The Taiwan Banker

The Taiwan Banker

Closing The Gap: In Pursuit Of Meaningful Sustainability Reporting

Closing

2020.03 The Taiwan Banker NO.123 / By Olga Rakhmanina

Closing The Gap: In Pursuit Of Meaningful Sustainability ReportingBankers Digest
As the world is experiencing unprecedented challenges created by climate change, industrial pollution and global inequalities, investors are under pressure to shift their funds towards more sustainable business activities that could offer solutions to the impending crisis. Challenges, however, persist in the field of corporate disclosure due to flawed data and deficient comparisons which hinder the potential of sustainability investments. This is now firmly on the agenda of both policymakers and regulators who look to adjust disclosure regimes in an effort to promote more responsible growth. Gone are the days when profit-making as a sole reason for corporate existence was socially acceptable. Instead, investors, consumers and regulators are increasingly demanding that businesses are run sustainably in pursuit of what some have termed ‘inclusive capitalism’. Firms are expected to consider long-term impact of their strategy and operations in the context of broader society and environment, rather than just chase financial returns in the sole interest of shareholders. On closer look, this makes perfect sense. Companies which damage the environment or generate social problems will be affected by the consequences just like the rest of us. Polluted ecosystems, climate change, a detached workforce and skeptical consumers are not exactly the right ingredients for a successful and profitable business. Activists are also insistent that as companies rely on social resources, such as an educated workforce and public infrastructure, they have undisputable responsibility to consider their impact on these shared assets. The Irresistible Rise of Long-TermismAs a result, investments which consider environmental, social and governance (ESG) factors have been rising to prominence in the last few years. A significant body of data now exists to confirm that companies which integrate these factors in their business activities do better financially. A widely quoted report by DWS, an asset management firm, found ‘a highly significant, positive, robust, and bilateral’ correlation between ESG and corporate financial performance (CFP) . This creates a virtuous circle effect: As the investment community shows more commitment to funding sustainable projects, businesses embrace sustainable practices in a bid to maintain or enhance their investment appeal. According to the Global Sustainable Investment Alliance, a platform which brings together sustainable investment organisations from around the world, sustainable investments worldwide reached US$30.7 trillion in early 2018, a 34% increase from 2016. Europe and the United States are clear leaders by the size of investments, but Japan, Australia, New Zealand and Canada demonstrate the highest growth rate . Bain & Co, a consultancy, has recently reported that Asian markets are increasing investments in businesses that seek to address environmental and social problems, with sustainable investments rising 60% to US$3.2 billion in the first half of 2019 .The pressure to change comes from all quarters, including investors, employees, suppliers and consumers. Millennials are widely viewed as the main driving force behind this evolution of expectations, and as they come to inherit the previous generation’s wealth, their calls for sustainability become ‘business as usual’. Asset managers now see ESG considerations as part of their fiduciary duty to act in the clients’ best interests.Public disclosure plays a key role in this transformation as it supports operational transparency and helps investors hold companies to account. In his recent letter to CEOs, Larry Fink, Chairman of the world’s largest asset management firm BlackRock, wrote that the fund will be increasingly voting against management and board directors where there is insufficient progress on sustainability-related disclosures and underlying business practices .Universal Push For DisclosurePolicymakers and rule setters increasingly recognise the important role that non-financial disclosure can play as they are looking for tools to move funding flows away from environmentally and socially damaging activities. But as the report by East & Partners, a research and analysis firm, published in 2018 suggests, the majority of investors and issuers around the world do not even go as far as disclosing their ESG policies, which increasingly makes regulation a tool of choice in the push to promote more transparency . The European Union is now operating a non-financial disclosure regime that requires certain companies, including listed firms and banks, to publish reports on policies they implement in relation to environmental, social, employment, diversity and other issues. Most importantly, it mandated disclosure to include information on the outcome of implementing such policies . Although adopted prior to the launch of the EU’s Action Plan for Financing Sustainable Growth in March 2018, the legislation is largely viewed as one of the supporting pillars of the region’s ambition for more responsible investment . Taiwan is reputed to be the first market in Asia-Pacific to mandate ESG reporting and its market disclosure efforts have won international praise. Introduced in 2015 for listed firms operating in specified sectors, including financial services, it was recognised by the biennial Corporate Governance Watch report in 2018 as one of the most extensive ESG reporting regimes . Unlike other jurisdictions, the Taiwan Stock Exchange specifically requires issuers to follow the GRI Sustainability Reporting Standards. In Singapore, listed firms are required to produce annual sustainability reports on a ‘comply or explain’ basis. The Singapore Exchange believes that disclosure helpfully complements financial reporting which by its nature captures information about the past performance, whilst sustainability data provide insight into the company’s future prospects . Others point out that this is a good opportunity for firms to review their business practices and encourage more responsible behaviour. Listed firms in Hong Kong are also experiencing increasing requirements in sustainability disclosure with the most recent enhancements to the reporting regime issued in December 2019 . A Way To GoDespite this enthusiastic rulemaking activity, investors remain unconvinced. In a survey conducted by McKinsey & Company in early 2019, investors expressed concern that they are unable to use corporate sustainability disclosures to reliably inform their investment decisions. The report by DWS struck a similar note of caution: ESG