The ESG Factor: How non-financial performance reporting can build investor confidence

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By John DeRose

In the last three years, there has been an expanding role of Environmental, Social and Governance (ESG) factors in the decision-making of investors worldwide[1], according to Ernst & Young’s third Tomorrow’s Investment rules survey. At the crux of this year’s discussion was a simple question: “Is investor appetite for more integrated, predictable and strategic ESG disclosure being met by businesses?”

This was a natural choice given how meaningful ESG analysis has become for institutional investors and the companies they follow. Consider a few of the recent headlines. In November 2016, Bloomberg Media declared, “Larry Fink Wants Companies to Talk More About the Future.”[2] In this case, the head of the world’s largest investment manager wrote to the CEOs of the S&P 500 companies and Europe’s largest corporations to extol the virtues of strong ESG performance and its effect on valuation. Or consider the steady uptick in calls to action as part of shareholder proxies. Close to a third of the institutional investors, investor associations and advisors EY spoke with prior to the 2017 proxy season said environmental and social risks should be a board priority in 2017. That’s more than double the number who said so last year.[3]

The Changing Face of ESG Information and Reporting

Historically, investors would often emphasize worker health and safety information from companies in heavy industry. But today, investor focus has expanded to more sectors and a broader range of ESG issues, such as changing societal expectations, impacts of disruptive technologies, changing demographics, scarcity of resources, human rights risks, treatment of employees, diversity and post-financial-crisis executive pay.

The Link Between ESG and Performance

The historical tendency to disregard a causal relationship between a company’s ESG performance and financial performance is fading. Serious reputational and environmental risks can and do surface, and they can have real impacts on the bottom line. Equally important, ESG factors can be used to help identify new opportunities and manage long-term investment risks, as well as avoid poor company performance due to lax governance or weak environmental or social practices.

In addition, studies show that strong ESG practices lead to better, long-term operational performance and superior, risk-adjusted rates of return. For example, a 2015 report by Oxford University and Arabesque Asset Management—based on more than 200 academic studies, industry reports, newspaper articles and books—found that 88 percent of research reviewed showed that “solid ESG practices” lead to better operational performance.[4] As studies like these continue to break ground, the attention of investors and companies will also continue to gain momentum.

Impacts on Investor Decisions

In EY’s recent survey of more than 320 senior decision-makers from buy-side institutions worldwide, it’s clear that investor demand for greater ESG transparency is rising, as is their consideration of ESG matters when making investment decisions. Eighty-one percent of respondents said they are now paying closer attention to non-financial disclosures. Sixty-eight percent said that a company’s non-financial performance had played a pivotal role in their investment decisions, up from 58 percent in 2015. Just how pivotal? Seventy-six percent said they would reconsider investment following the disclosure of key risk or a history of poor environmental performance. Risk areas tied to poor governance, human rights, the supply chain and resource scarcity represent a few of the potential drivers behind the reconsideration of an investment.

This increase in investor attention mirrors the intensifying call for businesses to focus on long-term value versus short-term returns. Ninety-two percent of respondents concurred that, over the longer-term, ESG issues have tangible and quantifiable impacts. Keeping this response in mind, it is not surprising that 89 percent also agreed that a sharp focus on ESG issues can generate sustainable returns over time. In addition, 71 percent said that they would rule out or reconsider investment in the absence of a direct link between ESG initiatives and business strategy to create value in the short, medium and long terms.

Are businesses responding?

Yet, even as ESG issues continue to gain momentum among investors, there remains a disconnect among companies that do not yet see ESG risks as core to their business. According to the survey, 82 percent of investors say ESG risks have been ignored for too long by the business world. Asked whether companies adequately disclose ESG risks that could affect their current business models, more than 80 percent of respondents said no. Sixty percent, a solid majority, called for companies to disclose these risks more fully. Investors are looking to company management and the board for increased accountability for improving ESG transparency and the quality of non-financial reporting. Seventy-six percent said that board oversight and audit committee oversight of non-financial reporting is either “essential” or “very useful,” and 68 percent of respondents agreed that third-party verification of non-financial information is either “essential” or “very useful.”

Looking ahead

As these findings indicate, the rapidly changing views among institutional investors may serve as a sharp call to action for chief financial officers who seek the attention of these very investors. To be sure, constructive change is taking place across geographies, sectors and individual companies, in areas such as improved corporate governance and oversight, the reliability of disclosed information, and stronger reporting processes and controls. And investors aren’t the only ones with rising expectations. As businesses continue to make progress, they also will keep pace with organizations like the International Integrated Reporting Council, the Global Reporting Initiative, the Sustainability Accounting Standards Board and the Financial Stability Board’s Task Force on Climate-related Financial Disclosures, among others, all of which are driving non-financial reporting standards toward a more credible, comparable and predictable future. With the right leadership, businesses can take significant strides to get there, while meeting investor demands and improving financial performance along the way.

 

John DeRose is the climate change and sustainability services non-financial reporting advisory and assurance service leader in the Americas for Ernst & Young LLP. The views expressed are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

References

[1] “Is Your Nonfinancial Performance Revealing the True Value of Your Business to Investors?”, EY and Institutional Investor (II) Research Lab, http://www.ey.com/gl/en/services/assurance/climate-change-and-sustainability-services/ey-nonfinancial-performance-may-influence-investors, March 2017

[2] “Larry Fink Wants Companies to Talk More About the Future,” Bloomberg News,https://www.bloomberg.com/view/articles/2016-02-02/larry-fink-wants-companies-to-talk-about-the-future, February 2016

[3] “2017 Proxy Season Preview: What We’re Hearing from Investors,” EY Center for Board Matters, http://www.ey.com/us/en/issues/governance-and-reporting/ey-2017-proxy-season-preview, February 2017

[4]“From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” Arabesque Asset Management and Oxford University, http://www.arabesque.com/docs/From_the_stockholder_to_the_stakeholder.pdf,  March 2015

Posted June 8, 2017 in Reporting