Vladimir Boshnjakovski explores origins and the evolution of ESG reporting, diving into the challenges of integrating social reporting into financial controlling, and looking at frameworks like GRI. He also discusses future trends, such as the move towards regulated ESG reporting and the development of metrics that align with financial performance.
I. HISTORY AS CONTEXT PROVIDER
It is 1758 and the Quakers’ Yearly Meeting takes place in Philadelphia. After years of debate, they have finally agreed to prohibit slave trade for their members . The decision was not an easy one. Many believed that given their small numbers, abstaining from slave trade will only give the economic upper hand to less moral groups and would not impact the “peculiar institution” ,. Others argued that trade in human cattle is not only morally abhorrent, but also exposes slave holders to laziness, unproductiveness, and risks (ex: slave rebellions). The duality of the arguments strikes as akin to current ESG debates. More importantly, it demonstrates that ESG was incepted long ago and that the “S” played a crucial role in its genesis.
The XIX century was dominated by Adam Smith’s classical economics. In his theory, a society’s benefits are derived by the acts of rational but self-interested individuals. In the XX century, this theory was reinforced by Milton Friedman’s shareholder capitalism. It runs that in general a corporation’s role is to generate profits within the boundaries of the law. Pursuing social responsibility would be inefficient, breach fiduciary duties, and distort free societies. This concept was seriously misunderstood in the business and popular narratives, so the late XX century forced a major reinterpretation of this concept. Enters: ESG!
Event such as the Exxon Valdez and Bhopal gas leak disasters, as well as the urgency of the global warming crisis made “E” the poster child of ESG . In addition, the fallout of the 2008 Global Financial Crisis put the “G” in the spotlight. The “S” was a relative late comer to the ESG game, though it was thrown in the central stage in 2020 by the COVID-19 crisis, Black Lives Matter, and concerns about structural inequality. The result is that the reporting frameworks for “E” and “G” are relatively more developed. On the other hand, it is still challenging to analyze, measure, and integrate the ”S” into investment strategies.
II. CURRENT SOCIAL REPORTING PRACTICES
a. Few general notes on ESG reporting
The current state of ESG reporting is best described by the adjectives: voluntary, private, decentralized, and unaudited. This has led to “a multiplicity of approaches to categorizing, defining, and expressing sustainability concepts” . Discrepancies between frameworks partly stem from differences in materiality assessments and target audiences. Therefore, there is “dissatisfaction at the presence of so many different and conflicting sustainability accounting frameworks” , which creates costs for both corporations that prepare reports and stakeholders that consume them.
As the field matures, certain reporting frameworks have come to dominate the market. They are believed to bring superior “precision, validity, consistency, and inter-operability.” The major ESG reporting players are: i) Global Reporting Initiative (GRI); ii) Sustainability Accounting Standards Board (SASB); and iii) Integrated Reporting Framework (IR). Despite their multiplicity there are indications that there is much collaboration among the listed players and that with some exceptions the standards can be used in tandem .
b. Global Reporting Initiative (GRI)
The GRI is by far the most widely adopted sustainability reporting framework, used by 10,000 companies across more than 100 countries, as well as by 75% of the world 250 largest companies . Therefore, it seems most appropriate to analyze social reporting under the GRI, as best reflecting the current state-of-the-art. All information included in the following sections text is derived from the Consolidated Set of the GRI Standards 2021, as publish by GRI in 2021.
The GRI standards are categorized in various modules that can be referenced and used together. They are organized in three groups. The key issues relevant for all organizations are included in the so-called universal standards GRI 1, 2 and 3, which cover the purpose, key concepts, definitions, general disclosures, reporting principles, practices, as well as guidelines for determining materiality. Then there are the GRI sector standards that deal with specific industries, such as oil & gas, financial services, textiles etc. Finally, there are the topic standards that deal with various aspects of ESG: i) GRI 201 – 207 deals mostly with governance reporting, such as procurement, anti-corruption, competition, tax etc.; ii) GRI 301 – 308 deals with environmental reporting; and iii) GRI 401 – 418 deals with social reporting.
The purpose of GRI is to “enable organizations to report information about the most significant impacts of their activities and business relationships on the economy, environment, and people.” The significance of an impact is determined through the materiality guides contained in the GRI 3, which requires an organization to: understand its context, identify actual and potential impacts, asses their significance, and give reporting priority to the most significant ones. One crucial step in determining materiality is examining the sector standards, which list likely material topics for an industry. The relevant impacts can be positive or negative. More importantly, impacts are material if they are relevant for: i) the organization; or ii) the economy, environment, or people. With this the GRI has incorporated the so-called double materiality. The report must be accurate, balanced, clear, comparable, complete, and verifiable. However, the organization is allowed to omit disclosing certain data based on not applicability, legal prohibition, confidentiality restraints, or unavailability of information.
c. Social reporting under the GRI
Social reporting under GRI is contained in the GRI 400 standards that include 18 modules that cover a total of 35 disclosures. Note that the disclosures are not the most granular unit of social reporting under GRI because many disclosures are measured by two or more metrics. The metrics are a mixed bag of quantitative, qualitative, and binary choice (yes/no) data. For 24 out of 35 of the disclosures it may be said that there is at least one quantitative metric. Eleven disclosures are measured only with qualitative data in the form of descriptions of policies and processes. Turning to the big picture, the 15 modules can be grouped into four categories based on area of potential impact: labor, human rights, consumers and specific.
