SEC commissioner Allison Herren Lee recently spoke about a paradigm shift with respect to ESG. In a June 2021 address at the Society for Corporate Governance national conference, she explained that ESG issues had traditionally been referred to as ‘corporate social responsibility’ (CSR) issues, and treated as if they were separate from the business of generating revenue and earning profits.
Arguing that ‘those days are over,’ she stated that today’s boards need to consider how and when ESG issues are material to financial performance, instead of whether they are material at all.
For anyone still doubting the grand awakening underway regarding ESG, consider the table below. It compares instances of specific terms in the 2010 IFRS Practice Statement 1 Management commentary versus the 2021 exposure draft of the same guidance. The IFRS Foundation publishes accounting standards used across the majority of the globe.
|Supplier, supply chain||10||0|
Some key takeaways include:
- The words environmental, social and governance didn’t appear at all in 2010, and now collectively appear more than 80 times
- Climate, reputation, customer and supplier also didn’t appear in 2010, but show up more than 80 times collectively in the current exposure draft
- The concept of value is far more significant, appearing 20 times more often in the current exposure draft than it did in 2010
- Considerations of the long term have also gained in importance, with the term appearing 71 times in the current exposure draft, compared with two times in 2010.
The purpose of the Management commentary guidance is to define important considerations for management as it explains its financial results and outlook. The shift toward ESG is convincing evidence that the global authority in financial accounting now considers ESG as integral to financial performance.
Environmental and social impacts can affect cash flows
Arguably the most significant declaration in the draft Management commentary guidance is that environmental and social impacts can affect an entity’s ability to create value and generate cash flows (clause 5.7). The IFRS Foundation is thus making a direct link between ESG and financial outcomes.
Echoing Lee’s sentiments at the beginning of this article, once the potential for ESG to affect cash flows is established, the question of whether ESG is financially material is moot. The question instead becomes which ESG issues are the most material. The draft guidance provides the following advice:
- Material metrics related to an entity’s business model may include environmental and social impacts of the entity’s activities – such as greenhouse gas emissions (5.10c) and brand reputation scores (5.10d)
- Resource availability, pollution, or climate-related regulations are examples of environmental concerns that might affect an entity (9.4e)
- Demographic, lifestyle, or cultural changes are social considerations that might affect an entity (9.4d)
- Changes in customer preferences or risks to supply chains, such as from protectionist trade policies, may be key risks to the entity and its resources or relationships (9.9)
- Customer retention statistics, customer satisfaction scores, and employee engagement survey scores may be material metrics for monitoring an entity’s resources or relationships (7.11)
The question of whether investors are interested in ESG is also moot, once the connections between ESG and financial outcomes are made clear. The 2021 exposure draft clearly states that investors and creditors are particularly interested in information about matters that could affect an entity’s long term prospects, which could include ESG matters (4.18).
From corporate social responsibility to integrated thinking
Lee’s comments and the draft Management commentary guidance reflect the increasing acceptance that company performance depends on its environmental and social contexts. Company impacts on society and the environment can rebound to affect its own viability and success – think of corporate carbon emissions eventually contributing to operational risks from extreme weather.
Recognizing this, The Business Roundtable famously articulated a revised purpose for business to operate for the benefit of all stakeholders – customers, employee, suppliers, communities and shareholders.
Despite the increased importance placed on understanding ESG issues and broader stakeholder outcomes, the draft IFRS guidance makes it clear that broader stakeholder outcomes are not always material when it comes to integrating ESG into management commentary. The draft guidance states that the concept of value refers to the value an entity creates for itself and hence for its investors and creditors.
It does not refer to the value that a company may create for other parties, such as customers, suppliers, employees or society in general. However, management should consider stakeholder impacts insofar as they affect the entity’s ability to create value for itself (3.13).
Integrating ESG into the management commentary, therefore, is unlikely to be as simple as combining CSR reporting with financial reporting. This is because CSR tacitly assumes that ESG is separate from the business of generating revenue and earning profits. CSR reporting generally follows the guidance of the Global Reporting Initiative, which defines material issues as those which reflect an organization’s significant economic, environmental and social impacts.
This conceptualization of materiality reflects the GRI’s 1997 origin as a mechanism for corporate transparency in the wake of the Exxon Valdez oil spill. But simply combining CSR reporting with conventional corporate reporting fails to demonstrate that management understands how environmental and social impacts affect its capacity to create value for itself.
Instead, companies should move to consider both their external impacts on environment and society, as well as how environmental and social factors impact the business itself. This means that the materiality of ESG issues needs to be evaluated not only through a lens of whether the company impacts its external environment, but also through a lens of how ESG issues affect the financial performance of the company.
Moving toward this double materiality approach would allow a business to align with the emerging expectations of the comprehensive corporate reporting system, which include:
- Reporting on sustainability matters that reflect positive or negative impacts on people, the environment and the economy – directed at users who want to understand a business’s positive and negative contributions to sustainable development
- Reporting on sustainability matters that create or erode corporate value – directed at users with specific interest in understanding corporate value creation.
It remains to be seen whether the draft Management commentary guidance will be adopted in its present form, and how it will impact accounting standards within particular jurisdictions, including the US, whose commitment to align with IFRS guidance has wavered over time.
Adoption of the draft guidance aside, the writing is on the wall for CSR. It’s now incumbent on corporates to articulate not only how they manage external environmental and social impacts, but also how they integrate ESG into their value creation strategy.
Dr Alex Gold is the head of ESG and CEO of BWD North America.