Getting into the ESG Disclosure, Rating and Ranking Game [Part 2 of 4]

In our previous alert, we discussed the evolution of the ESG (environmental, social and governance) landscape and how it is imbedded in or distinguished from various investor and business approaches such as impact investing and B Corp Certification. At the beginning of 2018, investors directed $30.7 trillion in ESG investments in the US, Europe, Japan, Canada, Australia and New Zealand, according to the Global Sustainable Investment Alliance. Representing a 34% increase over 2016, this marks a significant shift in the importance of ESG considerations for investors. In parallel, the ecosystem for evaluating, rating and ranking company ESG efforts has also increased, illustrating a push for companies to become more transparent through public disclosure of ESG impact areas and reflecting the shift to stakeholder capitalism. 

The public sector is also creating pressure as disclosure of various aspects of ESG are either mandated or encouraged in many jurisdictions. These include, for example, the UK with respect to mandatory gender pay gap reporting, France pursuant to Grenelle II, and modern slavery disclosures for certain companies under California, UK and Australia laws (to name a few). However, there is currently no common government regulated standard for comprehensive disclosure or measurement that allows for comparable, useful and verifiable information.

In the US, the SEC has been reluctant to shape the ESG disclosure conversation. Despite this, on May 14, 2020, the SEC’s Investor Advisory Committee, heeding the investor calls towards more ESG disclosure, recommended the SEC take a leading role in establishing a framework for ESG disclosure to investors. And, following a July 2020 US Government Accounting Office report evaluating the ESG disclosure arena, Senator Mark Warner called upon the SEC to create a task force to establish an ESG disclosure framework for reporting companies. Given the current administration and the election year, it’s unlikely there will be any movement by the SEC any time soon.  

Because disclosure is largely voluntary, the sustainability ecosystem is made up of (1) organizations that provide different sets of disclosure frameworks and standards for ESG self-reporting and (2) organizations that rate and rank company ESG efforts by aggregating publicly-available data, sometimes confirming findings with organizations and sometimes not.

Disclosure to Evaluate Risk

As discussed in our first alert in this series, the current business climate highlights that reputational and operational risks are on par and are interrelated to financial risk. In the Fourth Industrial Revolution, more than 80% of a company’s value is made up of intangible assets, including intellectual property, market share, brand awareness, good will and perceptions of a company’s effect on society and the environment, according to Ocean Tomo. This is the reverse of almost 40 years ago when tangible assets comprised more than 80% of a company’s value.

This fact bolsters investors views that ESG considerations are necessary to evaluate all elements of risk in their investment decision. It also frames the basis for the increased pressure by customers and consumers to be transparent and accountable on ESG elements, like climate and labor rights. For business to consumer corporations, in particular, reputational risks are now strongly grounded in how a company manages its role as a corporate citizen.

Regardless of the particular stakeholder’s perspective, ESG has become a matter of risk management, and disclosure is the means for stakeholders to evaluate all types of risk. Internal business conversations that weigh disclosure are not always straightforward as there is a tension between making the financial business case for disclosure and the calls for transparency, accountability and shared value creation. This has also contributed to a fragmented ecosystem that caters to disclosure for different purposes and different audiences.

Disclosure Frameworks and Standards

According to the Investor Responsibility Research Institute, in 2018, 78% of the S&P 500 companies issued a sustainability report covering various environmental and social metrics. Companies take a variety of approaches for shaping their ESG disclosure from broad frameworks that drive global commonality in reporting to specialized disclosures that target specific stakeholders.

Broad Frameworks

The main players in the ESG disclosure realm have created frameworks that are accepted and endorsed by the major financial institutions, most notably BlackRock.

• Global Reporting Initiative (GRI) – Through many iterations of metric recommendations, GRI evolved from environmental reporting in 1997 into an independent standards board that sets global standards for sustainability reporting to the broadest group of stakeholders. Partnering with many other international organizations, such as the UN Global Compact, they provide a marketable way to facilitate disclosure of a company’s economic, environmental and social impacts and implementation towards sustainable development.  

Materiality is generally defined with reference to the significance of a company’s impact on and for internal and external stakeholders. GRI defines impact as the effect an organization has on the economy, the environment, and/or society, which in turn can indicate its contribution (positive or negative) to sustainable development. In this regard, the UN Sustainable Development Goals serve as an important guide towards identifying a company’s sustainable development.

• Sustainability Accounting Standards Board (SASB) – Created in 2011 and modeled after the International and Financial Accounting Standards Boards, SASB is a non-profit, independent organization that sets standards for disclosure among the sustainability dimensions of the environment, social capital, human capital, business model, innovation, leadership and governance. Because SASB caters to the investor audience, it establishes industry and sector standards for companies to identify the ESG issues that are reasonably likely to impact the financial performance.  
• Integrated Reporting Framework (IRF) – The International Integrated Reporting Council urges companies to issue reports that combine the traditional, annual financial information with ESG data. Similar to SASB, global investors, lenders and insurers are the primary audience for these reports.

In the spirit of advancing stakeholder capitalism and harmonizing the disclosure ecosystem, earlier this year, the World Economic Forum’s International Business Council, a critical player in the global ESG discussion, proposed a common set of ESG metrics for disclosure in annual reporting.

