In recent years, investors, lenders, regulators, and other stakeholders have shown increased interest in Environmental, Social, and Governance (ESG) values and principles, as well as potential ESG risks and opportunities, which has translated into a strong desire for companies to provide more comprehensive and transparent ESG reporting and disclosure. As a result, many management teams that grew up in an environment focused on traditional finance and accounting concepts must now adapt and learn a whole new set of unfamiliar principles and metrics.
Many companies are several years into their ESG journeys. Such companies may routinely prepare and post sophisticated sustainability reports on their websites and provide extensive ESG-related disclosure in annual reports and/or other documents filed with the Securities and Exchange Commission (SEC). However, other companies just beginning that journey may find it challenging to navigate through new requirements, terminology, and metrics. For companies that are dealing with ESG for the first time, recent regulatory proposals, particularly those that would require financial statement disclosure, have increased management’s sense of urgency to tackle its learning curve. This summary is intended to provide an overview of the current ESG environment and help CFOs and their management teams begin this learning process.
THE BASICS
ESG is an abbreviation for Environmental, Social and Governance matters. Although the term is ubiquitous today, it was originally coined in a 2004 report issued by the United Nations, Who Cares Wins – Connecting Financial Markets to a Changing World.
Many topics fall under the broad ESG umbrella. In recent months there has been an increased focus on the “Environmental” component of ESG, which encompasses climate change, greenhouse gas emissions and ecological risks, and impacts. Environmental matters also include processes related to waste management, the development of sustainable products and packaging, energy management and efficiency considerations, and companies’ use of carbon offsets or other energy credits.
The “Social” component of ESG broadly addresses how entities interact with people, and includes areas such as diversity, equity and inclusion, labor management, employee welfare, community relations, and privacy and data security.
“Governance” covers matters such as leadership diversity, executive compensation, business ethics, and policies to combat bribery and corruption.
WHY YOU SHOULD CARE
Stakeholder Focus – People are Paying Attention
Based on recent heightened interest in ESG matters expressed by regulators, investors, and the general public, as well as the pace of new regulation, it is unlikely that interest in ESG reporting is going away. Many stakeholders already focus on companies’ ESG reporting; however, such reporting will likely become subject to even greater scrutiny in the future. Companies will need to adapt to this new environment, respond to stakeholders’ needs and comply with rules and regulations or possibly suffer reputational, economic, or regulatory consequences.
Existing Regulatory Requirements – Regulators Are Taking a Closer Look At Disclosures
Existing regulatory requirements in the United States and abroad may already require companies to provide some level of ESG disclosure. For example, in the United States, the SEC and its staff previously issued the 2010 Interpretive Release, Commission Guidance Regarding Disclosure Related to Climate Change, and the 2021 Sample Letter to Companies Regarding Climate Change Disclosure, and the SEC staff routinely issues comments to registrants regarding the adequacy of their ESG disclosure. The SEC’s Division of Enforcement also has a Climate and ESG Task Force that is focused on ESG disclosure. Although this guidance is targeted at public companies, other companies could potentially be affected if they intend to go public, are acquired by a public company or are an equity method investee of a public company.
Proposed or Pending Regulations – Additional Disclosure Requirements Are Coming
Regulators around the world have proposed to amplify existing disclosure requirements to respond to stakeholder and public policy demands for more consistent, comparable, decision-useful and reliable information about ESG matters. Highlights of these efforts and potential consequences for financial reporting include:
United States
- Climate-Related Disclosures Proposed Rule (Environmental)
The SEC’s proposed rule, The Enhancement and Standardization of Climate-Related Disclosures for Investors, may ultimately require disclosure of climate-related matters both within a registrant’s audited financial statements included in periodic filings and registration statements and in other areas of the filing outside of the financial statements. A final rule also may require disclosure of greenhouse gas emission information (including Scope 3 information for certain entities) and require attestation for reported Scope 1 and Scope 2 greenhouse gas emissions.
- Cybersecurity Proposed Rule (Social/Governance)
The SEC’s proposed rule, Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure, would require timely and transparent disclosure of material cybersecurity incidents. Under the proposal, registrants must report material cybersecurity incidents in a Form 8-K filing within four business days of the incident and disclose any material updates in subsequent Form 10-Q and/or Form 10-K filings. Additional disclosures about (1) cybersecurity monitoring and risk management policies and procedures, (2) management’s role in implementation, and (3) governance (including the extent of oversight by the board of directors) would be required.
