Companies affected|
|European Union||Climate-related disclosure only||Sustainable Finance Disclosure Regulation||Effective date: 10 March 2021 (Level 1 disclosures)|
1 January 2022 (Level 2 disclosures)
|All ‘financial market participants’, including:|
• investment firms and fund managers;
• pension or retirement product providers;
• providers of insurance-based investment products;
• credit institutions which provide portfolio management; and
• certain venture capital funds and social entrepreneurship funds.
All financial advisers, including insurance intermediaries, credit institutions or investment firms which provide investment advice.
|European Union||Climate-related disclosure only||Taxonomy Regulation||Effective date:|
1 January 2022
|Financial and non-financial companies subject to publishing non-financial information under the Non-Financial Reporting Directive. This includes large public interest companies (including companies listed on regulated markets, banks and insurance companies) with more than 500 employees.|
|E, S and G disclosure||Corporate sustainability reporting directive (CSRD)|
European Sustainability Reporting Standards
|Exposure drafts released: April 2022|
Public consultation: until 8 August 2022
Expected effective date: January 2023
|All large companies, being companies meeting at least 2 out of the following 3 criteria:|
• > 250 employees;
• > €40M turnover; and/or
• > €20M in total assets.
All listed companies, except micro-enterprises, being those meeting 2 out of the following 3 criteria:
• < 10 employees;
• < €700,000 turnover; and/or
• < €350,000 in total assets.
|Hong Kong||E, S and G disclosure||Main Board Rules Appendix 27|
GEM Rules Appendix 20
|1 January 2016|
Last amended 1 January 2022
|All issuers listed on the Hong Kong Exchange|
|India||E, S and G disclosure||SEBI vide Circular No. SEBI/HO/CFD/CMD-2/P/CIR/2021/562||Passed: 10 May 2021|
In force: 1 April 2022
|Top 1000 listed companies by market capitalisation|
|New Zealand||Climate-related financial disclosure only||Financial Sector (Climate-related Disclosures and Other Matters) Amendment Act 2021||Passed: 27 October 2021|
In force: Phased implementation, but initially 28 October 2021
Climate reporting from 28 October 2022
External assurance required from 28 October 2024
|Entities with total assets under management > NZ$1B that are:|
• Registered banks, credit unions and building societies
• Managers of registered investment schemes (other than restricted schemes)
• Licensed insurers
Licensed insurers with annual gross premium income over NZ$250 million.
Issuers of quoted equity securities with total market price > NZ$60M.
Issuers of quoted debt securities with total face value > NZ$60M.
|Singapore||E, S and G disclosure||Listing Rule 711A of the SGX Listing Rules|
Practice Note 7.6: Sustainability Reporting Guide
|20 July 2016|
Last amended 1 January 2022
|All issuers listed on the Singapore Exchange|
|United Kingdom||Climate-related financial disclosure only||Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2021||Passed: 17 January 2022|
In force: 6 April 2022
|Companies with over 500 employees which:|
• have transferable securities on a UK regulated market or admitted to AIM;
• are banking or insurance companies; or
• have > £500M in turnover.
LLPs with more than 500 employees which:
• have > £500m in turnover; or
• are traded or banking LLPs.
|United States||Climate-related financial disclosure only||SEC 17 CFR 210, 229, 232, 239, and 249|
The Enhancement and Standardization of Climate-Related Disclosures for Investors
|Exposure drafts released: 21 March 2022|
Public consultation: until 17 June 2022
Expected effective date: December 2022
|• Large accelerated filers – public float of US$700M+|
• Accelerated filers – public float between $US75M-US$700M
• Non-accelerated filers – public float of < US$75M
• Smaller reporting companies – publicly floated company with < US$250M or unfloated companies with < US$100M in annual revenue
1 McKinsey and Company, ‘Five ways that ESG creates value’, McKinsey Quarterly (November 2019).
2 Bloomberg, ‘The ESG Mirage’ (10 December 2019).
3 A 2021 study has found a ‘quantity bias effect’ whereby businesses that have reported a greater volume of ESG data appear to attract a higher ESG rating: Mike Chen, Rob von Behren, and George Mussalli, ‘The unreasonable attractiveness of more ESG data (6 July, 2021).
4 EY, ‘The future of sustainability reporting standards – the policy evolution and the actions companies can take today’ (June 2021).
5 According to the World Economic Forum website: ‘Creating a global coalition’.
6 IFRS, ‘ISSB: Frequently asked questions’ (2022).
7 IFRS, ‘ISSB establishes working group to enhance compatibility between global baseline and jurisdictional initiatives’ (27 April 2022).
8 Investor Group on Climate Change, ‘Investors release plan to establish mandatory financial disclosure on climate risk in Australia’ (29 June 2021).
9 Hon Josh Frydenberg MP, Address to the Australian Industry Group, Melbourne, ‘Capital markets and the transition to a low emissions future’ (24 September 2021).
10 The FSC and ACSI also believe that the Guide will assist ASX-listed entities in complying with Recommendation 7.4 of the ASX Corporate Governance Council Principles and Recommendations, which requires relevant entities to disclose whether they have “any material exposure to economic environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks”, or otherwise explain why it is unable to comply with the recommendation.