ESG Data and Reporting in the Forefront of Sustainability: Challenges and the Way Forward

Major legal advancements are taking place in the realm of sustainability. Alongside the proliferation of self-regulatory disclosure standards, the EU has been a pioneer in enacting legislation regarding sustainability-related disclosures. In order to incorporate and disclose non-financial information, an organization needs to access and collect a significant quantity of Environment, Social and Governance (ESG) data aimed at tracking sustainability performance. Yet, today’s challenge lies not only in ensuring access to an adequate quantity of ESG data, but more importantly, in verifying the consistency, reliability and comparability of these data.

Notwithstanding the EU’s leadership in the realm of sustainable finance law, there are manifold challenges that need to be addressed with regard to ESG data. In this regard, this post aims to provide an analysis of the contemporary landscape in ESG data and reporting, while underscoring the primary challenges and limitations encountered in ESG data in the broader context of ESG reporting.

Conceptualizing Key Terms: ‘ESG’, Materiality, ESG Data and ESG Reporting

Before elaborating on the building blocks of ESG data and reporting, it is instructive to designate what is meant by the term ‘ESG’. Interestingly, there is no globally harmonized definition of ESG and its content, whereas the term is invariably used interchangeably with the term ‘sustainability’, aimed at depicting non-financial factors to be taken into account in financial decision-making and corporate governance. More precisely, the ESG scope may vary contingent on the legal framework. For instance, the terms ‘ESG’ and ‘sustainability’ are used interchangeably within the context of the EU legislative package on sustainable finance. Notably, the EU benchmark regulation primarily refers to ESG factors, whereas the EU taxonomy regulation and the Sustainability-related Financial Disclosures Regulation (SFDR) predominantly refer to the term ‘sustainability’, with the latter determining ‘sustainability factors’ as ‘environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters’ under article 2(24) SFDR.

Furthermore, not all ESG issues are equally significant for an organization. Contrariwise, ESG-related information that can negatively impact the financial performance of an organization and its stakeholders are considered material and thus, shall be managed and disclosed. In this regard, the EU Non-financial Reporting Directive (NFRD) has adopted the principle of double materiality with respect to reporting climate-related information. This principle refers to both climate’s impact on a company’s development and performance, as well as to the impact of a company’s activities on environment and society. Overall, there is no uniform definition of ‘materiality’, as this can be widely interpreted and defined depending on the jurisdiction and applicable legal framework.

Last but not least, ESG data comprise raw data that when measured against accounting metrics, result in sustainability-related information (see ‘ESG metrics’ below). In addition, ESG reporting refers to the communication of ESG-related information by both financial-sector organizations and corporates. In general terms, there is no singular, uncontested definition of ESG reporting, while terms such as ‘reporting on non-financial information’, ‘Corporate Social Responsibility (CSR) reporting’, ‘ESG reporting’ and ‘integrated reporting’ are used interchangeably to comprise all those types of non-financial information that are reported by corporates and financial organizations on a voluntary basis. Aside from the lack of a uniform definition, the content of ESG reporting also varies depending on the organization. In this regard, some organizations report on particular aspects of sustainability, such as focusing merely on their environmental impact, whilst others adopt an integrated approach to sustainability reporting. Overall, ESG reporting is more likely to include ‘material’ for the organization information.

Relevance and Contours of ESG data and reporting

Today, there is increasing acknowledgement that overlooking sustainability issues goes against the notion of a socially responsible corporation, while falling short of potential opportunities. The key drivers of ESG reporting are diverse. First, there is growing agreement that corporates shall not merely pursue shareholder value maximization, but rather incorporate stakeholders’ interests within their decision-making and governance. In this respect, increasing pressure is placed on corporates in order to disclose how they take sustainability-related considerations, risks and opportunities into account. Therefore, ESG reporting is imperative as a means of communication to stakeholders and investors of how sustainability is perceived and incorporated by an organization.

Second, reporting on sustainability can be deployed as a risk management tool, assisting thus financial-sector organizations identify, assess, manage and mitigate non-financial risks that are material for both the organization’s financial performance and its stakeholders. Moreover, clarity on sustainability-related risks and material factors can enhance decision-making and governance, hence assisting organizations seek opportunities arising out of sustainability performance.  In order for corporates and the financial sector to survive the transition towards sustainability, they need to reinvent and redefine their governance and business models, while consistently tracking their contribution to sustainable development in the front of the environment and society.

Importantly, in alignment with article 2(1)(c) of the Paris Agreement, it is of overriding importance that non-state actors contribute to the transition towards sustainable development, while states shall enact legislation and oversee private entities’ non-financial performance. Therefore, ESG reporting based on reliable, consistent and comparable data concerning an organization’s ESG management approach and performance can reinforce and strengthen accountability of a given organization’s actions against concrete ESG targets.

