Extra-Financial Reporting Undergoing Profound Changes. Here’s why

Materiality and Regulatory Compliance of Extra-Financial Reporting

The work on materiality, offering conciseness methodologies, has developed over the past 15 years to provide a relevant response. Clearly without sufficient satisfaction, since the criticism aimed at the lack of conciseness remains recurrent.

Multiple organizations are of course trying to advance reporting and corporate disclosure on sustainability issues: SASB, the Global Reporting Initiative (GRI), the International Integrated Reporting Committee (IIRC), the CDP, the Task Force on Climate-Related Financial Disclosures (TCFD), and others are working hard on materialty and metrics converging expectations defined by hundreds of industry associations, such as WHO, CDP, EPA, OSHA and industry organizations such as ICAO, IPIECA, EPRI and GRESB. This leaves unresolved three essential questions for companies and the selection of topics on which to focus extra-financial reporting efforts:

• Which materiality methodology is relevant and credible for stakeholders who consult extra-financial information?
• How can materiality and regulatory compliance be combined, for example to provide extra-financial information that provides answers on the subjects deemed to be the most “material” both to US, UK, German, French or Danish regulations?
• For any Group operating internationally, i.e. any company eligible for extrafinancial reporting, how to respond to the compliance issues emanating from customers and authorities based abroad and address the associated regulatory mille-feuille?

Here again, the answer will emerge in the ever-increasing exercise of materiality, with its pros and cons:

• As presented in this briefing paper, the materiality of extra-financial reporting will become more and more important, and will focus on business issues that are increasingly strategic and associated with the company’s sustainability and the challenges of transforming the company in the face of its environmental, ethical and social constraints.
• Domestic and international regulatory compliance will increasingly be subject to materiality priorities. This is why the scope of reporting addressing human right or anti-corruption regulations will gradually become clearer – for example, on the issues of complaint mechanisms.
• The room for nuance and weak signals will be provided in supporting documents, or even in the provision of open data that will allow stakeholders themselves to compare and study subjects they consider important – with or without data provided directly by the company.

Increasingly more materiality will be the way for ever more concise and relevant extra-financial communication.

Big Data: a Major Shift in Non-Financial Disclosure

Various rating agencies, service providers and large companies have more than 20 years of extra-financial data at their disposal: social audits, carbon footprint on scope 1 and 2, social data… At a time when investments in all aspects of digital transformation of companies are growing and expected to expand exponentially, it is clear that the approach to extra-financial reporting will undergo significant changes, and evolve. A major paradigm shift is taking place before our very eyes:

• As its very name suggests, the logic of extra-financial reporting is currently mainly focused on monitoring past performance against defined objectives. This involves reporting data showing the monitoring of commitments to date. In 2010, companies were thus able to set, for instance a Factor 4 objective on carbon intensity over 10 years, and to report on the achievement of this objective in stages from past to present and up to 2020
• Gradually, and in an increasingly standardized manner over the next decade, the data will be used to attempt to define future trajectories. Echoing the insistent demand expressed at Davos 2020, many companies will gradually define trajectories, for example, towards carbon neutrality by 2050. The data will gradually be used to provide stakeholders – starting with board members and shareholders (this Blackrock 2019 CEO letter being a great example, for example) – with information showing predictable operational trajectories, based on data to date

Of course, such digital transformations are complex, and will face many pitfalls, starting with the relevance of past data to offer future trajectories (scope, quality, comparability), the possibility of drawing relevant future trajectories given the many unknown variables (merging & acquisitions, technological disruptions for example), the commercial and financial sensitivity associated with transparency, or the sharing of sensitive information concerning the probable future performance and related financial valuation of companies and entire industries…

However, and we can already see it in discussion with many customers, forums and other expert circles: big data will drastically change the use of non-financial data

Granularity and Evolution in Concentric Circles in Extra-financial Reporting

Social, environmental and ethical issues are of interest and concern to increasingly complex and heterogeneous communities of actors.

• 20 years ago, a CSR/Sustainability department would seek information from other actors to consolidate information and respond mainly to external regulatory compliance or ESG rating agencies.
• For the past 10 years, various corporate departments have been using their own extra-financial information to steer their actions. Responsible purchasing. Diversity and human resources. Subsidiaries responding to different issues and multiple regulatory constraints (e.g.: development of local market sustainability reports). The way in which extra-financial data is developed, centralized and processed has literally exploded in order to meet the needs of an ever-growing number of businesses with increasingly heterogeneous requirements

Today, the challenge for the coming years is to rationalize, improve the quality and granularity of access to non-financial data in order to provide access to information in concentric circles.

