Analyst Perspectives

Environmental, social and governance reporting by public corporations has become a top-of-mind issue for senior executives and boards of directors as countries increasingly consider or mandate its implementation in some form. The fundamental rationale for ESG reporting is rooted in the inability of purely financial measures to capture externalities (such as greenhouse gas emissions) or provide metrics that enable an objective assessment of management’s ability to properly determine trade-offs between short-term results and long-term sustainability. And, while in the United States the Sarbanes-Oxley Act mandates that auditors assess governance, the focus of this assessment is on preventing financial fraud as opposed to broader objectives that may be important to the functioning of the company as a sustainable entity.

While it is impossible to overlook the political nature of the topic of ESG reporting, which ultimately will determine whether and to what extent it is required by law or regulation, what matters most to company executives is their organization’s ability to comply with the outcome and minimize the risks associate with a novel reporting scheme. The challenge lies in the distance between the conceptual objectives of ESG and how such reporting mandates are implemented. Companies are facing fundamental questions, such as:

• Is a standard objectively measurable, and if so, how? How will that data be collected and by whom?
• How broadly can that standard be interpreted?
• To what degree can the interpretation of that standard be assessed for consistency?
• Does the measure lend itself to cross-checking for verification?
• Does the standard promote the objectives of the entity being measured?

These questions aren’t unique. They apply equally to accounting standards, which have been around either in practice or formal regulation for centuries. By contrast, sustainability has no mooring in time-tested, objective measures that have shown relevance and an ability to achieve their objectives.

The daunting challenge of compliance is apparent to those responsible for delivering results, but probably not to those who are unfamiliar with the difficulties associated with the relatively straightforward task of financial reporting. Nor is the track record of regulation in novel areas all that comforting for those responsible for compliance. History shows a tendency to write broad laws with pages of regulation that are then adjudicated in hindsight with after-the-fact requirements. In light of this experience, the objective of the corporation’s chief legal officer, chief financial officer and CEO must be to comply fully with regulations as they are written, revised and interpreted, while not diminishing the company’s strategic capabilities and while minimizing the cost of compliance. To do so, they must devise a process that is legally defensible and commercially viable. It starts with a recognition that this is not the job of public relations or marketing. It is the responsibility of the finance organization – specifically the financial planning and analysis group. By 2025, more than one-half of corporations required to comply with environmental, social and governance reporting will centralize responsibility for preparing related reports and filings with financial planning and analysis groups to achieve accuracy, control and efficiency objectives.

ESG reporting is similar in form and function to external financial reporting, so the process and analytical skills required are also similar and already present in FP&A. Understanding what data is required and how to work with it is well suited to FP&A’s competence and mission. FP&A also works with the corporate reporting group in creating external filings and financial statements. I assert that by 2025, FP&A organizations will be responsible for managing ESG data collection and analysis in two-thirds of public companies.

As much as practicable, executives should future-proof ESG compliance processes because of the uncertainty over how the adequacy of the disclosures will be assessed in hindsight. Collective experience over the past decades with a range of difficult compliance challenges (including the Sarbanes-Oxley Act) points to the need for a documented affirmative approach (showing evidence of serious intent and effort), that is frequently reviewed for efficacy and benchmarked against what other corporations are doing.

ESG reports must be reviewed and approved and, as with any other compliance requirement, companies must be able to demonstrate that it took affirmative steps to ensure the reliability and accuracy of its filings. This translates into the need for defined and controlled workflows that manage the process. ESG reporting also poses a data challenge that is similar to meeting other regulatory filing requirements. The quantitative information as well as declarations and documents necessary for these sorts of disclosures is dispersed in multiple systems. A data aggregation device is one effective approach to creating a data store designed for use by businesspeople – especially analysts – in a defined business process or set of processes. The data and analyses will be part of regulatory filings, so the data and data handling must be able to support a range of publishing capabilities that span simple paper documents to complex composite reports that incorporate text containing data, tables, charts and other illustrations.

ESG mandates will challenge companies on many fronts, but by using available technology and data management software, reporting should not be one of them. Technology can manage processes, assemble and retain documentation, assure efficient and accurate data collection and streamline reporting. By centralizing the data collection analysis and reporting in the FP&A group companies can take advantage of their analytical skills and potentially use existing applications to handle the task. I recommend that — if not already underway — senior executives and FP&A groups should begin investigating how to comply with mandates as they are applied.

Regards,

Robert Kugel