New Rules of the Game or Game Changer? Three Things to Consider as you Prepare for (mandatory) Sustainability Reporting

By Florian Hoos and Mahwesh Khan

The world is facing a dramatic change in corporate reporting, where the focus is on the harmonisation of the way in which ecological, social, and governance (ESG) issues are reported. For politicians and customers no less than for investors, sustainability is increasingly at the core of decision-making.

In 1993, Germany’s Daimler Benz AG listed its shares on the New York Stock Exchange for the first time. In the same year, it posted an after-tax loss of 1.84 billion Deutschmarks under US accounting principles, while reporting a 615 million Deutschmarks net profit under German accounting rules. No, this was not a case of fraudulent reporting or auditing malpractice! Different accounting principles led to different bottom-line results of the same entity in the same year. These variations due to different accounting standards were fixed by the introduction of International Financial Reporting Standards (IFRS) in 2001, which enabled a harmonisation of financial accounting and reporting.

Twenty years later, the world is once again facing a dramatic change in corporate reporting. This time, it is about the harmonisation of corporate sustainability reporting on ecological, social, and governance (ESG) dimensions. Politicians and customers are increasingly putting sustainability at the heart of regulation and purchase decisions. For the investors, there is compelling evidence that corporate investment and improvements in ESG practices generate an ESG premium, and/or make companies more resilient in the face of crisis. In response to this need for consistent ESG measurement and reporting standards, there are several regulations being introduced that will make sustainability reporting a de jure responsibility for listed corporations, and a de facto one for many value-chain partners.

Most notably, in November 2022 the European Union Council passed the Corporate Sustainability Reporting Directive (CSRD), which is targeted at making businesses more publicly accountable for transparency and disclosures around their social and environmental impact. Applicable as of 2024, it is estimated to apply to 50,000+ companies doing business in Europe and will lay the groundwork for sharper and more consistent sustainability reporting standards at global level. Similarly, in 2021 the IFRS Foundation announced the formation of a new standard-setting board – the International Sustainability Standards Board (ISSB) – which is currently developing non-financial sustainability disclosures for companies.

Whether big or small, the rules of the game are being changed forever. The new era of stronger sustainability reporting comes along with multiple possible crossroads that companies must navigate and prepare for. As business leaders prepare to face a very influential one-time change, what are the key questions to which they must have the answers ready?

1. Should your sustainability reporting be done on the basis of financial materiality or double materiality?

ESG

Financial materiality refers to disclosures on anything that can have a material impact on the finances of the company. Double materiality refers to considerations beyond immediate financial impact, i.e., those that create a wider environmental or social impact. From a compliance perspective, the question is easily answered, but it is not straightforward from a strategic perspective, since what is immaterial today might become material tomorrow.

The new era of stronger sustainability reporting comes along with multiple possible crossroads that companies must navigate and prepare for.

The European approach to reporting on sustainability, as seen in the CSRD, is based on double materiality. On the other hand, financial materiality is the basis for the US-based ISSB standards. Critics of financial materiality point out that there is a risk of excluding a company’s broader societal and environmental impacts, as it may lead to the omission of decision-critical information in the strategy setting and oversight processes. Numerous greenwashing scandals over the past years show that many companies have a too narrow view on sustainability, potentially influenced by a too narrow perspective on materiality.

Another important element to consider is that as disclosure requirements get stricter for scope 1, 2, and 3 emissions, companies will begin to ask their value chain partners, especially suppliers, to provide disclosures on their carbon footprint. For example, if you are a freight company, then your carbon emissions, aka your scope 1, become part of the value chain of your customer, say an FMCG company, and thus will be reported by them as their scope 3 emissions. The stronger your scope 1 reporting is, the better will scope 3 reporting be for your value chain members, thereby making this a solid value-add of doing business with you. Such interdependencies mean that there will invariably be a practical convergence between materiality reporting. Many companies will not be able to escape the stricter reporting, even if they are based in jurisdictions with relatively lax requirements.

Our verdict:

Prepare your strategy and consequently your internal reporting systems from a double-materiality perspective, even if you are in a financial-materiality- focused jurisdiction. When designing your sustainability report, consider choosing an ambitious legislative benchmark —perhaps one which applies to your competitors. Investors often use the highest standards in your industry as the sustainability reporting benchmark, when comparing potential investments.

