Accounting is the language of business, as we know. As financial accounting evolved over the centuries, new rules and standards emerged, terms were added to the lexicon, and applications clarified. In more recent years, the operating environments of companies have been changing dramatically along with the information requirements of investors. Climate change, globalization of supply chains and technological innovations are just several factors that have brought with them new risks and opportunities to identify, measure, and manage accordingly. There is universal recognition today that the language of business needs new rules and standards as well as clarity.
In this series we describe the need for sustainability accounting, examine the state of current disclosures, and end with an explanation of SASB (Sustainability Accounting Standards Board) Standards, key reporting standards for identifying, managing, and communicating sustainability information that is financially material to investors.
The ESG Ecosystem
The ESG ecosystem is a mix of rating agencies, data aggregators, reporting and control frameworks, and allied services, such as external auditors, that help stakeholders understand the ESG performance of companies they are analyzing. Among the segments that make up this ecosystem are firms that rate the sustainability of portfolios, which includes the long-standing fund rater Morningstar as well as InspIR Group’s ESG integration partner Third Economy. Over time, consolidation within and between each of the segments will occur, facilitating harmonization of standards, which will benefit companies and investors alike.
We focus on SASB in this series because we expect it to be the keystone ofthe ESG ecosystem as a robust set of accounting standards that enable investors, among other stakeholders, to accurately assess the ESG performance of companies and thus will be widely accepted in the global financial community, as are IFRS and US GAAP. SASB is, and will increasingly be, the language of investor relations alongside traditional accounting standards. It will be the precise intersection where issuers and investors meet. SASB takes its definition of a “material” topic from the seminal judgment by the US Supreme Court in the TCS vs Northway case, which has determined:
“There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information available.”
This focus has resulted in SASB research arriving at over 4,000 topics and 77 standards applicable to an equal number of industries that are grouped by similarity in ESG risks and opportunities. These are regularly revised as the financial materiality of E, S, or G issues change for any industry.
Lastly, to note, because sustainability is commonly defined as the ESG dimensions of a company’s operations and performance that allow it to sustain corporate life, or be financially sustainable, we use the terms sustainability and ESG interchangeably in this series.
Part 1: The Need for Sustainability Accounting
The rise of intangibles and new forms of risk
Businesses have become human capital intensive over the years. Further, other intangible assets like intellectual property, customer relationships, and brand value now dominate the asset bases of S&P 500 companies, a trend that will continue growing.
A 2019 report coauthored by insurance giant Aon reveals thattraditional tangible assets, like real estate and equipment, comprised just 16% of company value in the S&P 500, while intangibles, such as IP rights and corporate reputation, were 84% of value. Other more recent reports in 2020 have shown the composition of intangibles closer to 90% of company assets.
Source: 2019 Intangible Assets Financial Statement Impact Comparison Report
A look back at the names of the dominant companies in the S&P 500 over time clarifies this shift. The importance of raw materials, inventory and equipment is relatively less of a factor today than in the past, when oil companies and auto manufacturers were dominant in the index and the global economy. However, although technology companies’ share of the S&P 500’s value has skyrocketed, traditional brick and mortar businesses still face many of the same sustainability risks and opportunities faced by tech behemoths like Amazon, Apple and Facebook.
Consider the 2013 data security breach of online accounts at traditional retailer Target, which resulted in an $18.5B settlement several years later. Yet, the same virtual presence has been a major contributor to this company’s stellar performance during the Covid-19 pandemic. Can an investor adequately understand the risks and opportunities and thus accurately value Target’s virtual presence, using traditional financial statements alone? And what about the material risks of climate change facing a hotel operator with beachfront properties? The answer in both cases is no.
Attracting “patient” capital increasingly dependent on financial sustainability
A question that Investor Relations Officers are often asked by the C-suite is “What’s an ideal shareholder base for the company?” The answer, of course, varies by sector, current circumstances, and a host of other factors. The shareholder base of a biotech hanging its hopes on a major success in its testing pipeline will vastly differ from that of a regulated electric utility company.
Nevertheless, a common goal for most companies is to have a core group of long-term shareholders that provide some measure of stability in terms of price and trading volume – not just passive investors, but active investment managers who believe in management’s vision and growth strategy. But because the risks and opportunities related to most sustainability issues are long-term in nature, management and IR must clearly demonstrate to long-term investors that they have identified and are properly measuring, reporting and managing all issues related to operating in sustainable ways and thus being a financially sustainable company, in order to attract “patient” capital. Managements that believe sustainability issues are business issues have moved towards integrating them into strategy and ESG information disclosure, making it easier for long-term investors to understand what the company believes to be material and its performance against targets.
There is wide recognition that short-termism in corporate behavior is often at odds with long-term sustainability, irrespective of whether investors or executive compensation structures are to blame. But highly influential long-term global investors like BlackRock are clear in their demand for corporate sustainability and disclosure that allows them to accurately measure and monitor it. Alternatively, inadequate sustainability reporting can lead to divestment by long-term investors or to valuation discounts if material risks and opportunities cannot be evaluated.
Link between sustainability performance and financial performance
If sustainability issues can be material to long-term business performance, then, by extension, managing them must add value. The existing gap inside many companies between the recognition of this link and taking steps to identify the relevant risks and opportunities as well as measuring and reporting them, is quickly narrowing. A survey of CEOs jointly conducted by Accenture and the UN Global Compact found that 48% of CEOs were integrating sustainability into their company’s operations and reporting.
