Given both the cost of getting environmental, social and governance (ESG) reporting wrong and the benefits of getting it right, many financial institutions will likely need to invest more in how they communicate their approach to ESG to their stakeholders. In the past, the winners may not have been the ones who were really the leaders at ESG but rather those who could tell a more convincing story to the market. Going forward, the winners will be those who have a credible ESG story and a credible approach to ESG reporting.
The stakes are high and getting higher. Many investors now actively allocate capital based on ESG information and ratings. Two-thirds of institutional investors believe that ESG will become “industry standard” within five years. Many consumers already gravitate toward brands that address ESG issues in ways that align with their own values. Perception is reality, and the perception of your ESG efforts will depend on your reporting. Does your ESG reporting resonate with your priority stakeholders? Is the information you’re disclosing accurate and complete? Even if the answer is yes today, you may be left behind by competitors in the not too distant future. As ESG reporting continues to evolve, firms that progress faster than others—for example, by conducting real-time ESG reporting and analytics and using those insights to inform strategic decisions—will likely race ahead.
With pressure from stakeholders continuing to build, ESG is getting more attention at the C-suite level. Our March 2021 Pulse Survey shows that CFO survey respondents in financial services (FS) are more focused on ESG reporting priorities than CFOs in other industries.
Most financial institutions understand the need to devote more attention to ESG—both to differentiate themselves in the eyes of customers and other stakeholders and in response to regulatory pressure. However, many struggle to apply a structured approach to the topic, and few have met the standards of investor-grade ESG reporting.
Investor-grade reporting represents a big step up from the current level of ESG disclosure at most firms, which is largely voluntary and ad hoc. We expect ownership of ESG reporting to eventually shift to the CFO, with the CEO retaining overall responsibility for the ESG agenda. We also expect ESG reporting to become integrated with standard financial disclosures, meaning that reporting will need to meet investor-grade standards and could become part of FS companies’ compliance and controls program.
That’s why we recommend that FS firms incorporate ESG reporting into the processes already in place for financial reporting, leveraging existing competencies, controls and reporting architectures to meet investor-grade standards. In the next sections we provide an overview of challenges we see FS firms encountering and make recommendations for how they can strengthen their ESG reporting.
FS firms are often all over the map when it comes to tying the elements of ESG into consolidated reporting and to their broader strategy. They face many different frameworks and standards for enhanced ESG disclosures, including Global Reporting Initiative (GRI) standards that have advanced sustainability reporting for years and the Sustainability Accounting Standards Board (SASB) standards that provide detailed industry-specific recommendations to the varying expectations from the rating agencies. The World Economic Forum has launched an effort to move toward common “stakeholder capitalism” metrics. For climate change, consensus is building around the Task Force on Climate-related Financial Disclosure (TCFD), currently supported by more than 1,500 firms and key regulatory agencies.
The European Union (EU) has established a very ambitious set of regulations affecting the definition of sustainable activities (taxonomy) and increasing the disclosures requirements for financial institutions providing investment advice (Sustainable Finance Disclosure Regulation), both of which are applicable in full or in part in 2021. The EU has also decided to update its Non-Financial Reporting Directive (NFRD, applicable since 2014) with a targeted adoption of the revised requirements as soon as 2022.
In the United States, SASB has momentum. Recently, the SEC also requested feedback on how the agency can better facilitate climate-related disclosures. The statement contains 15 questions on potential approaches to enhance climate disclosures, including:
In addition to knowing which standards to follow, financial firms often struggle with how far they should go beyond standards, either to meet higher stakeholder expectations or as a way to strategically differentiate themselves. ESG rating agencies such as MSCI, Sustainalytics and CDP Worldwide evaluate company performance in ways that often go beyond regulatory standards. Consider a bank’s B2B loan portfolio. Historically, all that mattered was good fundamentals: As long as a borrower could repay the loan and meet regulatory standards (such as KYC/AML), the bank would be happy. Now, an ESG rating agency might evaluate a strict ratio to dollar value threshold of loans given to firms that don’t meet ESG criteria. That criteria can be subjective, so a bank could find itself tagged as having 20% of its B2B loans out to firms that are considered not to be aligned with ESG causes.
Many FS firms also struggle with how quickly to start reporting and what to include in their initial transparency reports.The trigger for deciding when to make reporting disclosures has usually been financial statement materiality, a static percentage of revenue or assets under management. However, the identification of material ESG issues is often less prescriptive and involves more judgment by management based on input from stakeholders like directors, customers and employees.
Once a firm works through the challenges of what ESG information to report, they often contend with the challenges of how to effectively collect, manage and produce the information in a manner in which they can have confidence. Both the breadth of ESG data types and the disparate internal and external users of ESG data drive significant reporting complexity. Those who perform ESG reporting pull data from a combination of financial and nonfinancial systems, in some cases going back to data from external vendors. The process of extracting, cleaning and aggregating data for disclosure is still largely manual—often on multiple spreadsheets—which means that poor-quality data can make its way into reports. We also see those responsible for reporting having trouble tying the information that ends up in the public domain back to trusted sources. The lack of controls and independent confirmations often result in metrics that are not verified. While beginning to focus on ESG reporting, traditional IT vendors have not yet developed enterprise solutions that support ESG data gathering and reporting. Adding to the difficulties, self-service analytics tools can be limited.
ESG frameworks, issues and metrics are evolving quickly, and they encompass many aspects of a firm’s operations. This makes it challenging to determine the leading way to report ESG performance with investor-grade standards. It will likely take time to get this right, so starting-and-refining will be far more useful than waiting-and-seeing. We suggest FS firms stick to a narrow set of priorities:
Whether driven by investor demand, regulation or the desire to enhance societal value, there’s now an expectation that financial institutions integrate ESG issues and sustainability into their corporate strategy, philosophy and reporting. With that expectation comes clear opportunities for firms that take a proactive approach and clear risks for those that don’t. Firms that tell a clear and credible story can not only establish themselves as leaders in the market, they stand to benefit from increased access to capital and the returns associated with that access.
Take advantage of tech-enabled solutions that can help you assess maturity, reduce potential risks, recalibrate your efforts using deeper insights and benchmark against your peers. This can help you develop required disclosures and transparency reports more quickly, gain a better understanding of your firm’s current ESG situation and more easily identify what actions you should take next.
In the longer term, as data and reporting get more regulated and standardized, objective comparisons will become easier. But by stepping into the spotlight now with a compelling ESG story, you can take strategic action in a measured way and start to build momentum over time to truly differentiate your firm.
Sustainability Partner, Financial Services Consulting Solutions Leader, PwC US