The current buzzword for listed companies is ESG (environmental, social and governance) reporting. We have come a long way since the bad old days of “shareholder value”, which saw profits for shareholders as the only bottom line.
Short-term shareholder value destroyed the long-term environment, fostered inequality and bred bad business behaviour. The 2008 global financial crisis was the wake-up call, because crises exposed the greed and costs of financial capitalism. But financial and crony capitalism is very much alive and kicking, thanks to central bank monetary creation that flooded the world with cheap and short-term money.
Companies today realise that the world has changed. They can either be reactive or lead that change. Doing nothing is not an alternative.
Several mega-trends changed the boardroom discourse — demographics, social injustice, climate change, technology and, today, geopolitical tensions. In 2015, the United Nations created 17 Sustainable Development Goals (SDGs) as a shared plan to end extreme poverty, reduce inequality and protect the planet by 2030.
The key goals are to end poverty, hunger, promote good health and well-being, quality education, gender equality, clean water and sanitation, clean energy, decent jobs, innovation and infrastructure, sustainable cities, responsible consumption, climate action on water, air and land, peace and justice and partnership to achieve all these.
Much to do, but how do we achieve this?
Since the corporate sector is right at the heart of the global economy, corporate behaviour is both the boon and bane of everything that is good and disastrous about our current mess. ESG is therefore the corporate response and action plan to achieve the SDGs. Can it work?
ESG reporting means a fundamental change in corporate mindset. We are in the current planetary mess because the different parts or players (silos) have very partial or parochial paradigms (worldview) that do not see that we live in a systemic and interconnected whole (One Earth), in which both the mindset and the institutions are outdated.
In short, we are moving along the S-curve of transformation in speed, scale and scope that are unsustainable.
The economic system comprises four interconnected and interdependent parts — meta-economics (the paradigm), macroeconomics (the big picture of economic behaviour), microeconomics (behaviour at the firm or individual level) and meso-economics, the institutional framework that links the micro with the macro.
Humans created institutions to implement the policy objectives framed by the paradigm (currently mostly neoliberal free markets, minimal government and profit maximisation). Both state and markets are social institutions to deliver human well-being but instead, we got huge inequalities and planetary pollution and destruction.
The 2008 financial crisis exposed this silo-based thinking of rational man as incomplete, flawed and fragile. The ongoing pandemic showed that one micro-virus can bring the whole economy to a lockdown. The micro has changed the macro but the mindset and the institutions cannot cope with the implications and damage. The mindset of old-style politics, and entrenched institutions (government bureaucracies and companies) are not changing fast enough to cope. Are we surprised that systems are failing?
As early as the 1930s, the Austrian philosopher Karl Polanyi already predicted that the free market economy model pushed by his contemporary Friedrich Hayek was flawed. The market is part of the economy, which is part of society, and society is embedded in the planet. So, how can a part explain the whole? Polanyi was prescient on how the free market blind spots would lead to the troubles today.
Mainstream economics assumed the rational man. But both human and institutional behaviour are not always rational, because they are driven by emotions, religion, culture and values that are far more complex and unpredictable than existing theories. Nature is also more unpredictable, with black swans and butterfly effects that appear chaotic. In effect, corporations must address today the twin injustices against human beings (inequality) and against nature (destruction of biodiversity).
In 2017, the International Business Council (IBC) of the World Economic Forum (Davos) sponsored the “Compact for Responsive and Responsible Leadership”, declaring that “society is best served by corporations that have aligned their goals to serve the long-term goals of society”. ESG therefore translates SDGs into action for the business and financial sector.
The Davos Manifesto 2020: The Universal Purpose of a Company in the Fourth Industrial Revolution articulates the principles of stakeholder capitalism as follows: “A company is more than an economic unit generating wealth. It fulfils human and societal aspirations as part of the broader system. Performance must be measured not only on the return to shareholders, but also on how it achieves its environmental, social and good governance objectives.”
At long last, CEOs and boards have responded to calls for stakeholder responsibilities and not just raw profits. But is this more whitewashing or greenwashing of raw capitalism?
The facts remain that 100 companies accounted for 71% of all carbon emissions in the world since 1988. Most of these are fossil-based energy companies. Companies make the products that consume energy and scarce natural resources, but also use advertising to “take, make, waste”.
Banks are happy to finance consumption today by taking on more debt to be paid back tomorrow. Excess consumption becomes possible through excess debt. Excess leverage yields more profit but makes the whole system more fragile.
Thus, corporations can reduce carbon emissions and wasteful production and consumption through designing, producing and selling green products and services that are also inclusive. Many see the rise of the circular economy to reuse, recycle and repair consumer durables. My car battery used to last six years; today my new car battery is gone in one year. It is cheaper to buy a new TV or appliance than getting them repaired. As long as companies design products to waste, pollution and toxic dumps cannot be avoided.
Corporate captains have now realised that ESG companies are valuable to investors and consumers alike. Green products are profit opportunities. Total investing to meet SDGs by 2030 will require US$5 trillion to US$7 trillion funding annually. So instead of ESG denial, smart CEOs have used the Covid-19 shock to completely retool and reset their policies and products.