2. Should you be a pioneer or a fast follower in your ESG disclosures and transparency approach?sustainable living environmentalist

As the new era of sustainability reporting dawns, corporate leaders find themselves in two camps: one, those who comply with the regulations but wait and watch before publicly announcing any voluntary actions beyond the regulatory requirements; and two, those who are playing a more proactive role in shaping and pre-empting the emerging standards and going beyond regulatory requirements in their external disclosure practices – hence taking on more of a pioneering role.

Clearly, companies in both camps will play the compliance game to perfection. Being compliant with regulation is a baseline licence to operate. However, stopping there means missing the opportunity to create an internal thrust for rethinking the performance metrics within their organisations.

Creating long-term value requires both a focus on financial and sustainability performance. This means we need tools for measuring sustainability performance just as we have for financial performance.”

– Klaus Schwab,Founder and Executive Chairman of the World Economic Forum

Those in the first camp may, as counterintuitive as it might seem, often be better off than those in the second. The smart ones prepare internally in anticipation of stricter regulations, thereby being ahead of the regulation curve but without externally disclosing their ESG data or strategies. This can be a good strategy. Recently, we have seen companies being penalised heavily for being too bullish when reporting on their ESG performance. In absence of non-mandatory external standards, companies are finding it harder to make their their externally communicated sustainability claims presented in bulletproof. Consider DWS, Deutsche Bank’s asset management arm, which learned its lesson the hard way. In mid-2022 the asset manager’s Frankfurt offices were raided by police, based on a whistle-blower report alleging that DWS reported a grossly inflated amount of ESG assets. Not only did the DWS CEO Asoka Wöhrmann resign the day after the raid, but the firm has also made a downward revision of 75 per cent in €459bn of assets that it noted as “ESG integrated” in its 2021 annual report. The firm’s new CEO, Stefan Hoops, has been reported by the FT to believe that the firm’s earlier communication on ESG might have been too bullish. And, while DWS was “fully committed” to ESG, “you will not hear me use terms like ‘leader’ or ‘world class’”. So, unrealistic sustainability promises based on voluntary disclosure, often supported by little or the wrong accounting metrics will most likely backfire.

Looking at the second camp, there are clearly also instances when having invested in exemplary ESG practices is an enabler for companies to build a competitive advantage, identify corporate opportunities, or preempt risks around the corner. Increasingly, the power of social media and sustained pressure from broader stakeholder groups is forcing companies to have a voice even about areas not directly related to their core business. In such instances, companies that have systematically developed a strong internal ESG muscle from stra- tegic, cultural, and operational perspectives are the ones that tackle these demands and challenges most effectively. For companies like Patagonia, Schneider Electric, and EDP, for example, reporting becomes almost an incidental by-product of well thoughtout internal sustainability metrics. Strong metrics and their active measurement help firms progress on their ESG mandates, but more importantly foster a culture of sustainability. As we all know, ultimately it is the culture of the organisation that is required to activate any strategic intent.

Our verdict:

When it comes to public disclosures and reporting, do not get carried away with the opportunity of marketing, over-promoting ideas, and making (often unfulfillable) long-term promises. You must communicate the direction your company intends to take on its sustainability journey but try to remain humble and cautious in external reporting.

3. Should you report better or do better?

windmill

In light of new ESG reporting regulations, there are many businesses that can optimise for sustainability only to a certain extent. An agriculture business can reduce water consumption, soil use, pesticides, and emissions. However, in most instances, unless there is a fundamental systems-level shift in business models and patterns of consumption and production, the metrics will not change as significantly as they should to bring about sustainability impact. Companies that have done well by doing good are those that go beyond the baseline rules of the game. For example, Infarm, a Berlin-based start-up that has attracted over $600 million in venture capital investments, for instance, was created to revolutionise the agriculture business through its vertical farming solution. Based on their communication, they reduce water consumption by 95 per cent, pesticide use to zero, and emissions by about 90 per cent relative to traditional agriculture businesses.

