September 30, 2022

The ESG agenda and the rise of extra-financial reporting

The environmental, social and governance (ESG) concept has evolved from an initial concept related to corporate social responsibility to a major driver for companies, in particular for the behavior of the board of directors and shareholders.
Climate change became its star child, and accusations of “greenwashing” its undesirable sibling. ESG has become perhaps the touchstone of that most elusive goal shared by most companies, a “best-in-class” corporate reputation.

Beyond the boardroom, ESG is increasingly influencing supplier and buyer decision-making. Shareholders and investors want to understand the long-term strategies of the companies in which they invest and the ESG role in their management.

In early June, climate diplomats gathered for the Bonn Climate Conference, a follow-up event to COP26, to discuss net zero progress amid renewed energy security concerns. The meeting was described by many as distraught and full of disappointment, with many citing the war in Ukraine and the resulting energy and food crises as the cause of stilted progress.

New Headwinds and Definition Dilemmas

The geopolitical environment presents new headwinds; an energy and cost of living crisis affecting even high growth markets like China, as well as most of the North Atlantic and EU economies. Governments, and therefore regulators, are faced with voters who are increasingly attentive to ESG measures which are only window dressing with an attached invoice. The UK, for example, recently suspended the complete closure of a controversial shale gas facility, in addition to considering renewing drilling licenses in the North Sea. Europe, following the war in Ukraine, is on the way to zero dependence on Russian oil and gas within a few years, with a doubling of wholesale prices well under way and a growing pressure on EU member states to increase renewable energy production .

There are also growing questions around the very scope of the ESG label, with some arguing that its definition is getting too broad for practical purposes. The OECD said that tax avoidance costs governments around the world 4-10% of revenues that could otherwise be spent on education and other social supports; Should tax transparency and justice now be part of any ESG rating system? Should “tax cooperation” be seen as a means of introducing tax issues into the ESG rating system?

This, and related issues, give rise to the joke that the letters “S” and “G” in “ESG” are silent. Some markets, however, have begun to take the “S”s and “Gs” seriously. In 2003, Norway led the way by requiring women to make up 40% of the board members of any large company. The European Commission then proposed a law requiring a minimum of 40% women on the boards of companies listed in the European Union by 2020. Today, Austria, Belgium, Denmark, France, Ireland, Italy, Germany, the Netherlands and Spain have adopted regulations. This demonstrates that there is growing political momentum for ethnic and other diversity measures to be encouraged, if not mandated.

For now, the regulatory change focuses on the “E” of ESG. According to the Harvard Law School Forum on Corporate Governance, over 85% of investors and over 90% of top business leaders now want quantifiable metrics they can use to assess their ESG impact. Much of this is now driven by investors through collaborations such as the Institutional Investors Group on Climate Change, which writes to companies demanding more disclosure about the impact of decarbonization in order to steer the world on a path that will allow us to stay below 1.5. C limit of global warming during this century.

Regulatory repression

In the investment context, while there is now evidence that ESG funds have helped stabilize the ESG equity market (Europe Corporate Governance Institute, June 2022), regulators are grappling with the complex new ESG criteria of selection of investments. This has caused the U.S. Securities and Exchange Commission (SEC) and other regulators to take a closer look at companies’ statements about their ESG credentials and to more closely monitor their ESG-related communications.

In March 2021, the SEC formed an ESG task force for the sole purpose of investigating ESG-related violations. At the same time, the SEC also announced plans to create rules for corporate disclosures related to ESG factors, including climate disclosures. The goal of the SEC’s ESG ruling was to create standardized and comprehensive disclosure requirements, making it easier for investors to compare ESG criteria between companies.

On March 17, 2022, the SEC proposed a rule that will require SEC-registered companies to include certain weather-related information in their registration statements and periodic reports. This includes disclosure of climate-related risks that are reasonably likely to have a material impact on their business, results of operations, financial condition and certain climate-related financial statement measures in a note to their audited financial statements. .

Interim public statements and audited annual financial statements are therefore placed squarely at the heart of public company communications on ESG. This creates new and nuanced challenges and risks for financial accounting and auditing firms.

What regulatory and financial risks will financial accounting and auditing firms face when regulators and investors believe these assessments are wrong? Government fines for violations of the US Foreign Corrupt Practices Act (“FCPA”) alone reached US$2.8 billion in 2020. How long before a financial and accounting firm be subject to significant penalties and fines for incorrectly reporting FCPA or other ESG violations, even without knowing it? ?

EU legislation went even further through European Parliament Regulation (EU) 2019/2088 published on 27 November 2019. This focused on sustainability disclosures in the financial services sector. The Regulation contains a definition of “sustainable investing” (Article 2, No. 17) and imposes rules on subjects acting as financial market participants and financial advisers regarding the disclosure of information on sustainability issues.

Financial market participants and financial advisers should therefore disclose data on how they take ESG factors into account at two levels:

1) Their decision-making processes for investment-related decisions;
2) All financial products they sell on EU markets.

The European financial world is therefore confronted with the new taxonomy of sustainable activities and is looking for financial products that can be cataloged in accordance with article 8 or 9 of regulation 2020/852 of 18 June 2020 (known as the “taxonomic regulation”), which amended the aforementioned Regulation 2019/2088.

Ethics and Energy

There is a new set of considerations for financial accounting and auditing firms tasked with assessing the ESG compliance and financial vulnerabilities of companies and public bodies tasked with delivering vital energy resources to the public. These include what constitutes reasonable and ethical behavior in pursuit of fundamental business objectives and the compatibility of those objectives with ESG objectives. For these companies from Eastern European countries, for example, the alternatives to buying energy produced in Russia are costly (especially for landlocked countries) and/or in the face of geopolitical relations of historical friendship , as for Hungary .

Many companies today are understandably confused about how best to approach reporting their ESG performance in a credible and accurate manner. Much of this confusion stems from a plethora of sustainability reporting frameworks. For many, the answer may well be the International Sustainability Standards Board (ISSB), which could do for sustainability reporting what the International Accounting Standards Board (IASB) does for financial reporting.

The ISSB, which was introduced at COP26, has the potential to redo ESG reporting. The Board aims to build global consensus on sustainability disclosures, simplifying the complex landscape and standardizing the practice of non-financial reporting. This is unlikely to be a complete reinvention of the ESG reporting process or a panacea. Instead, it is intended to support existing reporting processes and provide consistent standards for organizations around the world. The adoption of internationally recognized and consistent standards can only mitigate the risks and challenges financial accounting and auditing firms face in the evolving ESG context, as only a truly holistic and comprehensive approach can be crowned with success. hit.

RSM aims to be at the forefront of these reporting standards, with a particular eye on the needs of growing businesses. These are the companies that, over time, are likely to be subject to the same standards that the SEC and others impose on large corporations, and which could also find strategic differentiation by taking a leadership position in this key area.

If you have any questions regarding the ideas shared in this article, please contact our global legal group.