ESG Controlling: Current State and Next Steps for Integrating “Social Reporting” with Financial Controlling

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 the slave trade would only give the economic upper hand to less moral groups and would not have an impact on the “peculiar institution.” Others argued that the trade in human beings was not only morally abhorrent but also exposed slaveholders to laziness, unproductiveness, and risks (e.g., 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 19th 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 20th 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 business and popular narratives, so the late 20th century forced a major reinterpretation of it. Enters: ESG!

Events such as the Exxon Valdez oil spill and the Bhopal gas disaster, 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 of significant collaboration among the listed players and that, with some exceptions, their 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 organized into various modules that can be referenced and used together. The key issues relevant to 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 and 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 the GRI is contained in the GRI 400 Standards, which include 18 modules covering a total of 35 disclosures. Note that disclosures are not the most granular unit of social reporting under the GRI, because many disclosures are measured using two or more metrics. The metrics are a mixed bag of quantitative, qualitative, and binary choice (yes/no) data. Twenty-four of the 35 disclosures contain 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 metrics used in the disclosures involve risk assessments and screening for 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 do not fall neatly into any of these groups. 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) the regulation of ESG reporting; and ii) the introduction of metrics that better relate ESG reporting 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 model of ESG reporting toward a legally mandated, centralized, and audited model. 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 it comes to ESG reporting, the Corporate Sustainability Reporting Directive (CSRD) plays a crucial role. Adopted in 2022, it created mandatory sustainability-related disclosure obligations that were expected to affect nearly 50,000 EU companies. Initially, for the 2024 reporting year, large listed companies with more than 500 employees were expected to file sustainability reports. Then, for the 2025 reporting year, the scope was expected to expand to include other large companies, followed by certain listed companies in subsequent reporting years. A further significant extension of the scope was also envisaged for certain non-EU companies doing business in the EU.

Standards and content of the reporting are set out in 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 requirement to have the information in the reports subject to independent assurance. 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, the CSRD has the potential to become a global reference point for ESG reporting regulation, much as the GDPR has inspired many non-EU laws and standards, thereby demonstrating the EU’s soft power. However, there is uncertainty how things will develop in the USA. There, we have seen initiatives by the SEC that directly or indirectly address aspects of ESG-related disclosure. 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 better metrics and better integration of ESG into financial controlling demonstrate that ESG can be interpreted as a reinterpretation of the shareholder-capitalism model for the 21st century.

b. Moving towards controlling-relevant metrics

Analyzing the GRI framework on social reporting demonstrated the existence of elaborate and sophisticated tools for social reporting. Nonetheless, even today’s best ESG frameworks have real limitations because they seem to “put the 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 whether they provide management teams with adequate signals regarding their corporations’ capacity to “navigate the megatrends that lie behind the sustainability imperative.”

The general idea is that corporations will face costs and limitations or, conversely, savings and benefits depending on their reported performance. These can manifest in many ways: i) scores in the labor category affect the recruitment, retention, and development of talent; ii) scores in the human rights category affect brand reputation and the risk of boycotts; and iii) scores in the customer category also affect reputation and the risk of boycotts. Low scores in any category increase the risk of penalties, criminal liability for management, lawsuits, or the loss of 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 socially responsible investment and 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). Although social reporting has been a relative latecomer to the ESG game, solid social reporting frameworks already exist. However, these frameworks are only a starting point in the still-developing field of ESG reporting. As we move towards regulatorily mandated ESG reporting, we must also improve the current metrics to better align them with financial control of risks and performance. This is essential to convince investors and other constituencies that ESG matters and works—and to demonstrate that ESG can be reconciled with shareholder capitalism.

or advice on ESG regulation and practices in North Macedonia or ESG reporting in North Macedonia, feel free to write to contact@boshnjakovski.com or call +389 70 257 879.