ESG: Identifying metrics that matter most

In the past, companies might have responded to a push like this with a few well chosen words and glossy pictures in the annual report. That was not really adequate to manage ESG as a public relations issue then, and it certainly isn’t enough to manage the demands of investors now. What the market wants is convincing evidence that companies have a sustainable economic model.

This requires the disclosure of a set of robust non-financial metrics. The question a finance director (FD) faces is: which ones?

The current proliferation of available options is a minefield. There could be a temptation to either leave this aspect of reporting to sustainability experts or to try to keep it out of the annual report and other market-facing information altogether. Neither approach is adequate. FDs should play a leading role in deciding what to disclose beyond the regulatory baseline, using these three fundamental questions to drive outcomes.

Which metrics matter most to our business?

As with financial reporting, what is measured, monitored and reported should start with a company’s specific strategy and purpose. There needs to be a clear link to strategy. The Blackrock letter is instructive here - it asks companies to disclose, specifically, how ‘their business model will be compatible with a net zero economy’. Generic statements are not enough.

While FDs should lead the internal discussions, the heads of strategy and operations are crucial because of their understanding of the factors that will determine the success of the business. The ultimate decision about which metrics to disclose should be taken by the entire top team, working in collaboration.

Which metrics matter most to our stakeholders?

What matters to management and what matters to their stakeholders will inevitably overlap, but the match is unlikely to be perfect. There will often be a need to provide information simply because stakeholders demand it.

Just as FDs listen carefully to shareholders, so they also need to listen carefully to other groups of stakeholders. Frameworks like the UN Sustainable Development Goals or the WEF/IBC reporting framework can be helpful guides, but there is no substitute for engaging directly with employees, regulators, NGOs and local communities. This is where maintaining a robust dialogue with externally-oriented functions like Corporate Affairs, Investor Relations, Legal and Sustainability can short circuit a lot of work. These groups can bring rich insights into what specific stakeholders are looking for.

When it comes to investors it’s just as important to think about what they don’t care about as what they do. Before committing to a new disclosure, FDs should ask whether investors find it useful. Rushing out a new metric in haste is much easier to do than taking it back, so make sure it’s the right one.

Do we have the systems and processes that we need?

Ultimately, companies will need to disclose the information that investors and other stakeholders want, or they will suffer the consequences. However, it will often be a journey to get from what is disclosable today to what is needed tomorrow. Non-financial disclosures will only be credible to markets if the data that is collected and analysed is as robust as the data used in financial disclosures. Companies therefore need to bring the same focus on relevance and reliability as they bring to financial reporting. One untrustworthy disclosure - or material omission - can undermine confidence in everything else.

The sophisticated mechanisms that ensure the accuracy of financial information - including control procedures, internal audits, external assurance and cyber and other security systems - should be deployed to meet the same high standards for non-financial information. Again, the FD has a crucial role.

The new reality is that the demand for transparency over ESG is set to increase. Companies that don’t publish information, or that publish information that turns out not to be trustworthy, will miss out on investment and access to capital. Those that get it right - hitting the notes that investors and other stakeholders expect to be hit - will gain an edge. Two identical companies could end up in very different places simply by virtue of the quality of the information they share.

^{_{*Source: Morningstar Direct, Manager research. Data as of December 2020.}}