Disclosing just performance metrics does not constitute effective environmental, social and governance (ESG) reporting. Dr Glenn Frommer and Theodora Thunder, Principals, Sustainability Partnership, give some practical advice on how companies can structure a connected narrative about their management of ESG risks and opportunities.
The new Hong Kong Stock Exchange rules for ESG performance disclosures (as set out in the ESG Reporting Guide – Appendix 27 of the listing rules) signals the local regulatory catch up with the international financial community on the reporting of non-financial risks that impact corporate performance.
Appendix 27 suggests a series of environmental and social performance indicators in which the reporter is asked to identify material ESG issues (including those not included amongst the stated Key Performance Indicators) and present the performance data quantitatively and consistently. A key component of disclosure is the suggested management discussions of performance in the business review section, cautionary of an unbiased and balanced approach. The underlying challenge in these discussions is not box ticking but, rather, reporting performance in a concise and connected narrative that enables investors to make intelligent investment decisions, while guiding internal decision making for future sustainable development.
Follow the money
Recent public studies point to three core expectations from investors (and stakeholders) when reporting ESG risks: what are the material issues, how is risk managed and what is the value to the business? Management should have these same expectations of internal operations when formulating and implementing business strategy. More specifically, transparency is needed in the following areas.
Good risk governance
Is there a clear and coherent understanding of the risks to the broader social, economic and environmental context in which the company is operating? Is there the demonstrated ability by the board and senior management to not only steward the organisation in managing such risks but also to leverage ESG factors for competitive advantage?
Management of opportunities and risks
Does management understand the ESG risks and opportunities that have significant financial influence on operations, supply chain and end products/services? Are the appropriate management systems in place to address and monitor such risks? Are timely and effective actions being undertaken to manage the allocation of internal resources (capitals) to mitigate risks and benefit from the potential opportunities? How is successful risk/opportunity management rewarded?
Creating value for the business
Are the decisions and actions to manage ESG issues supporting the ambitions and business strategy envisioned by the board? How are the outcomes of such actions being measured, monitored and translated into the balance sheet?
Structuring the connected narrative
Communicating non-financial issue management is a challenge to reporters as it is dependent on the filter of materiality, which can often be subject to vested or arbitrary decisions. A helpful, more objective architecture for the reporting narrative follows the classical management method known as the ‘Deming Cycle’ or ‘PDCA’ – which is based on four steps: plan, do, check and act. This transforms to the ESG reporting framework of: governance, strategy, risk management, metrics/targets, treatment and evaluation. This should not be viewed as a linear process but rather an interconnected framework in which a particular issue is present at each stage and is influenced by and influences the other stages, signalling a significant business impact. By using this framework, ESG issues are progressively filtered for priority and take on a disciplined management cycle that is measurable for efficacy and outcome.
Governance is the foundation. The board leads by defining the ESG challenges (material risks) and recommends with senior management the strategy and treatment with which to navigate for sustainable development. With far more at stake today in mandatory ESG reporting and with the spotlight of social media, boardrooms and companies run a far greater reputation risk by not addressing ESG factors at the governance level.
It is the responsibility of senior management to manage the identified challenges through business strategy development and implementation. Decisions are made, actions initiated and risks managed (effectively or not so effectively). Management’s duty is to report the results (supported by valid data) and consequently, improve or change to achieve stated goals.
Metrics and evaluation are the hard outcomes of strategy in action. They are the progress signposts that point to integration of ESG factors into corporate development and serve to inform future performance decisions. It is important to use a standard and the metrics that are relevant, consistent and comparable for year-on-year reporting. These can include the Global Reporting Initiative, Sunstainability Accounting Standards Board and other sector/industry-specific standards. Specifically for Appendix 27, the ESG Dashboard (www.esgdashboard.com) has been recently introduced to facilitate compiling and presenting the required information and data. However, the narrative should not just focus on the data itself, but rather on how management is using the data to advance the company along a sustainable pathway.
Mining for Value
Investors mine for environmental and social (E&S) data/information that is relevant to their investment modelling. This includes analysing risks and balance sheet impact, industry and market trends and comparisons, and importantly, the potential for future growth opportunities through the E&S advantage. Smart management engages investors on this subject on a regular basis in addition to annual ESG reporting.
A similar case can be presented for internal value delivery. Strategic business decision-making in the context of sustainable development starts with management’s grasp of industry trends and direction, and the commercial, social and environmental context in which the company operates. A performance review aids in formulating the internal pathway that transforms the organisation and its products/services guided by material ESG assessment, managed risk, cost efficiencies and the leveraging of potential growth opportunities.
Creating a report that is of value to both investors and the company is an investment in and of itself. It requires commitment and leadership of the board and senior management, the internal competencies to manage expectations and the social and business systems to deliver envisioned goals. A report that seeks such coordinated participation from its people and systems, clearly is positioned to connect the disconnect between expectations and reporting.
Dr Glenn Frommer and Theodora Thunder
Principals, Sustainability Partnership
The Sustainability Partnership advises companies on the end-to-end management of ESG issues and their reporting. Materiality assessments, reporting strategy and fulfilment and the comparative analysis to industry and peer ESG performance are amongst the services provided. For further information contact: Thunder@streeter.com.hk.