ESG Disclosure: Capturing The Zeitgeist of EU Capital Markets
In our latest Roundtable blog, Denis Clancy considers recent developments in corporate environmental, social, and governance practices. This critical analysis examines the lack of common ESG reporting standards across rating providers, proposals for a global baseline of sustainability disclosure standards, and the fragmented landscape of voluntary and mandatory non-financial reporting schemes within the European Union.
According to Milton Friedman, the primary objective of a company is the maximisation of shareholder returns. Pursuant to this shareholder primacy model, which has been dominant for decades, environmental, social governance (ESG) considerations are not regarded as relevant to corporations. ESG responsibilities are not just viewed as having negligible incidence on financial performance, but are often regarded as a burden on profits. However, over the last two decades or so, robust ESG practices have been increasingly shown to have positive impacts for companies – not just for their profitability, but also their long-term viability. This has triggered a paradigm shift in financial markets as investors realise that financial and non-financial considerations are increasingly intertwined.
Formalised ESG practices are now becoming a commercial imperative for many companies today. Sovereign wealth funds and pension funds in countries such as France, Sweden and the UK, are requiring corporations to disclose ESG-related information. Moreover, funds have been moving speedily into the ESG sector in recent years – in the US, net flows into ESG funds of $51 billion in 2020 were nearly 10 times more than in 2018. This trend is poised to continue as a report by financial technology company Broadridge indicates that global ESG assets could tip $30 trillion by 2030, up from the $7.8 trillion today.
Why are Companies Disclosing ESG Performance?
One issue emerging from this new ESG landscape for Irish firms is the disclosure of ESG performance. Whereas corporate social responsibility (CSR) can be regarded as a more overarching attitude toward sustainable business, ESG focuses on specific and measurable metrics which provide an ESG rating. In this sense, ESG performance provides a data-driven assessment of whether the firm’s CSR objectives are being met in practice.
It is well established that corporate ESG adoption can help with risk management. Recent research indicates that highly sustainable companies have relatively low downside risks and are more resilient to market volatility. Hoepner and others found that good ESG practices reduce firms’ downside risk, while Ilhan and others suggest that companies with poor ESG processes due to high carbon emissions have higher tail risk. Studying the global financial crisis, Cornett found that firms with high ESG ratings outperformed those with lower scores.
Corporate risk mitigation can translate to investors the enhanced ability to manage investment risk which, in turn, can open the equity capital taps for sustainable companies. For instance, the disclosure of ESG performance is being used by cross-listed firms – companies with equity shares listed on one or more foreign exchanges, in addition to their home market – to reduce the capital market liability of foreignness (CMLOF). CMLOF, a concept developed by Bell and others, explains that foreign corporations are at a disadvantage to domestic companies when accessing capital. However, empirical research shows that cross-listed companies tend to disclose more ESG data as an indication of quality and stability to investors in foreign markets: ‘[b]y disclosing a greater quantity of ESG data … cross-listed firms can alleviate the adverse effect of CMLOF when they issue equities outside their home country.’
And the ease of accessing capital is not unique to equity markets. Attig and others have suggested that firms with good social performance benefit from high ratings provided by credit rating agencies. Similarly, both Devalle and others and Weber and others have found that corporations with good environmental and sustainability records are benefiting from high credit rating scores. Indeed, the big three credit rating agencies (Moody's, Fitch, S&P) have now begun including ESG performance in their ratings.
ESG Standards: Navigating the Murky Waters
Unlike credit ratings, ESG measurement is somewhat nebulous given the lack of a common definition and reporting standards across rating providers. Windolph identifies six factors which explain the lack of objectivity in ESG ratings: lack of standardisation; trade-offs; bias; poor credibility of information; lack of independence; and lack of transparency. Furthermore, the external environment in which companies operate is a rapidly changing one, and so, the assessment criteria are constantly evolving.
