Why is it a risky strategy to approach ESG reporting purely from a compliance standpoint?
18th August 2022
Environmental, Social, and Governance (ESG) is an evolving concept that has become pervasive in terms of reporting and compliance. There are multiple risks involved while reporting ESG and it can become a risky strategy for any company if it is not done in the right way. Cutting back on short-term profits and creating long-term shareholder value is one of the most popular strategies used by companies in present times. However, if it is done in a lopsided manner without accurate data management, it can lead to a severe cash flow crunch that can harm a company’s liquidity and valuation in the long run. There, it is vital to examine the reasons behind ESH reporting being a risky strategy from a compliance standpoint and what measures can be taken to mitigate the risk.
To begin with, ESG reporting is a cumbersome process due to the existence of multiple ESG frameworks. There are industry-specific reporting standards and regional ESG standards that make it risky for companies to choose from and adhere to in both, the short and long run. Moreover, there are latent costs associated with the management and analysis of data in relation to a specific reporting standard. The oil and gas industry has stricter regulations for carbon emissions reporting than the logistics and supply chain industry and the risk associated with reporting for the industries within their frameworks has to be carefully studied by industry experts and data analysts. In addition, more than 85% of companies around the world use more than one ESG reporting framework, and maintaining each database becomes a risky strategy.
Furthermore, there is a greater risk of evolving ESG regulations that hinder a company’s progress in terms of reporting sustainable financial disclosures. For instance, from March 2021, the new Sustainable Finance Disclosure Regulation (SFDR) has been in effect. It requires financial market participants to disclose 18 mandatory indicators and another two of 46 optional indicators. Additionally, the Non-Financial Reporting Directive (NFRD) (a standard that lays down the disclosure rules for non-financial and diversity information by large companies) is also in the pipeline. As a result, a new and strengthened version of the NFDR’s basic disclosure requirement, known as the New Corporate Sustainability Reporting Directive (CSRD) launched in June 2022, adding to the list of evolving ESG regulations.
Most of these regulations are meant for a change in reporting standards in the European Union. However, the international market tends to permeate into domestic markets for international deals and trade agreements. Consequently, any deal between an Indian and European company would force the former to file their ESG reporting as per EU standards as well as Indian standards. Therefore, from a purely compliance standpoint, it becomes a risky strategy.
At last, data management and identifying indicators is the biggest compliance risk for companies reporting sustainability. It is hard to quantify a qualitative metric like sustainability, there companies find it hard to identify which environmental, social, and governance indicators do they need to follow for an appropriate financial disclosure. Companies spend a lot of expenditure on quantifying the risks and sustainable activities done by them to mitigate those risks. Consultancies often figure out the right metrics to not let the company fall under immense scrutiny. The key role ofconsulting agencies is to analyse the data and manage millions of data points that paint a picture of their ESG risks and what needs to be reported. For instance, data points gathered over the last decade would show the carbon emissions emitted due to air travel by a company and the amount of carbon price they have to pay or have paid to neutralise that risk. In short, net zero emissions goal.
Data management and reporting mechanisms are the primary risks that companies need to mitigate on an immediate basis if they have to approach ESG through a compliance standpoint. Industries like oil and gas are taking a step ahead by integrating ESG into their bottom line operations because the industry is responsible for the majority of GHG emissions. On the other hand, industries like real estate keep the ESG reporting and integration in their top line since a compliance standpoint is enough for it to sustain in the immediate future. Hence, ESG reporting in the bottom line mitigates the risk but it is still a risky strategy to follow ESG reporting standards just for the sake of compliance.