The biggest and most developed social reporting category is related to labor issues. This category includes six modules with 20 disclosures, of which 12 are reported with quantitative data.
The second most elaborate category is related to human rights. This category includes five modules with five disclosures. The nature of the metrics used in the disclosures are risk assessment and screening regarding human rights violations. Only two of the five disclosures are of a purely quantitative nature.
The third category is related to customers. This category includes three modules with five disclosures. The nature of the metrics used in the disclosures are quantitative, qualitative, and binary choice data. It must be said that for each disclosure there is at least one quantitative metric.
Finally, there are three modules that defy classification in any group. Here we can find three modules with five disclosures. The nature of the metrics used in the disclosures are a mix of quantitative and qualitative data. It must be said that for each disclosure there is at least one quantitative metric.
III. THE FUTURE: REGULATION AND INVESTOR FRIENDLY METRICS
The available literature suggests that two main trends can be expected: i) regulation of ESG reporting; ii) introducing metrics that better relate to financial controlling.
a. Moving towards regulation of ESG reporting
The academic literature suggests that the most imminent and impactful change would be in the field of regulation of ESG reporting. We will see a move from the current voluntary, decentralized, and unaudited ESG reporting towards legally mandated, centralized, and audited reporting. The European Union leads regulation of ESG in general and ESG reporting in particular. It has created a regulatory landscape that encompasses the European Climate Law, EU Taxonomy, EU Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Due Diligence Directive (CSDDD).
However, when we talk about ESG reporting, the Corporate Sustainability Reporting Directive (CSRD) plays a crucial role. Adopted by the European Commission in November 2022, it creates mandatory non-financial ESG related disclosure obligations that are expected to affect nearly 50.000 EU companies. Initially, for the reporting year 2024 large, listed companies with more than 500 employees will be expected to file their ESG reports. Then for the reporting year 2025 the applicability will be expanded to include non-listed large companies, while for 2026 all listed companies will need to report. However, a very impactful scope extension will come for the year 2028 when also certain non-EU companies doing business in the EU will be affected.
Standards and content of the reporting will be regulated by the European Sustainability Reporting Standards (ESRS). The ESRS has a very similar framework like the GRI, with only “minor differences… [that] can be bridged.” As a matter of fact the ESRS was developed with having “interoperability” with existing frameworks . One very important novelty introduced by the CSRD is the obligation to have the information in the reports assured by an independent third-party (or audited) . There are still uncertainties on who that independent third-party may be and whether the limited assurance or reasonable assurance standards will apply.
All in all, there is no doubt the CSRD will become the global reference point on ESG reporting regulation, in a similar way as the GDPR has inspired many non-EU laws and standards, thus demonstrating EU’s soft power. However, there is uncertainty how things will develop in the USA. There we have recently seen some initiatives by the SEC that indirectly and partially regulate ESG reporting. However, in the same time we are seeing backlash on state level with a patchwork of anti-ESG regulations, mostly based on the fiduciary duty argument that managers need to act in the best interest of their principals and refrain from pursuing “environmental, social, political, or ideological interests”. However, this resistance might abate if metrics and better incorporation of ESG with financial controlling demonstrates that ESG is actually just a reinterpretation of the shareholder capitalism model for the XXI century.
b. Moving towards controlling relevant grade metrics
Analyzing the GRI framework on social reporting demonstrated the existence of elaborate and sophisticated tools for social reporting. Nonetheless, even the best ESG frameworks of today have real limitations, because they seem to “put spotlight on what is available, rather than what is most important”. As such, they have limited value in terms of financial controlling. It is questionable if they provide management teams with signals about the capacity of their corporation to “navigate the megatrends that lie behind the sustainability imperative.”
The general idea is that corporations will face costs and limitations or vice versa savings and benefits depending on how low or high their reported data is. These can manifest in many ways: i) scores in the labor category impacts recruiting, retaining, and developing talent; ii) scores in the human rights category impacts the reputation of the brand or risks of boycotts; iii) scores in the customers category also impacts reputation or risks of boycotts. Low scores in any category increase the risk of penalties, criminal liability for management, legal suits or losing the social license to operate. However, the current reporting tools somewhat fail to give the necessary details, correlations, and interpretation tools to “deliver material sustainability-related impacts on the key value drivers of growth, productivity, and risk.“
As ESG moves away from its roots in the socially responsible investment into the realm of traditional investment, we can expect metrics and models that better demonstrate how “sustainability-related drivers affect business strategy and thus translate into value based on gains in growth, productivity, and risk management.” They will pay more attention to “factors such as value creation and cash flow.”
c. Conclusion
The rush to ESG has prompted a revolution in finance (ex: impacts financial performance, materiality, metrics), law (fiduciary duty, customer protection, greenwashing fraud) and popular narratives (woke capitalism). Even though social reporting has been a relative late comer in the ESG game, there already exist solid social reporting frameworks. However, these frameworks are only good starting points in the early stages of ESG reporting in which we currently are. As we move forward towards regulatory mandated ESG reporting, we must also improve the current metrics to better align with financial controlling of risks and performance. This is essential to convince investors and constituencies that ESG matters and works – prove that ESG is reconcilable with shareholder capitalism.
For advice on the regulation and practices of ESG in North Macedonia or ESG reporting in North Macedonia, feel free to write (contact@boshnjakovski.com) or call (+38970257879).