This issue drew some attention at COP26 where the International Financial Reporting Standards Foundation announced the establishment of the International Sustainability Standards Board (ISSB). It is estimated that there are over 600 ESG reporting standards globally, and the role of the ISSB is to set a baseline and increase harmonisation between them.This should go some way in facilitating the adoption of more standardised ESG benchmarks.
In March 2022, the ISSB published two exposure drafts detailing proposed Sustainability Disclosure Standards. The proposed standards are intended to provide a global baseline of sustainability disclosures to meet the information requirements of investors by requiring firms to report on all relevant sustainability-related opportunities and risks and not exclusively on climate matters. Significantly, the framework requires that sustainability reporting be a component of the company’s financial statements and released at the same time, suggesting a belief on the part of the ISSB that non-financial reporting be placed on an equal (or at least relative) footing with financial reporting.
The Regulation of Non-Financial Reporting
The Companies Act 2014 requires directors of all companies to prepare financial statements and reports and lay them before the company’s shareholders at the AGM. Listed companies also have obligations to make financial statements publicly available. Additionally, Irish companies must comply with an increasing number of regulations, particularly at the EU level, governing the regulation of non-financial reporting – a form of reporting where businesses disclose information not related to their finances, including on human rights, anti-corruption, and environmental and social impact.
There is a fragmentation of voluntary and mandatory non-financial reporting schemes to be considered. However, these frameworks exist to facilitate the flow of information to end investors and ‘not to regulators to support any form of supervisory intervention in the market’. Below is a flavour of some of the regulatory frameworks governing non-financial disclosure.
Sustainable Finance Disclosure Regulation
The SFDR was enacted to address the ‘twin objectives’ of increasing transparency of sustainability disclosures and increasing comparability of disclosures for end investors. Pursuant to the Regulation, asset managers, insurers and pension funds operating in the EU are required to disclose how they consider sustainability risk in their investment decisions. If it is not taken into account in investment decisions, this must be disclosed along with an accompanying statement explaining why not. The information is to be disclosed on the firm’s website and in their fund documentation, and must identify where exactly the ESG risks are in their investment portfolio. The rationale for the regime is to prevent the practice known as greenwashing, whereby an investment is presented as being more sustainable than it actually is.
The objective of the Taxonomy Regulation is to act as a reference guide for both companies and investors, identifying investments which are ‘economically sustainable’. In particular, it lays down criteria for determining whether or not an activity contributes towards: the protection of ecosystems; climate change mitigation; climate change adaptation; the transition to a circular economy; and the sustainable use and protection of water and marine resources. Additionally, it will require investors and asset managers to disclose sustainability information about their portfolio which, in turn, requires portfolio companies to disclose more information about their sustainability.
Corporate Sustainability Reporting Directive
The CSRD updates the pre-existing Non-Financial Reporting Directive by widening the net of firms caught in its ambit and increasing its reporting obligations. The CSRD requires all regulated companies to audit their reported information, comply with mandatory sustainability reporting standards, and include a digital tag to reported information so as to adhere to the ‘single access point’ scheme of the Capital Markets Union. The purpose of the mandatory standards is to enhance uniformity by replacing the current patchwork of standards. Such standards will be developed by the European Financial Reporting Advisory Group and must consider existing frameworks, including the Taxonomy Regulation, SFDR, and environmental legislation.
In recent years, there has been a marked shift away from the shareholder primacy model towards a model of stakeholder capitalism in which firms prioritise long-term value creation by considering the needs of all stakeholders, and society at large, in their business decisions. Nowhere has this shift been more palpable than in the capital markets where the value of ESG’s ability to mitigate investment risk is being recognised. As investors open their coffers for sustainable investments, companies are increasingly disclosing their ESG performance. However, despite the alluring pay-off, it has been seen that navigating the murky waters of non-financial reporting standards and regulations is no mean feat for European companies.