Specialized Disclosure

• Task-Force on Climate-Related Disclosures (TFCD) – As its name suggests, the TFCD is focused on the environment. While TFCD is voluntary, the Principles for Responsible Investing, beginning this year is requiring its signatories to report on the TFCDs.
• Human Rights – In 2011, the United Nations published its Guiding Principles on Business and Human Rights setting its expectation of both governments and businesses to protect and respect human rights. Following this, a number of jurisdictions have adopted laws requiring certain companies subject to the law to disclose, in general, where modern slavery is occurring in their operations and supply chains, and their efforts to remediate and prevent modern slavery. California, the UK, Australia and New South Wales are among those mandating this disclosure. Many foreign and US multinationals are subject to these laws and are, or will be, publishing their Modern Slavery Statements, accordingly.

Notably, human rights is not just forced labor. Human rights is a broad arena capturing diversity and inclusion, gender equality, land use, income inequality, and a host of other rights keyed to the International Bill of Rights. For more information on this topic, please see our blog series on the landscape for addressing modern slavery by business and framing a human rights due diligence strategy that allows for the policies and checks and balances needed for appropriate disclosure.

In April, the EU announced an intent to legislate mandatory human rights due diligence in 2021, signaling a shift from voluntary disclosure to a “know and show” approach for human rights.

Disclosure Misconceptions

If a company undertakes ESG disclosure, it is also critical to understand the various misconceptions.

• Misconception #1: Frameworks Are An Either/Or – GRI and SASB are distinct, but complementary frameworks. Because SASB is focused on financial materiality and the investor audience while GRI is focused on broader risk management (financial, operational and reputational) and all stakeholders, many companies who disclose using SASB cross-reference to the GRI standards. In fact, SASB and GRI have a workplan that allows disclosures to use both standards. Similarly, they can be used to shape a disclosure per the TFCD standards.

• Misconception #2: Disclosures Are Only for Public Companies – Given the support by the institutional investor community, like BlackRock, State Street and others, it may appear that disclosure is just for public companies. However, given the movement towards stakeholder capitalism, the disclosure standards are intended for all companies. And, even if a company chooses not to disclose, the frameworks are useful tools to understanding and shaping the material sustainability priorities of a company.

• Misconception #3: Disclosure is only for Certain Industries – Environmental issues (Green House Gas and carbon emissions, water use, land use) have often dominated the ESG conversation in the US giving the perception that disclosure may only be for certain industries. Addressing ESG generally is industry-agnostic. But, the specific issues to address and disclose can be sector specific, which is something that SASB recognizes by developing industry and sector-specific standards.
• Misconception #4: Disclosure in a Regulatory Filing – Unless a jurisdiction mandates a disclosure in a regulatory filing, the disclosures do not need to be made in a regulatory filing for the investor audience. In fact, companies disclose in a variety of ways – through an annual sustainability report, integrated reports, and even through varying social media if the company chooses to create a level of transparency that is tangible to the end consumer.

Rankers and Raters

The sustainability ecosystem also includes a plethora of organizations that are ranking and rating companies on their ESG performance and risk. Sustainalytics, now wholly owned by Morningstar, and MSCI are the two main rating agencies. A host of others include, but are not limited to: Bloomberg, Dow Jones Sustainability Index, Institutional Shareholder Services (ISS), Thomson Reuters, and countless others. In general, these companies collect data on companies via questionnaires, surveys, and publicly available information to rank and rate companies.

In addition, organizations within the ecosystem partner with other organizations to benchmark companies on specific issues. For example, Know the Chain, a partnership between Sustainalytics, Humanity United, the Business & Human Rights Resource Centre and Verité, benchmarks companies on their human rights efforts, primarily forced labor. It recently published its rankings in the Information and Communications Technology (ICT) sector, a high-risk industry for forced labor, and serves as an example of how players in the space collaborate to aggregate data and use it to influence behavioral changes.  

The raters and rankers can be criticized for moving ESG to a check the box endeavor and/or compliance type exercise instead of a mechanism to drive genuine engagement, education and overall shared value through collaboration and continuous improvement. ESG disclosures are already met with a suspicion of greenwashing and if the ratings and rankings are dependent, in large part, on public disclosures, a loop of mistrust can be created.

Approaching Disclosure

The ESG reporting space is incredibly fast-moving as the definition becomes more inclusive, raising a challenge for companies to sift and organize the macro frameworks and adapt to the tension of varying disclosure guides that may not reflect what is material for the company or its sector. Companies also experience fatigue and a resource drain as they respond to questionnaires that may have the effect of companies focusing on non-material factors to their business.

If companies choose to disclose, disclosure should be approached carefully and cautiously. When deciding where and when to disclose, consider the following:

• Why does a company want to disclose? Stakeholders increasingly become more sophisticated and vocal. As such, disclosure for disclosure sake or as a check the box exercise should not drive disclosure. Over the last decade, investors have become privy to organizations “paying to play” for a score and not authentically integrating the “E” and the “S” into their overarching “G.” The why is needed to shape the narrative.
• What does a company need to disclose and to whom? Because the frameworks discussed above are intended to be guides, a company first needs to assess what is material for their business and shape the narrative in a way that is most authentic, transparent and tangible to their specific stakeholders.
• What are you willing to disclose? When sustainability reports are used solely for marketing purposes, there’s a temptation to disclose only the strengths and conveniently or strategically leave out the opportunities for continuous improvement. As such, while there may be a hesitancy not to disclose less positive elements, it can minimize litigation risk and build trust with customers and consumers if a company highlights the areas for improvement. 

Up next

With all the eyes on ESG, particularly the social factors, disclosure is almost never without litigation risk. In our next post, we highlight the current theories being advanced in the space, lessons learned and best practices for disclosures.