Research into links between ESG and financial performance tends to show correlation. A popular paper published in the Journal of Sustainable Finance & Investment by Gunnar Friede of Deutsche Asset & Wealth Management and academics Timo Busch and Alexander Bassen aggregated evidence from more than 200 empirical studies showing positive correlation between ESG and financial performance in 63% of them. But most studies use a broad set of sustainability factors and few have focused on issues that are financially material. One study by Harvard Business School showed that companies that focused on outperforming in material factors delivered a higher alpha to investors, highlighting the importance of arriving at company-specific sustainability topics for disclosure.
Source: SASB, Harvard Business School
While risk mitigation is often what comes to mind when people think of ESG, it is only one side of the story. Sustainability accounting is not just about playing defense, so to speak. It can also reveal opportunities for competitive advantage, from innovation of new products and services that are more sustainable or alternative growth avenues that tap into new markets comprised of consumers and businesses that care about sustainability. In fact, it is relevant for all stages of value creation at companies, as these examples demonstrate.
Investors’ growing emphasis on sustainability
Given the heightened importance of sustainability factors to company performance, it is only natural for them to become essential for sound investment decisions. Additionally, many of the world’s largest asset managers are considering using their voting power against directors if they found companies’ lacking in managing key ESG risks. The Big Three, BlackRock, SSGA, and Vanguard, have all said they are revising their approach to board accountability based on ESG factors through public statements.
Asset owner behavior, at both the retail and institutional levels, is also driving the adoption of sustainability in the investment world.
Like previous years, 2020 has seen a flood of money into ESG-linked investments. The value of global assets applying ESG data to investment decisions has more than tripled over the last eight years. This growth is likely going to expand because of generational shifts in asset ownership. In a survey by Bank of America, 78% of high net worth millennials reviewed their portfolios for ESG investments in 2019. The same survey revealed that the Gen X number was at 63%, up from 36% in 2013. Consequently, the much deeper pockets of Gen X investors are currently moving the needle more strongly in favor of ESG-linked portfolios and investment products. But as wealth is accumulated by the next generation of investors, all indications point to an even greater shift towards ESG-linked investment.
As key institutional asset owners, like endowments and pensions, incorporate ESG in decisions, they are driving transparency in the incorporation of ESG factors by managers and change what products managers offer. According to Callan Institute’s 2020 ESG Survey, 63% of endowments consider ESG in their investment process, up from 58% in 2019. Others, like public pension and corporate defined contribution plans have also seen increases in ESG incorporation.
Just as companies seek out patient capital, asset owners, both at individual and institutional levels, with ESG-linked strategies, are more likely to be long-term clients for investment managers
Regulators increasingly demanding robust sustainability reporting
The “pull” for sustainability information from stakeholders is accompanied by “push” from regulators.
In the corporate and investment world of the EU, ESG-related regulation has roughly the same weight as Brexit and MiFID II. Important among regulations, the Non-Financial Reporting Directive (NFRD) has been in operation since 2017. This directive requires large EU companies to disclose data on both the impact of ESG factors on their business and their own ESG impact on the environment and society. For example, relevant and material social factors, including those related to employees, human rights, anticorruption, bribery, and diversity, must be disclosed.
In the US, the Securities and Exchange Commission (SEC) has issued specific guidance on a handful of sustainability issues, most notably on climate change, in 2010. But comprehensive regulation is still being sought. The Investor Advisory Committee of the SEC has said that “the time has come” for this regulator to act on mandatory ESG disclosure requirements. With a Democrat-controlled SEC, ESG disclosures and regulation may become a greater priority.
A recent Commodity Futures Trading Commission report called for a coordinated effort by federal regulators, including the CFTC and SEC, to recognize, measure, and tackle the financial risks presented by climate change. Though legislative action would be needed to build the regulatory system, the call for a price on carbon emissions is unambiguous.
In addition to regulators, the World Federation of Exchanges (which includes NASDAQ and the NYSE) has engaged investors on the efficacy of sustainability disclosures. In 2017, the London Stock Exchange released a guide to ESG reporting aimed at high-quality reporting and effective communication around sustainability.
SASB is unique among the widely-accepted initiatives because of its laser-focus on the investment community and industry-specific reporting standards This allows companies to start their journey with an understanding of topics across E,S, and G that are financially material in the industry to which they belong.
While sustainability issues are increasingly recognized as financially material business issues, tailored sustainability stories with actionable information is uncommon. SASB reports that while 80% of the companies in the US disclose information on at least one SASB topic relevant to their industry, 40% of the disclosures are boilerplate, and only 18% have related metrics. This has led to a chicken and egg dilemma, where investors are unable to use sustainability factors in decisions and companies wonder if there is any ROI in gathering ESG data and disclosing it, if investors are not using it.
In the second part of this series we will dive into disclosures of financially material topics in regulatory filings and considerations around that. The third and final part will focus on SASB Standards and the using them to build your own credible and compelling integrated ESG story as an issuer.
Article by Sudarshan “Sudi” Setlur, a SASB-credentialed sustainability analyst and expert in using data and analytics to optimize investor relations and corporate governance programs with InspIR Group.
The InspIR Group can help you learn more about ESG reporting. Call or email us if you would like to discuss customized projects to initiate or advance your journey to develop best practices in ESG reporting.
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