Beyond ESG reporting disconnects between issuers and institutional investors
It may not feel like it, but we’re still in the early stages of the evolution of ESG reporting. It took at least half a century to get to a set of generally accepted accounting standards and those, of course, have continued to evolve. We expect the ESG reporting space, moving at capacity-straining speed, to complete its journey faster. Nonetheless, if ESG reporting were a baseball game, we’re probably at the bottom of the third inning.
Early-stage big ideas are ripe for misunderstandings and disconnects, and ESG reporting is undoubtedly a big, complex and contested idea. This is particularly so when passed through a mechanism as complex and intermediated as the capital markets. The main disconnects on ESG reporting have been disclosure and the engagement between issuers and institutional investors.
The core elements of these disconnects are well known. Issuers have expanded their reporting effort to address ESG themes, but institutional investors have consistently responded that the products of that effort are not decision-relevant, lack comparability and timeliness, are full of gaps, are often boilerplate in nature, lack rigor and often appear in a format not designed for use by an investor audience, even when numeric data is provided.
And yet progress is being made. ESG policy disclosures are steadily (albeit unevenly) being replaced with numeric data, goals and supporting narratives. Regulatory engagement aims to set a high minimum baseline for ESG disclosures. The height of that baseline and topics covered will vary across geographies. But the informational needs of institutional investors are not monolithic, as information is being used in different products and strategies, across equities and credit, and with different investment time horizons.
Given these disconnects and increasing demands, how can issuers adjust their operational processes and disclosure stance to meet the informational needs of sophisticated ESG investors? How can issuers tell a compelling value narrative to the capital markets that authentically builds in ESG themes?
Priority: To the uninitiated, ESG can seem to encompass everything – an amorphous cloud of issues. In fact, for investors, on an industry-by-industry basis, ESG issues can be narrowed down to a focused set of value-critical, financial drivers. The tool to strategically cleave off issues of low salience is materiality.
The ESG ecosystem has developed tools, such as the standards developed by SASB that provide a set of topics and metrics more likely to be material for companies within different industries. This can provide a high minimum baseline of smart disclosure. It can also help prepare companies for regulatory codification, as the existing ESG disclosure ecosystem has helped structure the emerging regulatory landscape.
Supplementing the focus provided by financial materiality, companies should also engage year-round with their largest investors on ESG and understand the two or three key data points those investors need to analyze and track performance.
Context: ESG data requires context to be useful, yet depth and context are often lacking in ESG data as currently disclosed. Disclosure can lack supporting data to understand trends or the scale of an initiative in the context of the overall business impacts.
For example, a sustainability topic as central as water illustrates that layers of data are required to enable investors to bring their insights to bear. A metric on overall water used alone is not particularly useful; it needs be contextualized with the amount of water consumed to derive an understanding of water use efficiency. To understand risks of disruption and sensitivity to climate impacts, derive location-specific data that demonstrates whether water is being used in areas of water stress. That type of contextualized data can help investors understand the capital exposed to risks of disruption.
Absent layered data, investors are left guessing. It is important for issuers to understand that for many investors, ESG reporting provides new sources of insight. To capitalize on those insights, ESG analysts are bringing deep industry knowledge and judgment to interpret the impact of ESG on prospects and performance over time.
Strategy: Surveys of corporate leaders are increasingly recognizing that ESG performance is a strategic opportunity. On an industry basis, sustainability strategies tend to converge around a narrow set of core practices. That may provide opportunities for differentiated strategic approaches on ESG-related initiatives, whether that’s product innovation, R&D or new product development.
As such, contextualized ESG data should be wrapped into strategy development and narrative. After all, ESG issues (though they can crystallize over the short term) are often investments that require a medium to long-term time horizon to fully pay off. Given that, ESG should be part of a company’s forward-looking story, with a clear tie to conventional business outlooks from financial value to competitive positioning and access to finance.
Data availability: ESG information has tended to be disclosed on websites and in sustainability reports. These lengthy reports, prepared with a diverse audience in mind, have often placed data in PDF formats, buried in lengthy paragraphs, with limited summaries and tables. That has begun to change with the advent of SASB indices and summary tables. Ultimately, however, for ease of use and practicality of analysis, ESG data should be accessible and machine-readable. For example, providing an Excel file rather than a PDF demonstrates that companies want and expect their data to be used and analyzed.
Engage the finance function: As ESG approaches become subject to regulation, ESG data points are expected to be part of process and controls architecture to enable their inclusion in regulatory filings. This practical requirement for process credibility is inducing a steady responsibility shift around ESG data. This may necessitate the deeper engagement of the finance function and general counsel with ESG data. Who better than those in the finance function to establish the policies, frameworks and process maps that consolidate a range of ESG data collection approaches into a structure with more certainty and rigor?
These strategic approaches provide companies with an opportunity to define and own their ESG narrative. The ESG ecosystem of ratings and rankings likely will generate opinions, many of which companies may not like. By providing strategic, financial-focused, contextualized and robust ESG data, companies can help meet the needs of their institutional investors and have more agency over market perception.
Brian Tomlinson is managing director of ESG at EY. The views reflected in this article are his and do not necessarily reflect the views of Ernst & Young or other members of the global EY organization