After 10 or 15 years in which environmental disclosures were first encouraged, then advised, and then demanded, and debated, and debated again, sustainability reports are now on the verge of becoming legally required. Stephen Ferguson of The Hackett Group reports.
Until recently, the opinion among the 150+ large global companies we work with was divided between proactive and reactive camps – those who believe it is essential to get ahead of this, and those who hoped that the regulators’ mandates would get watered down, delayed, or go away.
Now we can see strong evidence that the times are changing as finance functions face the reality that this new category of reports will soon be mandatory. Within one to three years, we expect most global companies will be required to file environmental, social and governance (ESG) reports that include auditable data, beginning with greenhouse gas emissions and eventually incorporating other social and governance themes, too.
An accelerated pace
Although there have been signs for years now that mandatory emissions reports were on the way, the pace seems to be accelerating. Both the European Union and the U.S. Securities and Exchange Commission (SEC) have moved closer to firming up the precise requirements. There is a broad global coalition of support formed. The recent announcement by Nigeria that it would commit to the adoption of the International Sustainability Standards Board (ISSB) Disclosure Standards is indicative of support coming from Africa and the so called “Global South,” so progress is clearly being made beyond the G20 nations. There is intent to have interoperability, and there is mature dialogue going on between the different standard-setting bodies. It is also reassuring to hear them acknowledge that companies and countries are going to need time to build capability and competency. It will thus be an initial phase of limited assurance audit and safe harbour provisions, and an allowance will be made for companies to scale up. While it won’t be a cliff edge, it will ratchet up in a relatively short time frame if we compare it to a traditional accounting standard, so there will not be time for a wait-and-see approach
Already, in the more progressive multinationals, the finance functions are making the right moves to operationalise the enterprise response to handle the new requirements, with many having already appointed or recruited global process owners to lead the change. For the proactive global companies, they recognise this is a whole new dimension of accounting and reporting to manage. It is imperative that finance take over the job from the often exhausted company’s first responder ESG swat teams because it seems natural that regional or global hubs are the right place to build out the teams required. As Michael Tovey, the former corporate controller of Bank of America and the bank’s current ESG controller, recently told the Financial Times, “No company can afford to have a material misstatement in any of its reporting – be it financial reporting or ESG reporting.”
There is real risk here of a scandal in the future if a publicly listed organisation is seen as playing games on ESG. We have seen fragments of that with very recent negative coverage of a leading energy company’s failure to alert the world to what they knew 40-50 years ago about emissions impact on the climate. The mood of investors, consumers and employees seems to have shifted a lot. We can also draw parallels with the vehicle emissions scandal that had a major impact on a large European automotive manufacturer. The X-ray is coming, and don’t be naïve to think it won’t find anything malignant lurking inside a living and breathing global company. Instead, wake up and address what Mark Carney UN Special Envoy for Climate Action called ‘the tragedy of the horizon’– the long term is no longer something to pay lip service to as this time, and this tide will wait for no one.
Where to begin
The question is: Are you ready?
Although many companies have made great strides in understanding their environmental impact in recent years, chances are that most still have significant work to do. If you’re like most finance leaders, you will know a whole lot more about, say, the concept of accruals accounting than estimating emissions in the upstream and downstream supply chain as prescribed by the Greenhouse Gas Protocol, and it’s probably been a while since your last chemistry class. Where should you begin?
Find experts. If you have internal expertise, particularly on emissions, get to know those people. If you need to bring in outside expertise, hire it now, before demand for the right people gets even hotter. Approach this task with the same seriousness as you would any other mandatory filing. If you’re challenged, remind your colleagues that soon the finance function will be just as legally accountable for ESG numbers as any other numbers in your annual report.
Educate the organisation. Make sure finance becomes very familiar with the Task Force for Climate-Related Disclosures, the Climate Disclosure Project questionnaires, the Global Reporting Initiative and Sustainability Accounting Standards Board standards, and the Greenhouse Gas Protocol and other relevant organisations. Don’t be surprised if you have to spend a few nights burning the midnight oil reading another voluminous tomb or two because the thinking is as broad as it is deep. In addition to understanding these important foundations, make sure you properly review and interpret the draft standards that have been published by the International Sustainability Standards Board, European Financial Reporting Advisory Group (EFRAG) and other leading jurisdictions, and reflect on the guidance from the SEC if you are subject to their scrutiny.
Follow the debate. It is fair to say the ball is still in play. While ESG reporting rules are in the consultation, deliberation or ratification phases, they are very close to final and very well substantiated. There’s no real indication at this stage that there will be any backtracking, although we wouldn’t rule out some robust legal challenges in certain jurisdictions. The SEC is accepting comments on its draft rules in a delayed and extended consultation phase. There are some robust discussions going on, and there does seem to be pushback coming from some U.S. companies. It will be interesting to see how it plays out. In November of last year, EFRAG – the EU’s standard-setting body – released 12 standards that go into nonclimate-focused areas like biodiversity, water and marine resources, and workers in the value chain. These are due to become delegated acts in June. The overarching EU Corporate Social Reporting Directive that will come into force with these standards is not just for EU-headquartered companies but also any business that generates significant revenue in any of the member states of the European Union. So large U.S. multinationals would be well-advised to pay attention and not miss the implications of that. The Inflation Reduction Act is going forward, and the Democrats performed better than predicted by many in the recent midterm election, so the U.S. still seems on board under the Biden administration.
File, but don’t forget there is much more to this. As with other financial statements, your firm’s ESG reports need to reflect both your present reality and actual future goals. ESG concerns will need to be embedded in your strategy, featured in strategic and operational planning, and brought to life in new processes like carbon budgeting or carbon pricing and via extension of core accounting and analytical processes, including risk management, incentive-setting and performance management. The act of measurement and public reporting of progress will likely shine a light on areas where organisations are lagging behind the public targets that they have set. This can cause reputational damage, so there must be a comprehensive focus on moving the needle via true behaviour change in the organisation.
ESG accounting and reporting needs to become routine and not a one-off annual event at the group level. It needs to be made operational in every country and consolidated up to group level and ready for audit scrutiny at both levels. It needs to be delivered by accountants who are advised by ESG experts, and it should be taken off the existing task-focused swat team. Within a decade, it will all just feel like normal financial accounting, and the annual report will provide reporting that supports multiple stakeholders, with Milton Friedman’s famous doctrine seeming to fade from view. This year is going to be a big one for ESG. Don’t be late, make sure your organisation is taking the right steps to be ready and don’t underestimate the effort. There is a lot of work to do, but it can be really rewarding and interesting so make the drive toward net zero a net positive and embrace the change.
Stephen Ferguson is the director of The Hackett Group’s Account-to-Report Advisory Program in Europe, an advisory service that serves a network of 150 major companies.