When the EU’s Sustainable Finance Disclosure Regulation (SFDR) came into force on March 10, it might well have been news that passed many businesses by, writes Bart van Praag, General Manager, EMEA, Workiva. After all, at first glance, the regulation only applies to financial market participants (asset managers, pension providers, insurance company investors, etc.) and financial advisors (consulting on investments or insurance). But scratch the surface of the regulation and the implications for business of all types across the EU and the UK become clear.
In simple terms, SFDR aims to direct financial investment towards more sustainable businesses. To do that, it mandates that financial market participants and advisers disclose Environmental, Social and Governance (ESG) factors in any investment recommendations.
Firms with 500 or more employees were able to start evaluating principal adverse impacts - or PAIs - on March 10, and must do so by June 30. Market participants and advisors must disclose how they consider PAIs - negative and material effects on sustainability - and create policies on integrating sustainability risks when it comes to their investment decisions or financial advice in Europe.
Starving businesses of the oxygen of capital
In looking to encourage European organisations to act more sustainably, it would be obvious to ask the question as to why the EU isn’t regulating those companies directly, rather than investment companies?
In fact, European Union regulators are being particularly clever with how they tackle one of the toughest problems around ESG disclosures - materiality - without passing more direct requirements for companies. In mandating that investment firms disclose the ESG factors taken into consideration in any investment recommendations, they are effectively steering capital towards those businesses that are operating more sustainably, and away from those that aren’t (or, at least, can’t demonstrate it through comprehensive ESG reporting).
The initial focus on the finance sector will eventually see ESG disclosures adopted across all industry sectors and with it, hopefully, an end to greenwashing.
Selective sustainability reporting replaced by irrefutable data
Current sustainability reports can often represent the pinnacle of slick and selective corporate storytelling. Glossy ‘greenwashed’ publications and websites packed full of smiling people, lush green forests and charitable endeavours are typical. But these often paint an incomplete if not inaccurate picture of an organisation’s efforts; showing healthy gender diversity is one thing, for example, but not revealing a related and significant gender pay gap is misleading, at best.
See also: Goldman Sachs will add carbon accounting of client portfolios to its investing application.
Sustainability reporting needs to evolve, and fast. A very different animal, genuine ESG reporting will be based on data and, with that, it will be transparent, irrefutable and auditable. But when stakeholders of all types – including an increasing number of consumers – want to see evidence of non-financial factors from companies where they’ll be placing their hard-earned cash, the rigour needed in ESG reporting is every bit as critical as that used for financial reporting. And herein lies a challenge that many businesses have yet to adequately tackle.
Reporting beyond the balance sheet
By its nature, reporting on the non-financial aspects of ESG means that the data required, both structured and unstructured, sits in numerous locations across an organisation, ranging from dedicated systems to files and folders sitting on employee’s desktops. Add to this the plethora of ESG measurement methods, frameworks, guidance, protocols, rankings, indices and standards, and the complexity of ESG reporting becomes clear.
Collecting and aggregating this data is an enormous challenge, and undermines some of the core principles of effective ESG reporting, namely data accessibility and data availability. If disconnected desktop tools are used to gather, store and share data - as is the case in many organisations - audit trails, transparency, and the ability to audit data is lost.
Beyond the fundamental impact on the efficacy of data, working in silos is the antithesis of the collaborative exercise that ESG needs to be; the team sport increasingly located between the office of sustainability and the office of the CFO.
It’s a new area that can’t be managed with antiquated tools, and with the ever-higher stakes represented by ESG reporting to regulators, investors and other stakeholders, process and audit transparency becomes paramount. The same rigour and tools that have become familiar in the reporting of financial information need to be applied to the non-financial factors of ESG.
An opportunity to lead
Few people still doubt the large-scale impact of ESG issues on the world’s population at large. But how those same issues impact the value of a single entity, that contributes to or is affected by ESG problems, has proved trickier.
In an effort to enhance the level of materiality of ESG disclosures, European Regulators have initially shifted that decision, in part, to the financial markets. In doing so, however, they have made ESG disclosures increasingly material to businesses by mandating that capital markets take these measures into consideration in their investment decisions.
SFDR will help drive further commitment to meaningful sustainability disclosures through the entire range of European industries. It is an ambitious program to put ESG disclosures front and center in many sectors, with financial services just the starting point. Businesses should welcome its arrival.