George Briford
George Briford (Associate Research Director, IDC Financial Insights)

The old truth that “what gets measured is what gets managed” is still valid when considering disclosure and reporting requirements related to environmental, social, and governance (ESG) topics. The problem starts when you want to compare how various financial entities stand against each other. ESG indicators seldom have the same definitions and to make e.g. an investment or credit decision of the financial entity itself is thus impossible yielding a comparison useless.

There is also another aspect of the issue. Financial entities provide credit or equity to a large number of clients and therefore need to get the right and consistent tools to manage the ESG risk of their own borrowers.

ESG reporting is facing a number of challenges in many areas of the value chain, starting with data gathering and ending with interpretation. We will explore just a few of these hurdles below.

Lack of Consistency of Measures

Assume that you are an asset manager interested in assessing if Bank A is doing better than Bank B in terms of its ESG engagement. Many banks currently report on their ESG performance but the banks and other financial entities often report on different topics, use different accounting metrics and apply a different unit of measure. Another complication is that there is a plethora of regulations, which often overlap. The ESG domain also tackles a number of types of risks that have not been under scrutiny earlier. It is therefore paramount that these risks are identified and most importantly quantified in meaningful metrics to enable financial entities to steer and mitigate them. On top of this, disclosures can be both mandatory and non-mandatory.

This makes it difficult if not impossible to compare and make rational investment decisions. And it is not only about making investment decisions — it is also about making sure that the disclosures can be used for other types of assessments, such as credit granting to the financial institution, reviewing how sustainability is dealt with by job seekers and whether the financial entity is eligible for any types of state subsidies if relevant.

Given that, it is obvious that a major ESG reporting challenge is the lack of consistency. Every bank and financial company uses different measures for performance on ESG issues or focus on different types of exposure. On top of this, we should not expect a single vision or interpretation of sustainability even within a single subindustry such as banking. But investors and other stakeholders will still need to use a set of standardised metrics as a starting point for their analysis.

Financial accounting disclosures are also subject to international and regional standards and principles, but with the major difference that their interpretation is relatively standardised in comparison to ESG standards.

Irrespective of disclosure requirements, all stakeholders have different goals that are even more difficult to meet in the case of ESG reporting. Corporate leaders want measures that are easy to understand and avoid litigation. Data processors in the financial entities want simpler reporting processes to do their jobs in a trustworthy manner. Stakeholders want standardised data to support their decision making.

Data Accessibility and Quality

Another problem is that primary ESG data must be accessible and verified. This problem again has several layers. Imagine that a banking institution finances a dam through project finance or a non-recourse financial structure and one of the indicators or covenants that the bank monitors is the amount of CO2-free concrete. Obviously, the data must come from a trusted data supplier and must be independently verified and therefore reliable. Another criterium is that the data must be standardised to avoid confusion. Standardisation will enable the financial entities to cut their costs when assessing the various ESG risk of their clients.

Need for Consolidation of Reporting Requirements and Disclosures Framework for European Financial Entities

European financial organisations are subject to an excessive amount of sustainability requirements. Some of these are mandatory, imposed by regulatory authorities, whereas others are voluntary and proposed by various industry associations. EFRAG, a private association established with the encouragement of the European Commission to provide technical advice on EU Sustainability Reporting Standards, counted in a 2021 report that there are around 70 ESG KPIs that banks should be reporting on across three core legislative measures in the EU. This includes the NFRD (the Non-Financial Reporting Directive), the SFDR (the guidelines of the Task Force on Climate-Related Financial Disclosures) and Taxonomy (the Taxonomy Regulation). Some of these overlap and organisations should take this into account to align the TCFD (Task Force on Climate-Related Financial Disclosures — a supranational financial services regulator) and NFRD legislations.

In addition to these mandatory frameworks, there are a number of major non-mandatory bodies with the intention to provide best practices:

  • The IFRS Foundation, which sets financial reporting standards, published a consultation on establishing the International Sustainability Standards Board (ISSB). The intention is to establish a sister board alongside the existing IASB (International Accounting Standards Board), which sets financial reporting standards.
  • Global Reporting Initiative (GRI) Sustainability Reporting Standards, which aims to provide best practice for reporting publicly on a range of economic, environmental and social impacts and risks related to sustainable development.
  • Sustainability Accounting Standards Board (SASB) Standards, which are industry-specific standards that set out a minimal set of sustainability topics and associated accounting metrics.

Recommendations

Lack of consistency is why generally accepted ESG accounting standards should come into play. ESG-related reporting frameworks and standards are necessary but are currently not sufficient to create the market infrastructure that will improve the comparability, availability and usefulness of corporate disclosure.

One solution to the consistency issue is to have a worldwide organisation that can be trusted to provide rules and guidelines to develop a shared and common understanding of how to account for (non-financial) ESG measures, which are essential to make well informed and consistent long-term investment decisions. There are a few global initiatives and the time to come will tell how many in reality “global” measures will prevail. Irrespective of the hurdles, promoting global standards for sustainability reporting is the right way to go.

ESG and sustainability topics will be high on the agenda at IDC’s annual Financial Services Summit in November 2022. Join us at the event to learn how financial entities approach the sustainability challenge.

 

For more information, please contact George Briford or head over to https://www.idc.com/eu and drop your details in the form on the top right.

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