Research

31 Mar 2021

Sustainability is much more than a reporting challenge

Financial Reporting Brief April 2021

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Sustainability reporting is the most talked about topic of corporate reporting in recent times and will continue to be near or at the top of the list going forward. Later in this article, and in future articles, we shall comment on the reporting challenges and developments towards meeting those challenges. In this article, we comment on some of the factors underlying the demand for improved reporting and how the investment marketplace is behaving.

‘Meeting the needs of the present without ever compromising the ability of future generations to meet their own needs’. Stark in its simplicity, the UN definition of sustainability from some years ago continues as the primary purpose of protecting sustainability. It has been broadened in more recent years by reference to three pillars of sustainability – environmental, social and governance factors (ESG), with the need to meet economic demands.

Probably even more stark are the reminders of the consequences of not protecting sustainability. Perhaps, the words of a leading global professor provide us with one of the clearest messages in these times when the Earth has been ravaged by the global COVID-19 pandemic.

The pandemic does have a silver lining – it confirms that sustainability is an effective but urgently needed response. If we do not change, it will not be the end of the world, the Earth will certainly continue as it has for billions of years. Perhaps with a diminished human presence or none – a relatively minor blip in the greater scheme of things

The global professor is the Vice Chair of the UN Intergovernmental Panel on Climate Change.

While climate change may be the headline grabber when we focus on sustainability, warnings from leading scientists, experts in bio-diversity, should be heard loud and clear. A general consensus is that we are the most dangerous species in global history with bio-diversity loss at an unprecedented level in the history of our planet. Assessments indicate that 75% of land and 66% of the oceans have been degraded by human activity. Some alarming highlights of this are:

1.9 million square kilometres of natural habitat lost since 2000 (8 times size of UK)
1 million wildlife species threatened with extinction
1.3 billion tons of food wasted each year – worth at least $1 trillion.

World leaders are being asked to pledge to developments and initiatives regarding protection of the Earth by 2030 through an overall strategy that puts nature and the climate at the heart of recovery plans from the pandemic.

Scientists have warned that we are at risk of the sixth mass extinction, with whatever we do now likely to define the future of humanity.

Investor Response

When the COVID-19 pandemic took hold in Spring 2020, there was expectation that a worldwide crisis of its magnitude would divert attention from climate and other ESG risks. These risks are a fundamental element of investment risk, and it is very encouraging that what has happened in investment markets has been the opposite to the initial expectation. The allocation of capital to sustainability funds has accelerated at a far greater rate than many would have anticipated.

Global reviews indicate that at the end of 2020, investment in sustainability funds reached a record high of $1.7 trillion, up by 29% in the final quarter of the year. European funds accounted for 79% of the total, and there is clear evidence of continuing growth in 2021. Equities are the main market. The longer-term flow picture looks even more striking, with inflows into European sustainable funds almost 5 times higher in 2020 than they were three years ago and almost double last year's, at $273bn.

Global observers have noted that sustainable investing performs well with, for example, S&P 500 constituents in the top-quintile of social sustainability consistently outperforming the bottom-quintile.

In 2020, there was also record growth in the sustainable debt market. Companies and governments raised nearly three-quarters of a trillion dollars of sustainable debt in 2020, beating the previous record set a year earlier, by more than $160 billion.

A major growth area was social bonds, with Governments and supranational bodies such as the European Union and the African Development Bank issuing almost all of 2020’s social bonds to fund pandemic healthcare and relief efforts. These were attractive not only because of the way the proceeds were going to be used, but also for their high credit ratings. The EU’s first social bond, issued in October 2020, was 14 times oversubscribed.

Many surveys of this growing trend towards sustainability funds in investment markets have published findings, with a global review by Forbes magazine indicating:

Major investment firms see sustainable investing as the future;
Fund companies are launching sustainable funds at a record pace;
Sustainable investing is being used to help manage risk in uncertain times; and
Performance has become a top reason to invest sustainably.

European Strategy

Climate change and environmental degradation are existential threats to Europe and the world. To overcome these challenges at the European level, the European Green Deal is being put in place by the EU.

The European Green Deal is the master plan for making the EU's economy sustainable, with the key objective of turning climate and environmental challenges into opportunities and making the transition just and inclusive for all. Europe needs a new growth strategy that will transform the Union into a modern, resource-efficient and competitive economy, where:

There are no net emissions of greenhouse gases by 2050;
Economic growth is decoupled from resource use; and
No person and no place is left behind.

The current COVID-19 pandemic has reinforced the need to redirect capital flows towards sustainable projects in order to make our economies, businesses and societies, in particular health systems, more resilient against climate and environmental shocks and risks with clear co-benefits for health.

To achieve this, a common language and a clear definition of what is ‘sustainable’ is needed. This is why the action plan on financing sustainable growth called for the creation of a common classification system for sustainable economic activities, or an ‘EU taxonomy’.