Companies today appoint more women to leadership roles, have more racial and cultural diversity and design new green products and services online. Corporate captains realise that consumers and investors expect them to meet higher standards of integrity and performance, and be inclusive and environmentally sustainable.
On the finance side, under the leadership of former Bank of England governor Mark Carney, who is today UN Special Envoy on Climate Action and Finance, the Financial Stability Board (FSB) created a Task Force on Climate-related Disclosure (TFCD) to improve data standardisation and integrity on climate-related issues. Basically, TFCD pushed companies to measure and publish their Greenhouse Gas (GHG) emissions. But this is not mandatory.
In 2017, the central banks created a Network for Greening the Financial System (NGFS) to push the financial system to meet the goals of the Paris Agreement. The Bank for International Settlements (BIS), which houses the secretariat for central bank policy discussions, published last year “The Green Swan: Central Banking and Financial Stability in the Age of Climate Change”. The NGFS also guided asset managers managing US$17.5 trillion in global assets to try and fulfil ESG requirements.
While I would be much happier if central banks directly financed green infrastructure projects, the BIS urges central banks to act indirectly by using central bank reserve management policies to buy more green bonds, and apply bank supervisory powers to push banks to lend to green projects and uplift green project disclosures.
In 2021, the United Nations finally announced the implementation of the System of Environmental Economic Accounting (SEEA), which follows a similar accounting structure to the System of National Accounts (SNA). The inclusion of the natural capital concept, measuring pollution, biodiversity and non-replaceable natural assets in national accounting, means that there will be pressure for companies to measure and disclose their environmental and social footprints.
Unfortunately, the International Financial Reporting Standards (IFRS) Foundation has yet to issue a unified ESG disclosure standard, but it created an International Sustainability Standards Board in June this year to improve ESG disclosure.
In short, the ESG ecosystem is evolving rapidly, requiring issuers and investors to measure and disclose more ESG information. The top four accounting firms (Deloitte, EY, KPMG and PwC) have prepared a Common Metrics and Consistent Reporting of Sustainable Value Creation report, presented in Davos, which outlines such ESG metrics. This is a formidable list.
Under the four pillars of principles of governance, planet, people and prosperity are 22 metrics. The objective in the Integrated ESG reporting is to enable all stakeholders to evaluate how ESG issues are incorporated into core business strategy and governance processes, including their implications. In other words, investors, workers and governments need to know whether the company meets the ESG performance standards, delivering profits as well as fulfilling social and governance responsibilities.
On the governance side, the company must disclose its governing purpose, board quality, stakeholder engagement and also ethical behaviour, such as action on corruption, and reporting and handling of ethical issues.
On the planet side, the company must report on GHG emissions and meet all TFCD reporting requirements on climate risks and opportunities. The impact of nature loss, such as land use and ecological sensitivity, water consumption and usage in water-stressed areas, would be disclosed. Under the people pillar, the company will disclose gender pay equality, diversity and inclusion, wage levels, risks for child labour, health and safety, and training provided.
On prosperity, the company will disclose the net number of jobs created, net economic contribution and net investment. To highlight innovation, it should also disclose the R&D spend ratio. On contribution to community and social vitality, it will disclose community investment, as well as country by country tax reporting.
There is no doubt that the ESG reporting burden will increase substantially, putting huge stresses not only on boards but also on staff and all operating and reporting processes. The good news is that a lot of jobs will be created, but given the cost burden, many small companies will struggle to find the skills and resources to meet all the ESG requirements.
My grouse with all accounting and reporting standards is how small and medium enterprises (SMEs) can cope with these stringent and costly requirements. Expecting community banks to meet the onerous Basel III reporting standards is tough enough. To expect SMEs to disclose ESG will require a quantum leap in staff quality.
Accountants and consultants love more reporting and disclosure requirements because they generate more fees. Regulators find it easier to write new rules and laws as an excuse to change behaviour. In fact, additional ESG reporting is only the beginning of a long journey. Implementation will be tough for all.
Regulators, accounting bodies and chambers of commerce must work closely together to ensure that “the best is not the enemy of the good”. Namely, in pursuit of ideals, the cure is worse than the disease.
Laws that are easy to understand, easy to implement and enforce, will be obeyed. Laws and rules that are too complex and costly will be ignored or avoided. Worse, companies may pay lip service to compliance, but create information that is misleading, false or seriously incomplete.
A sustainable ESG reporting system has to be fair, efficient and adaptable to local conditions. Principles are easier to understand than very complex detailed rules and metrics. If companies comply with the spirit of the ESG principles, and slowly but surely work towards better compliance, that would be a major achievement indeed.
To be sustainable and effective, the spirit and processes for ESG must be embedded in all corporate staff, from CEO to the lowest worker. ESG objectives are wishful thinking, until they are transformed into actionable performance that delivers results visible to all.
The phase of talking ESG is over; let the walking begin.
Tan Sri Andrew Sheng comments on global issues from an Asian perspective. The views expressed are wholly his own.