For: Time to bring corporate reporting into the 21st century.
By Anne Simpson, Director, Board Governance & Strategy, CalPERS; Directors & Boards Editorial Advisory Board Member
What drives company value? What are the risks? Balancing these twin issues is at the heart of corporate reporting. As investors increasingly call on companies to provide more insight on environmental, social and governance drivers of risk and return, corporate boards are responding with a wide array of supplemental reporting.
The reason is clear. Investors are looking beyond the mandatory financial reporting to gain understanding of what drives value creation and where risk may reside. The company balance sheet is one example. In the S&P 500, 85% is now made up of intangibles and just 15% comprises the fixed assets which traditional financial reporting covers. The bulk of company value simply is not captured by the financials.
This reflects a profound shift in the U.S. economy. Intangibles such as human capital, reputation and intellectual property are the source of competitive advantage and also potential constraints on growth. Investors have been asking companies quietly to do more on their reporting around these factors which are so vital to long-term sustainability.
Asset owners, including large pension funds like CalPERS are moving to focus engagement and action, where needed, to ensure that companies report on sustainability risk and opportunity.
One example of how ESG is moving to the mainstream is the building of a powerful alliance of investors in the $32 trillion group Climate Action 100+, which CalPERS chairs and is also a founder. The group is engaging corporate boards with three goals: to ensure boards exercise governance oversight of climate change risks and opportunities; that companies with a systemically important impact on global warming set targets for bringing down greenhouse gas emissions in line with the Paris Agreement; and that companies disclose risks in line with the framework developed by the Taskforce on Climate Related Financial Disclosure. That framework was developed at the request of the global central banking body, the Financial Stability Board.
"Asset owners, including large pension funds like CalPERS are moving to focus engagement and action, where needed, to ensure that companies report on sustainabilty risk and opportunity.”
~ Anne Simpson
However, to the disappointment of many — including supporters of this work like CalPERS — the vital signs are missing in the reporting standards overseen by the financial bodies responsible. When CalPERS attempted to assess its “carbon footprint” in publicly listed companies worldwide, we found data reported on less than half, according to a variety of sources including CDP (the Carbon Disclosure Project) data, among others. We have to estimate or model the rest.
Less than 1% of our companies were responsible for the overwhelming bulk of greenhouse gas emissions. Hence, even in identifying the source of a systemic risk in our portfolio, required piecing together ad hoc sources of information, in a painstaking exercise that should have been routine for a long-term fiduciary with global exposure.
In the United States, shareowner proposals focusing on environmental and social disclosure now make up the overwhelming majority and a growing number of these proposals are winning majority support. These are important signs of investor opinion on the relevance of ESG risk and return reporting. However, they are not enough. Voluntary reporting favors those with a good story to tell, and leads to false positives. We need consistent, clear standards, which will allow tracking of performance over time, within sectors and across markets.
Where do corporate boards turn to for guidance in the midst of these requests from investors for reporting on ESG? An array of best practice initiatives abound. In the U.S., the Sustainability Accounting Standards Board provides industry-level guidance on reporting standards, building on long standing international projects like the Global Reporting Initiative. Such work provides corporate boards with a rich array of analyses and examples. However, for investors, this is only the start. Fiduciaries, like CalPERS, are looking for holistic reporting from companies, where financial reports are enhanced by relevant, timely and reliable reporting on the sustainability issues driving value and posing risk. This is the focus of the integrated reporting movement.
The time has come for the financial standards setters to move with the times. They have the mandate, the experience and, ultimately, the responsibility for ensuring that corporate reporting meets investors’ needs. CalPERS’ investment beliefs state that long-term value creation requires management of three forms of capital, financial, human and physical. We now need a corporate reporting regime, in the United States and in other markets, which reflects 21st century drivers of risk and return, and turn the data chase on ESG into something better than a guessing game.
Against: Take an industry-based approach to ESG reporting.
By Tom Quaadman, Executive Vice President, Center for Capital Markets Competitiveness, U.S. Chamber of Commerce
For any business to flourish, information and communication are vital. SEC-mandated statements are a critical tool for public companies to communicate with investors about the direction of the business and how the company is faring. An investor should be able to use the information companies disclose to determine whether they want to invest, retain or sell their stake in a company.
Materiality has been the lodestar of the public company disclosure regime under the federal securities laws. The longstanding materiality standard — what is important to a reasonable investor who is focused on investment returns — has instilled in investors and issuers alike a confidence in the accuracy and integrity of information that promotes market efficiency, competition, liquidity and price discovery.
Recently, demand has grown for disclosure relating to environmental, social and governance (ESG) reporting, and while ESG information can be material, that’s not always the case. To preserve every possible incentive for companies to go — and stay — public, the private sector should take an active role in developing consensus-based ESG reporting criteria.
Different audiences have different interests in ESG. Customers, employees, regulators, NGOs, academics and students are just some of the audiences — beyond investors — who read ESG disclosures. Each of these users has different needs and expectations when reviewing ESG information, and what is material to an investor may not necessarily mirror what other audiences look for when reading ESG disclosures.
A diverse collection of reporting standards has emerged from a variety of organizations. The U.S. Chamber of Commerce’s most recent work in the ESG arena has led us to the conclusion that, in order to avoid the politicization of federal securities laws, ESG disclosures should not fall within the mandated reports of the Securities and Exchange Commission, nor should standard-setting fall to the Financial Accounting Standards Board (FASB) or the International Accounting Standards Board (IASB). Doing so would apply a shareholder regime upon a stakeholder model.
"Companies are already leading the way in developing an approach to ESG Reporting. For example, the Edison Electric Institute (EEI) spent over a year in dialogue with investors and stakeholders on ESG issues allowing EEI to determine what ESG information is material and how it should be disclosed. Ultimately, EEI's process was collaborative and transparent, and it should serve as a model for other companies and industries to replicate. Instead, an industry- based approach to ESG reporting is the way to go. Business can reach out to their stakeholders to determine the level of materiality for ESG information, which would allow the industry to craft disclosures with useful information for investors, as well as for the full range of industry stakeholders. ”
~ Tom Quaadman
Broadening the mandate of FASB and the IASB could also dissipate their resources, harming financial reporting as a consequence.
Third-party ESG raters have widely discordant views and ratings of disclosures. A company may receive a high ESG rating from one standard setter and a low rating from another. Unlike financial reports, which are comparable across all businesses and industries across the spectrum, ESG reports are not.
Instead, an industry-based approach to ESG reporting is the way to go. Businesses can reach out to their stakeholders to determine the level of materiality for ESG information, which would allow the industry to craft disclosures with useful information for investors, as well as for the full range of industry stakeholders.
Companies are already leading the way in developing an approach to ESG reporting. For example, the Edison Electric Institute (EEI) spent over a year in dialogue with investors and stakeholders on ESG issues allowing EEI to determine what ESG information is material and how it should be disclosed. Ultimately, EEI’s process was collaborative and transparent, and it should serve as a model for other companies and industries to replicate.
Materiality is, and should remain, the guiding principle for public company disclosure. An industry-based approach to ESG reporting can help mitigate confusion and unnecessary costs while accounting for the range of priorities that exist in the realm of ESG disclosure. In the near term, corporate leaders will have more opportunity than ever to participate actively in a process to develop modernized and effective standards, and the U.S. Chamber looks forward to being actively engaged in that work, as well.