The EU Taxonomy is a classification system, establishing a list of environmentally sustainable economic activities. It provides appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable, it is expected to create security for investors, protect investors from greenwashing, help companies to plan the transition, mitigate market fragmentation and eventually help shift investments to where they are most needed.

The EU Taxonomy Regulation establishes six environmental objectives

Climate change mitigation
Climate change adaptation
The sustainable use and protection of water and marine resources
The transition to a circular economy
Pollution prevention and control
The protection and restoration of biodiversity and ecosystems

Different means may be required for an activity to make a substantial contribution to each objective.

Greenwashing

A recent EU report on online breaches of EU consumer law found that greenwashing is on the increase.

The Commission and consumer authorities examined 344 seemingly dubious cases where advantage appeared to be taken of consumers looking to buy environmentally sound products and found that:

In more than half of the cases, the trader did not provide sufficient information for consumers to judge the claim's accuracy;
In 37% of cases, the claim included vague and general statements such as "conscious", "eco-friendly", "sustainable" which aimed to convey the unsubstantiated impression to consumers that a product had no negative impact on the environment; and
In 59% of cases the trader had not provided easily accessible evidence to support its claim.

In their overall assessments, taking various factors into account, in 42% of cases authorities had reason to believe that a claim may be false or deceptive and could therefore potentially amount to an unfair commercial practice under the Unfair Commercial Practices Directive (UCPD).

Regulators and policymakers are engaged in a robust drive to stamp out greenwashing. It is imperative that the sustainability features and risks of products are properly designed and disclosed and that the additional layer of complexity this represents is navigated properly.

More than €3.2 trillion of international assets are domiciled in Irish funds with forecasts that this will rise to more than €5 trillion by 2025. Euronext Dublin is the world’s biggest venue for the technical listing of debt instruments issued by states and companies globally. The Central Bank, which regulates the market, will focus this year and beyond on the implementation of the incoming international regulatory changes aimed at working out what financial products are “truly eco-friendly”, and will closely scrutinise applications for authorisation of green funds or securities offerings where prospectus approval is required.

ESG Reporting

As ESG gains increasing prominence, leaders must find ways to ensure impact measures continue to grow and evolve with changing needs.

Many factors can help leaders continue to drive impact, including the following:

Intersectionality: ESG-committed leaders must develop their impact strategies with intersectionality in mind. The success of each of the UN’s 17 Sustainable Development Goals (SDGs) – goals such as eradicating poverty or creating fairer economies – are linked;
Partnership: Such growth and change are only possible through collaboration and cooperation. As the UN Foundation states, “When we act together, change happens.”; and
Accountability: Ultimately, these efforts will not create sustainability without meaningful transparency. Only standardization and transparency can prevent ESG from becoming a hollow tool for marketing or greenwashing.

Many global organisations have been engaged in the pursuit of improved, globally consistent reporting on sustainability. Key issues being highlighted are:

For sustainability reporting to contribute to better decision-making, reporting needs to transition from voluntary practices to mandatory requirements;
Financial reporting itself must be strengthened to reflect the implications of sustainability issues; and
A new corporate reporting regime is needed in which financial and sustainability reporting is given equal footing.

Comprehensive Corporate Reporting

Investors and others are demanding more and better reporting. Two of the major initiatives that are at the early stages of responding to the demands are (1) IFRSF Sustainability Reporting, and (2) EU non-Financial Reporting.

The IFRS Foundation Trustees have concluded that, based on their consultation paper published in September 2020 and the extensive responses received, there is a need for a global set of internationally recognised sustainability reporting standards and for the IFRS Foundation to play a role in the development of these standards.

A new Sustainability Standards Board (SSB) is to be set up to pursue the objective of comprehensive sustainability standards which are fully integrated with financial reporting standards.

The European Commission has published two reports received from the European Financial Reporting Advisory Group (EFRAG) in response to its request of July 2020:

Proposals for a relevant and dynamic EU standard setting process
Proposals in response to potential need for changes to the governance and funding of EFRAG

The Commission notes that EU sustainability standards are essential to support reporting on how the demands of the European Green Deal are being met. The EC intends to develop standards on a coordinated, consistent basis with global standard-setters.

IOSCO has published statements expressing the need, and its support, for a unified, consistent approach to setting sustainability standards.

Conclusion

Sustainability will continue to be the dominant feature of challenges that are pervasive at an environmental and socio-economic level. It will drive the escalating expectation and demand for robust, transparent sustainability reporting, and the development of comprehensive corporate reporting, on a consistent globally accepted basis.

It is incumbent on all engaged in the reporting process to maintain awareness of developing requirements and standards, and ensure that high standards prevail in reporting to investors and other stakeholders.