disclosure and audits demonstrate significantly weaker correlation with CFP than other aspects, such as corporate reputation and operational efficiency . The key culprit behind this skepticism is the wide range of reporting standards currently available in corporate disclosure, which – according to both issuers and investors – leads to inconsistency and incomparability of information. As the International Organisation of Securities Commissions notes, individual jurisdictions design local disclosure rules in the context of their own legal and regulatory regimes, which results in a great deal of variability in disclosure content. Furthermore, some countries operate voluntary reporting regimes, whilst others mandate disclosure with the ‘comply-or-explain’ approach sitting somewhere in the middle . It is not surprising that investors would like to see less variety in the standards to promote more consistency in the field. At least 67% of respondents in McKinsey’s survey said that they would prefer to see a single reporting standard. In their view, this should bring efficiencies to the analysis as decision-makers spend less time and resource in an attempt to make data more meaningful. More uniformity should help minimise ‘greenwashing’ practices where companies seek to create a more favourable picture of their business and its products while leaving out some less appealing details.Linked to this concern is investors’ call for ESG reports to be independently audited to boost their trustworthiness. Without third-party sign-off, disclosure is largely viewed as a biased opinion or a self-promotion opportunity; investors that this information is designed to impress learn to ignore it in the absence of an independent opinion. In Singapore, for example, audits are encouraged but remain voluntary . However, companies which get their sustainability record independently verified stand to benefit significantly as investment markets reward them with more deals. Issuers too are hoping for greater consistency in reporting standards. Differences in definitions and approaches to establishing materiality (which in many countries serves as a trigger for reporting information) hinder companies’ disclosure efforts. Less variability should reduce the number of one-off enquiries from investors, which boards often complain about as they frequently involve recycling the same information for a different format. Transparency and comparability should also attract more investment to sustainable companies and projects as investors get support to make quicker decisions.The existing inconsistency in reporting obligations also affects the reliability of rankings given to companies by rating agencies and third party service providers. The Economist has recently pointed out that firms’ sustainability credentials depend very much on which rating firm is consulted as analysts struggle to work with incomplete or out-of-date data producing some surprising results along the way. As the newspaper pointed out, Tesla, a famous electric car maker, gets a worse rating than companies producing conventional petrol-reliant models . Recent discussions in the UK led by the Financial Conduct Authority have also highlighted that lack of transparency around rating methodologies compounds matters with the industry calling for more insight into how ratings are determined . The EU has shown interest in the issue too and has recently announced a study of the industry to develop tools for improving the quality of sustainability ratings . Meanwhile, Steven Maijoor, Chairman of the European Securities and Markets Authority, went as far as calling for rating agencies to be regulated by public sector authorities .Europe Leads The WayAs a result, policymakers are shifting their focus towards making disclosure more meaningful and user-friendly. In his address at the last year’s event on sustainability reporting, Tan Boon Gin, Chief Executive of Singapore Exchange Regulation, promised more engagement with investors to understand how to make data more useful for them amid concerns that current reporting requirements allow for too much flexibility . This is no easy task, however, as issuers caution against overly burdensome disclosure requirements which may, at best, provide information useless for investors or, at worst, inadvertently release commercially sensitive details. Since the launch of its Action Plan for Financing Sustainable Growth, Europe has seen a flurry of legislative proposals aimed at promoting responsible investments through standardisation of ESG investment practices. Valdis Dombrovskis, the European Commission’s Executive Vice-President with the financial services portfolio, recently said that Europe will need up to €290 billion in additional yearly investments if the region is to meet targets agreed under Paris climate accord . Contributions from the private sector are essential to reach these numbers and effective disclosure mechanisms are seen as key to bringing investors on board.A key milestone in this task was last year’s adoption of regulation on sustainability-related disclosures in the financial services sector, paving the way for a fundamental reform of the EU’s reporting practices . Its core ambition is to harmonise rules on how financial firms integrate ESG risks in their investment advice and decision-making. Asset managers and institutional investors will be required to provide information about ‘principal adverse impacts’ that investments have on sustainability as well as the impact that ESG elements have on the investments’ financial returns. Interestingly, in a bid to align corporate aspirations with management practices, firms are also obliged to disclose how their remuneration policies are consistent with the integration of sustainability risks. Additional disclosure requirements on institutional investors and asset managers are widely expected to encourage issuers to publish more meaningful information on their sustainability practices as they seek to comply with information requests from their investors. Policymakers are not convinced, however, that this is enough as the debate keeps reverting back to the question of consistent reporting standards. The European Commission has therefore committed to review its non-financial reporting requirements to make disclosure more reliable. Most significantly, it is now looking to support the development of the European-wide non-financial reporting standards to eliminate the current inconsistencies and, consequently, reduce associated costs to businesses . There is little doubt that a significant shift in sustainable reporting has already occurred but a lot remains to be done if policymakers are to achieve their desired destination of effective corporate transparency on ESG matters that supports sustainable growth.