• Rationalization: Each extra-financial theme can offer different interpretations, and is likely to respond to great regulatory heterogeneity. More than 4,000 regulatory initiatives are already mapped around the world. Without streamlining, there is a real risk that non-financial reporting will become lost in a complexity that is neither necessary, nor the best use of limited resources.
• Quality: Each extra-financial theme can suffer from the production of poor quality data, associated with the lack of information, the lack of competence of the people responsible for providing the data or the lack of traceability. The explosion and heterogeneity of functional needs increases the risk of decreasing data quality.
• Granularity: However, different business lines and different entities within the same group need to have granular access – i.e. adapted to their own needs – to relevant (streamlined) and reliable (quality) non-financial data

This is a new story for non-financial reporting in 2020 and beyond: the rethinking of the ever-growing needs and the ever-increasing volume of data to ensure accuracy and compliance.

Convergence of ESG and CSR Taxonomy and Practices

The interest of investors and financial professionals in ESG is real, and growing. For CSR/Sustainability professionals, there is great value in being able to form alliances with Corporate Finance Departments as well as build coalitions with investors and shareholders on environmental, social and ethical issues.

However, these communities do not speak the same language, working with different concepts, taxonomy and objectives. Convergence on themes cannot progress without further convergence of ESG and CSR/Sustainability taxonomies and practices

• The convergence of taxonomy should allow the actors to speak the same language. European green finance is making a taxonomy effort that is eagerly awaited in 2020. Let’s bet that it will be a step forward to allow greater convergence with the CSR/Sustainability taxonomy.
• Practices are gradually being harmonized. The design of extra-financial reporting on assets is gradually being structured according to standards that are similar to those found in companies’ extra-financial reporting

In a context where the pressure and demand for environmental, social and ethical performance of companies and assets is accelerating, the convergence of ESG and CSR professional taxonomies and practices will make it easier to mobilise the resources needed to accelerate the transformation of corporate practices.

Access to Extra-Financial Reporting for SMEs / Micro-Enterprises

Finally, extra-financial reporting is spreading to ever-smaller segments of companies.

• This is a desire of multiple regulators across OECD economies (e.g.: Europe, several States in the US or Japan) and beyond (e.g.: South Africa or Brazil), which is gradually broadening the base of companies eligible for various non-financial incentives and must report information in this respect.
• It is in the necessity of different programmes carried by the larger corporations. For example, different approaches deployed by industry or company level responsible purchasing programs imply that subcontractors must be able to report non-financial information – which naturally infiltrates the communities of SMEs and micro-enterprises. US supplier diversity programs can be good example. Thousands of company programs collecting carbon data from tier one suppliers can be another good example.
• Finally, it is obviously in the interest of SMEs and micro-enterprises which, in addition to responding to their customers’ requests, are gradually seeing their own stakeholders asking for information (e.g. banks discussing debt management). The development of ESG Loans will no doubt encourage these companies to professionalize extrafinancial reporting and optimize cost to access liquidities.

Conclusions : Extra-financial Reporting is Undergoing Profound Changes

Extra-financial reporting is often criticized for its lack of simplicity, and the effort it entails is ultimately rewarded by the small number of parties who study it in detail. These are all efforts and resources that are more useful to deploy above all in defining and implementing strategies to transform companies and assets towards greater environmental, social and ethical performance, rather than ineffective and inaudible reporting.

In this logic, what is at stake in 2020, in an increasingly converging international regulatory context, is essentially three elements:

• The clarity of the objectives pursued, informed by the clear identification of its extra-financial materiality and the structuring of fully coherent strategies and actions.
• The strategic management of non-financial data, in order to ensure its rationalization, pertinence and quality, and to organize the transformations offered and expected by Big Data.
• Agility and the ability to provide relevant information to a growing diversity of actors, entities and stakeholders. To this end, the taxonomical and practical convergence of the CSR and ESG areas remains necessary and useful in order to accelerate the pace of change expected in the 2020s and to maintain and nurture the competitiveness of a number of assets and companies that are rapidly losing ground in relation to the digital, environmental and social changes currently underway