The ambition of companies like Infarm is not to reduce but to disrupt those activities that produce ESG footprints. As a company, reporting better is an immediate necessity to remain compliant with new regulation and to compete in both financial and sustainability disclosure dimensions. Nevertheless, companies will need to have the ambidexterity to also simultaneously think about new business models and creating customer value by better embracing the principles of circularity, ecosystems plays, and consideration of the natural capital — not just footprint measurement.

Consider Ørsted — by 2020 the company had completed its divestment in fossil fuels and ramped up its investing in offshore wind power, which enabled a reduction in carbon emissions by 83 per cent. “The transformation has now come to a point where the vast majority of our energy production comes from renewable sources,” said its then CEO, Henrik Poulsen. After taking over from Poulsen as CEO in 2021, Mads Nipper expressed a company-wide ambition of installing 50 GW renewable capacity by 2030, as well as building a global leadership position within renewable hydrogen and green fuels. Ørsted has set targets for net-positive biodiversity impact from all new renewable energy projects commissioned by 2030. These shifts would not have been possible without a fundamental business model shift that saw Ørsted transform from being one of Europe’s most coal-intensive energy companies to the largest renewable-energy company in the world.

Our verdict:

It is important to adhere to reporting requirements by enhancing ESG footprint tracking and subsequently doing timely disclosures. However, true sustainable value can only be created when companies are open to fundamentally transforming their business models by being ambidextrous, improving the ESG dimensions of the current core business while inventing the sustainable business model for the future. That is when you not only report better but actually do better.

Conclusion

Mandatory sustainability reporting will be one of the big challenges for your company in the future – one that will be decisive in terms of maintaining or gaining competitive advantage. A candid introspection around the questions provided in this article will enable corporate leaders to devise the best pathways applicable to their individual context.

This article was originally published on May 19, 2023.

About the Authors

Florian HOOSFlorian Hoos is a Professor of Sustainability and ESG accounting at IMD and the managing director of the Enterprise for Society Center (E4S). Before joining IMD, he was a professor at HEC Paris and a visiting assistant professor at MIT Sloan School. Besides his academic career, he accumulated 10 years’ experience in leadership positions as managing director and entrepreneur, with his own firm advising a wide range of companies on their ESG strategy. He is an award-winning teacher, innovator, and writer who was selected by Poets&Quants as one of the world’s top 40 Business School Professors under 40.

Mahwesh KHANMahwesh Khan is a senior advisor and researcher at IMD. She has over 15 years of experience in facilitating transformation journeys for companies and organisations. She works with IMD faculty on practitioner research and delivery of advisory projects, focusing on qualitative analyses across diverse business domains. Her expertise lies in working with corporate boards and C-suite, where she focuses on sustainability, governance, and strategy. Mahwesh has an MPhil in Management Studies from the Judge Business School, University of Cambridge, and is a former corporate governance officer at IFC, World Bank Group.

References:

  1. https://group.mercedes-benz.com/documents/investors/berichte/geschaeftsberichte/daimler-benz/daimler-ir-annualreport-1993.pdf
  2. For instance, a recent study by Deloitte found that a 10-point improvement in a company’s ESG score may increase its EV/EBITDA (Enterprise Value to Earnings before Interest, Tax, Depreciation, and Amortisation) by up to 1.8 times (see https://www2.deloitte.com/ch/en/pages/financial-advisory/articles/does-a-company-ESG-score-have-a-measurable-impact-on-its-market-value.html).
  3. Serafeim (2020). Social impact efforts that create real value. Harvard Business Review (September-October).
  4. CSRD will apply to all companies: CSRD will apply to all companies with (1) over 250 employees, (2) more than 40€ million in annual revenue, (3) more than 20€ million in total assets, (4) publicly listed equities that have more than 10 employees or 20€ million revenue, and (5) international and non-EU companies with more than 150€ million annual revenue within the EU and which have at least one subsidiary or branch in the EU exceeding certain thresholds.
  5. https://www.ft.com/content/ac3af778-025f-47a4-af7f-9b3a82e01ea4 (accessed 19 January 2023)
  6. https://www.crunchbase.com/organisation/infarm/company_financials (accessed 19 January 2023)
  7. https://www.forbes.com/sites/samanthatodd/2020/01/21/who-are-the-100-most-sustainable-companies-of-2020/?sh=70dab9414a49 (accessed 20 December 2022)

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