When my private equity peers ask me how to handle ESG disclosures, my answer is typically, “don’t let the tail wag the dog.” What I mean, is it’s better to proactively report on what you know to be the most material and substantive representations of actual ESG performance for your companies, before being prompted to do so.
In my experience, investors appreciate thoughtful, proactive disclosures, which saves them time issuing and chasing completion of proprietary forms; further it engenders trust based on open and transparent communication of these key metrics and considerations. While regulators require a more structured framework of reporting, I believe taking this proactive approach is still valid. Early movers in ESG disclosure will, at the very least, set themselves up better for inevitable regulation and made a head start, even if final requirements have a different total scope.
Fundamentally, all of these disclosures serve the same purpose: to inform better investment decisions. The conversation around ESG has moved on significantly in recent years and it is no longer seen as mutually exclusive from strong returns. It is actually quite the opposite – it is seen as an essential lens through which to consider investment opportunities. In this context, the imperative to accurately inform your investors remains more important than ever.
How disclosures are born
Understanding what informs disclosure obligations and how they evolve is essential in knowing how to approach them
In the early days of ESG taking root in the private equity and wider investment industry, individual actors collected and reported information they deemed appropriate. These were informed largely by the practices in the (slightly) more established corporate sustainability sector that developed in collaboration with academics and NGOs. The ESG officers at the various private equity firms collaborated informally, creating some consensus, but without formal obligations. Prominent asset owners, who are the primary investors in private equity funds, put out questionnaires or data requests as needed. Their counterparties, as well as smaller actors, frequently adopted the same approaches in order to streamline their work and maximize market acceptance.
Over time these informal collaborations became formal though still voluntary initiatives, notably the ESG Data Convergence Initiative (EDCI). These initiatives tend to be based on a set of key performance indicators (KPIs) deemed most essential and widely applicable, and were agreed across market actors through a consultation process. Processes like these have fed into the formal regulatory rulemaking across industry that has produced legislation such as the EU Sustainable Finance Disclosure Regulation (SFDR). The EU SFDR includes a similar set of “converged” KPIs as the EDCI. In time, the different regional standards will revise themselves to become more interchangeable to make business easier for multinationals.
How to predict the future
The good news for your business is these convergences are not unpredictable; the requirements that win out generally come from good sense and can therefore be identified well ahead of time. In anticipation of what a business will be required to report, the following are helpful considerations:
- What issues are of generally universal interest, and particularly within your industry?
- What issues are relatively easy to quantify in a substantive way?
- What issues have existing formal (voluntary or regulatory) initiatives in place globally?
- Assuming an issue has been identified, is there a manner of tracking it that reflects the realities of a business?
Greenhouse gas (GHG) accounting is a very straightforward example of the above. It’s of universal interest across all industries, it’s easy to quantify substantively, a large body of organizations already govern its disclosure, and accommodations to reflect business realities (such as reporting intensity metrics rather than absolutes) are well accepted. Taking a narrower example, in food and cosmetics supply chains, sourcing of palm oil is an important issue since it is linked to significant environmental degradation and other issues. While on the surface this degradation may seem difficult to quantify, the fact that a voluntary framework already exists, the Roundtable on Sustainable Palm Oil (RSPO) allows for a percentage of RSPO-certified procurement to be reported.
Another factor to consider is that many who oversee ESG initiatives are not necessarily experts in the area. However, the good news is developments are not unpredictable if you keep your ear to the ground. Look back to my description of how disclosures typically are born: the early stages involve academics and NGOs. So, following media on particular topic areas will surface issues well ahead of time. Then, as practitioners begin discussing it, it will crop up in trade publications and conferences.
ESG matters such as climate change and diversity, equity, and inclusion (DEI) dominated agendas before they ever hit regulations. Around this point, you will begin to see formal requests from investors, customers, employees, NGOs, or other groups about the area, making the need for reporting on these topics very clear. By the time regulators begin discussing this, in what are typically lengthy rulemaking processes, you still have significant runway to prepare before you’re required to formally report.
When you identify areas of increasingly urgent interest, keep in mind the adage “progress should not be the enemy of perfection.” It’s always better to collect and report some information than none in this field – as long as it’s represented accurately.
How to prepare
When you identify areas of increasingly urgent interest, keep in mind the adage “progress should not be the enemy of perfection.” It’s always better to collect and report some information than none in this field – as long as it’s represented accurately. GHG accounting is an infamously opaque exercise compared to its financial accounting cousin. However, while it does lean heavily on assumptions, using imprecision as an excuse to report nothing at all is much worse, both from a financial and environmental perspective.
Second, ensure access to adequate expertise on the topic area. While this may seem daunting at first glance, it doesn’t necessarily mean hiring an army of new employees. Frequently, existing employees already work on the topic and have quite a bit of knowledge, and simply need a bit of guidance for how to convert that knowledge into a useful ESG disclosure. For example, HR professionals already live the day-to-day of DEI, and already frequently collect and report demographic information. Another example is the access to ESG reporting metrics such as energy consumption, which is typically already available to facilities personnel and needs to be consolidated in a more formalized fashion. For more resource-constrained organizations, an outside consultant can be used to steer what specific ESG areas ought to be tracked and what measures need to be implemented, in lieu of hiring an entire team dedicated to ESG.
Third, pick a framework that makes sense for your business and commit to it, regardless of what you think the future may hold. For example, biodiversity is an incredibly hot topic on the conference circuit at the moment and has essentially no universally accepted definitions or assessment frameworks, despite the fact the EU requires disclosures in its SFDR. As such, you’ll need to look at what others are doing and pick a framework that is a good fit for your organization. In this example, perhaps you have a Europe-based business and define a biodiversity sensitive area as a Natura 2000 space (EU-defined wildlife conservation area). You then use a spatial tool to look up if any of your operations are present in any of those areas and report the percentage that are.
Perhaps you accidentally got it exactly right and predicted what would later become the regulation. But even if you don’t, you have investors appreciative of your proactive disclosures that still provide useful information – and are likely material to your business, even if you’re not required to report on them. In the best-case scenario, your proactive leadership can encourage other market participants to adopt the same approach.
Perhaps you accidentally got it exactly right and predicted what would later become the regulation. But even if you don’t, you have investors appreciative of your proactive disclosures that still provide useful information – and are likely material to your business, even if you’re not required to report on them.
ESG disclosures do not have to be intimidating or burdensome. Imperfect disclosures now will help you comply with stricter and more complex regulations when they come down the road. The ESG field is relatively new and will mature in the years to come. Stay on the front foot, do not worry about heading in precisely the right direction, and simply start moving.
2023 Prediction
For companies of any size, GHG accounting will become as normal and universal as financial accounting. Further, companies will realize (at least for Scopes 1 and 2) this accounting actually isn’t particularly difficult. I also predict that biodiversity finally gets more widely accepted definitions of what constitutes biodiversity sensitive areas, and what basic procedures or resources can help assess businesses for their impact on them.
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