- Pay Versus Performance Final Rule (Governance)
Under the SEC’s final rule, Pay Versus Performance, most registrants will need to disclose specified compensation and financial performance measures in proxy and information statements to provide investors with information that links the compensation of named executive officers to company and peer group performance.
- Listing Standards for Recovery of Erroneously Awarded Compensation Final Rule (Governance)
The SEC issued a final rule, Listing Standards for Recovery of Erroneously Awarded Compensation, that would require national securities exchanges/listing associations to establish standards that require each listed issuer to develop, implement and disclose a compensation recovery policy (a “clawback policy”) to recover incentive-based compensation paid to current or former executive officers based on any misstated financial reporting measure and provide certain compensation recovery policy disclosures. The recoverable amount is the difference between incentive-based compensation actually received and compensation computed using the restated financial measures, subject to limited impracticability exceptions, and applies to the three-year period preceding the restatement. Noncompliance with the clawback policy could result in delisting.
International
- Existing Regulatory Requirements
Directive 2014/95/EU, otherwise called the Non-Financial Reporting Directive (NFRD), governs disclosure of non-financial and diversity information for certain large companies under the jurisdiction of the European Commission, specifically those with more than 500 employees.
- Corporate Sustainability Reporting Directive (CSRD) Proposal
As noted, on the European Commission website the CSRD, as proposed:
- “Extends the scope [of existing reporting requirements] to all large companies and all companies listed on [European] regulated markets (except listed micro-enterprises);
- Requires the audit (assurance) of reported information;
- Introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards;
- Requires companies to digitally ‘tag’ the reported information, so it is machine-readable and feeds into the European single access point envisaged in the capital markets union action plan.”
Other Drivers of ESG Reporting
Even absent a regulatory requirement, many companies would feel compelled to report ESG information because of increasing demands from the public and other stakeholders for information that enables assessment of a company’s commitment to ESG principles and values and its management of ESG risks and opportunities.
For example, the SEC’s Climate-Related Proposed Rule notes that:
“Several major institutional investors, which collectively have trillions of dollars in investments under management, have demanded climate-related information from the companies in which they invest because of their assessment of climate change as a risk to their portfolios, and to investments generally, and also to satisfy investor interest in investments that are considered ‘sustainable.’ As a result, these investors have sought to include and consider climate risk as part of their investment selection process. [footnote omitted] These institutional investors have formed investor initiatives to collectively urge companies to provide better information about the impact that climate change has had or is likely to have on their businesses, and to urge governments and companies to take steps to reduce investors’ exposure to climate risks.”
Other potential drivers of ESG disclosure include, but are not limited to:
- Multiple agencies such as Bloomberg, S&P, and ISS assign ESG scores or ratings to companies. Institutional and retail investors, other capital providers, shareholders, and other stakeholders may factor such ratings into their investment analysis and decision-making. Companies want to avoid comparing unfavorably with their competitors. Also, as alluded to in the above excerpt from the SEC proposal, a poor ESG rating could even potentially affect a company’s ability to obtain capital or attract investment from outside parties.
- Many institutional investors have established ESG-focused funds to appeal to certain investors, and a company’s poor ESG score may prevent such funds from investing in the company.
- Certain financial institutions may factor perceptions about a company’s approach to managing ESG risks and opportunities into the determination of whether to extend credit to that company.
- Other companies may be striving to meet publicly reported greenhouse gas emission reduction targets or other ESG goals. To meet their stated goals, companies may need to (1) consider and measure how effectively suppliers, customers, and other business partners manage ESG-related challenges and (2) reduce their level of interaction with companies that have poor ESG ratings.
- A poor ESG rating or perception of how a company manages ESG risks may make a company less attractive as a merger candidate/acquisition target to companies that operate in jurisdictions subject to ESG regulation.
- A subsidiary or investee of a company that operates in a jurisdiction that requires ESG compliance or disclosure may find itself subject to such requirements.
CFGI – How We Can Help
CFGI is an established leader in accounting advisory, business transformation, and risk advisory services and provides technical accounting and operational finance expertise to clients. Our firm was built by dedicated professionals who are innovative and passionate experts in their field. We work alongside our clients to solve their most complex and critical issues. Implementing an ESG reporting process affects many elements of a company’s financial reporting process, and CFGI professionals have the skill sets to help you meet these challenges.
Contact us if you would like to learn more about how CFGI can help you navigate the challenges of ESG reporting.