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IPE special report May 2018

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ESG: A new reporting paradigm

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A new EU directive mandates non-financial corporate disclosures. In light of the Volkswagen emissions scandal, Elisabeth Jeffries finds reason for praise as well as for caution

It has been described as historic. The first directive mandating non-financial corporate disclosures, due to take effect across the EU next year, breaks new ground in reporting requirements. A cynic might describe it as fodder for Europe’s marketing mills. Yet there is a case to praise its introduction.

At a glance

• A new EU directive mandates non-financial disclosures from certain entities, including around 6,000 large companies.
• Statements should contain information on ESG issues.
• Large listed undertakings are also required to disclose diversity policies. 
• Guidelines on methodology for reporting non-financial information apply from December 2016, by which time member states must transpose the directive.

First, it extends corporate social responsibility (CSR) to Europe’s furthest boundaries. Mandatory reporting on ESG issues already exists in some countries. The UK’s 2006 Companies Act, for example, requires UK quoted companies to report greenhouse gas emissions in their directors’ reports. France’s Grenelle II law obliges many companies listed on French stock exchange to incorporate information on the social and environmental consequences of their activities into their annual reports. In Germany, a Sustainability Code (DNK) covers many of the new directive’s obligations.

Nevertheless, many of the EU’s newer members or less developed countries will need to implement the directive in national law to introduce their first non-financial reporting rules. At the same time, companies that have withheld information will need to supply it. “It will require 6,000 companies across Europe to disclose certain ESG information, and many of these companies have never done so before,” says Elaine Cohen, sustainability reporting consultant at the CSR consultancy Beyond Business. 

The directive also represents a major leap from previous ESG reporting rules, which mainly targeted the extractive industries as part of a clampdown on bribery and corruption. One implicit aim was to stop EU businesses from trying to bribe officials in resource-rich developing countries. “In some countries, this might be the only way the local population could find out what their government was up to,” says a senior executive at one professional accounting organisation.

The directive broadens and strengthens existing accounting law, which set quite high-level conditions that were open to interpretation. It covers a far wider range of corporate responsibility concerns than the previous legislation, as well as much national legislation. This includes bribery, human rights, employee diversity and the environment. 

But as a tool for greater transparency to guarantee accountability to the general public, its merit will take many years to prove. The directive originally proposed to cover a far wider spectrum of business activity, aimed at about 20,000 companies, but this intention was diluted during the legislative process. 

Meanwhile, some observers believe accounting processes continue to be unsatisfactory. Social or environmental impacts are most commonly buried in the hard numbers in the financial statements. Typically, those numbers only indicate responsibility when misconduct is exposed. “The costs associated with being found out relate perhaps to general loss of reputation, reduced sales and potential litigation. The litigation risk can later turn into contingent liabilities or recognised provisions,” points out Peter Pope, professor of accounting at the London School of Economics. Alternatively, the ESG impacts behind the numbers are not explained. Paying an employee below the minimum wage, for example, is likely to be concealed while lowering costs.

Bad news may leave a financial scar on the company’s profit and loss account despite a clean CSR report, as the emissions debacle at Volkswagen shows. Sales in some countries have fallen while the company’s share price has halved. Not surprisingly, use of the underlying software was not revealed in the company’s 2014 sustainability report. Any investor reading it might have found it impressive.

Dense pages printed in a literary style using an interesting font suggest thought leadership and Germanic introspection: “It’s not about growth at all costs,” states one heading. An article entitled ‘SUVs – where emotion meets reason?’ justifies its role in the gas-guzzling SUV market through its impact on reducing weight and electric vehicle innovation. 

The Global Reporting Initiative, a standards organisation, confirms the report included material disclosures and Cohen points says it set high standards: “Volkswagen disclosures have been consistently in line with reporting expectations and the company received recognition from many ranking and rating organisations including the Dow Jones Sustainability index”, she says.

Clearly, the new directive in itself will not put a stop to commercial conjuring tricks or pollution incidents. Mainstream auditing procedures may shine a bright light on particular activities while failing to detect dark matter surrounding it. They may focus on final sales, for example, rather than operational decisions supporting them. As Pope explains, a sustainability report can well be accurate while presenting the company through a particular lens.

“CSR reports may sometimes reflect the perceptions of the board of directors, whose perspective on actual business practices might not correspond to reality because they don’t know the fine detail. Management control in complex organisations can be problematic,” Pope says.

The transparency and reliability of the non-financial statement in the management report, when it becomes mandatory, could be compromised. The record of previous laws on disclosure also suggests compliance may be limited. The adoption of International Financial Reporting Standards (IFRS), made obligatory by the EU in 2005, is a case in point. “Enforcement of IFRS in financial reporting is much more patchy than policymakers had intended. It is a major problem,” notes Pope. Miscreant directors rarely suffer severe penalties or imprisonment.

The influence of this directive is likely to be indirect, nudging companies to improve their corporate culture, creating a level playing field and raising the standards of member states with lower requirements. “The European Commission’s motivation for a directive of this kind is to protect the single market and improve its rationalisation and harmonisation,” comments the senior accounting executive. A single accounting code will help support that objective now that CSR reporting has become commonplace.

At present, CSR analysts can perceive poorer performers through unsubstantiated numbers or shifting methodologies from one year to the next. “A company has many ways of communicating its activities, not just a sustainability report. In general, however, there are certain frameworks and expectations of sustainability reporting at a global level, and it is fairly easy to note if a company is not achieving this expected level of transparency,” says Cohen. Now that non-financial reporting is to become law across the EU, it is reasonable to expect those failings to become even more evident. 

Sustainability reporting has so far worked largely as a marketing device rather than an accounting statement reflecting the true and fair view of the business, though it does open up the agenda. “The point of reporting is that it starts a conversation,” says Cohen. The same may be said of this directive. Non-financial reporting has largely worked as a defence, with the responsibility for quantifying anti-social behaviour left to financial accounting rules from an earlier era. 

Activists have high hopes for methodology guidelines, to be published in December this year. By embedding a consistent approach, they should help investment analysts detect poor performance more easily. However, non-financial reporting is unlikely to grow full teeth unless ESG matters are fully recognised as material to the business and incorporated to the accounting system.

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