 Milton Friedman, ‘A Friedman doctrine‐- The Social Responsibility of Business Is to Increase its Profits’ The New York Times (New York, 13 September 1970).  So Ra Park and Jae Young Jang, ‘The Impact of ESG Management on Investment Decision: Institutional Investors’ Perceptions of Country-Specific ESG Criteria’ (2021) 9(3) International Journal of Financial Studies 48.  Jon Hale, ‘A Broken Record: Flows for U.S. Sustainable Funds Again Reach New Heights’ (2021) Morning Star. Available at <www.morningstar.com/articles/1019195/a-broken-record-flows-for-us-sustainable-funds-again-reach-new-heights> accessed 8 March 2022.  Broadridge, ‘ESG and Sustainable Investment Outlook: $30 trillion by 2030 on the Way to Net Zero’. Available at <www.broadridge.com/white-paper/asset-management/esg-and-sustainable-investment-outlook> accessed 8 March 2022.  Andreas G. F. Hoepner, Ioannis Oikonomou, Zacharias Sautner, Laura T. Starks, and Xiao Y. Zhou, ‘ESG Shareholder Engagement and Downside Risk’ (European Corporate Governance Institute Working Paper No. 671/2020). Available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874252> accessed 8 March 2022.  Emirhan Ilhan, Zacharias Sautner, and Grigory Vilkov, ‘Carbon Tail Risk’ (2021) 34 The Review of Financial Studies 1540.  Marcia Milon Cornett, Otgontsetseg Erhemjamts, and Hassan Tehranian, ‘Greed or Good Deeds: an Examination of the Relation Between Corporate Social Responsibility and the Financial Performance of U.S. Commercial Banks Around the Financial Crisis’ (2016) 70 Journal of Banking & Finance 137.  R Greg Bell, Igor Filatotchev and Abdul A Rasheed, ‘The Liability of Foreignness in Capital Markets: Sources and Remedies’ (2012) 43 Journal of International Business Studies 107.  Ellen Pei-yi Yu and Bac Van Luu, ‘International Variations in ESG Disclosure – Do Cross-Listed Companies Care More?’ (2021) 75 International Review of Financial Analysis 101731.  Najah Attig, Sadok El Ghoul, Omrane Guedhami and Jungwon Suh, ‘Corporate Social Responsibility and Credit Ratings’ (2013) Journal of Business Ethics 679.  Alain Devalle, Simona Fiandrino and Valter Cantino, ‘The Linkage Between ESG Performance and Credit Ratings: a Firm-Level Perspective Analysis’ (2017) 12 International Journal of Business and Management 53.  Olaf Weber, Roland W. Scholz, Georg Michalik ‘Incorporating Sustainability Criteria into Credit Risk Management’ (2008) 19 Business Strategy and the Environment 39.  Monica Billio, Michele Costola, Iva Hristova, Carmelo Latino and Loriana Pelizzon ‘Inside the ESG ratings: (Dis)agreement and Performance’ (2021) 28(5) Corporate Social Responsibility and Environmental Management 1426.  Sarah Elena Windolph, ‘Assessing Corporate Sustainability Through Ratings: Challenges and their Causes’ 2011 1 Journal of Environmental Sustainability.  Billio and others (n 13).  EY, ‘The Future of Sustainability Reporting Standards: The Policy Evolution and the Actions Companies Can Take Today’ June 2021 <https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/sustainability/ey-the-future-of-sustainability-reporting-standards-june-2021.pdf>.  Thomas Bullman, ‘Regulating ESG: the Multidimensional Challenges Accompanying a Global Financial Market Paradigm Shift from Investing Based on Financial Considerations to Evaluating Social Impact’ 2021 29(2) Commercial Law Practitioner 32, 34.  Joint Committee of the European Supervisory Authorities, Final Report on Draft Regulatory Technical Standards (2 February 2021).  The objective of the European single access point is to provide for seamless, EU-wide access to all relevant information (including financial and sustainability-related data) disclosed by companies.