In order for organizations to communicate their ESG performance, they need considerable quantity of ESG data that depending on the sector and the type of organization may take a diverse form. For instance, financial intermediaries will focus in their reporting on how they identify, assess and manage sustainability-related risks in their investment decision-making, whereas corporates will predominantly focus on how they address material for their performance ESG issues so as to internalize ESG externalities derived from their operations.

What are the main sources of ESG data?

It is noteworthy that the primary source of ESG data is corporates. Irrespective of financial-sector organizations disclosing sustainability-related information, it is undeniable that their investment decision-making is predominantly conditional on the information reported by the companies in which they intend to invest, i.e. corporates. Therefore, inconsistent data on a corporate level can negatively affect the activity of dependent actors, such as financial actors and data providers. Overall, the primary source of ESG data comprises self-assessed corporate and integrated reports, whilst the secondary sources are (i) publicly available statistics and socio-environmental datasets, (ii) industry-level questionnaires and surveys, and (iii) NGO/NPO generated reports.

Who is concerned?

A vast industry has been created around ESG data involving a wide range of actors. Aside from those actors disclosing ESG data, there are actors that develop disclosure frameworks, i.e. framework developers, as well as actors that collect ESG data, i.e. data collectors, or use them for other purposes, i.e. data providers. More precisely, data collectors systematically collect organizations’ self-reported ESG data. One such example is the CDP (formerly Carbon Disclosure Project) constituting one of the most comprehensive collectors of ESG data through questionnaires, while also providing verification of these data for a limited time period. Alongside data collectors, data providers gather and assess ESG-related information for corporates and score them through the development of rating systems. Indicative examples of data providers are Sustainalytics, MSCI, S&P Global, VigeoEiris, Bloomberg, and FTSE Russell. They acquire the information from annual reports, company websites, NGO websites, stock exchange filings, CSR reports and news sources.

Contemporary Legal Landscape

In the absence of global disclosure standardization, a wide array of international disclosure standards and principles has been developed, aimed at providing best practices for financial-sector organizations and corporates, lacking nonetheless a legally binding status.

With regard to the most widely used international disclosure standards, the Global Reporting Initiative (GRI) sets out reporting standards representing global best practice for sustainability reporting. Following the GRI standards assists a company disclose information on how it manages material issues and their impacts, as well as what is the company’s positive or negative contribution to sustainable development. In addition to the GRI, the Sustainability Accounting Standards Board (SASB) provides standards for the identification and assessment of the financially material issues for a company, depending on the sector and industry in which the respective company operates – including inter alia the financial sector. Despite being a US initiative, SASB standards are exponentially adopted in Europe as well.

Another framework established by the Financial Stability Board is the industry-led Task Force on Climate-related Financial Disclosures (TCFD). The TCFD has developed recommendations for financial-sector organizations focusing on proper climate-related data and disclosures required to provide transparency of materiality of investors’ decisions. It is noteworthy that not all frameworks focus on all three environment, social and governance aspects, as SASB and the GRI cover all ESG issues, whereas the TCFD merely focuses on climate-related issues.

Furthermore, international disclosure standards often provide ESG metrics to facilitate the assessment of ESG performance, while some frameworks establish ESG indicators. The main distinction between these two terms lies in that ESG indicators aim to measure organizations’ progress and impact on sustainability-related issues, whereas ESG metrics aim to ‘capture as accurately as possible a firm’s performance on a given ESG issue’. One example of ESG indicators commonly deployed by data providers to measure a company’s progress is the United Nations Sustainable Development Goals indicators.

Examples of ESG metrics can be found in the GRI and SASB standards, which provide accounting metrics in order to assist corporates measure their ESG performance concerning the management of particular issues, such as measuring scopes 1, 2, and 3 of CO2 emissions, emissions from air pollutants and hazardous materials waste; describing water management; reporting the fatality rate concerning employees’ health and safety; reporting on risk management systems etc.. ESG metrics can be both quantitative and qualitative in nature. Other ESG metrics commonly used by financial actors are ESG ratings, labels and indices. What all these have in common is that they focus on grading corporates’ ESG performance. The main distinction between ratings and labels is product-driven, i.e. ratings concern corporates’ performance, whereas labels concern funds and bonds.

Aside from self-regulatory standards, the EU established a comprehensive legally binding disclosure framework. More precisely, the SFDR sets out standardized transparency rules for financial actors ‘with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability-related information with respect to financial products’. In reinforcing ESG disclosures, the three European Supervisory Authorities – European Banking Authority, European Insurance and Occupational Pensions Authority and European Securities and Markets Authority) have developed Regulatory Technical Standards (RTS) supplementing and guiding the implementation of the SFDR. The RTS are to be implemented by March 2021, but their adoption is still pending. In addition to ESG disclosures by the financial sector, the EU has also paved the way for the amendment of the NFRD so as to cover disclosures on the impact of climate change on a corporation and vice versa. To date, the NFRD is under public consultation with its scope, legal status and content still pending. Overall, both frameworks constitute the first EU comprehensive endeavor of sustainability-related disclosures’ standardization for both financial-sector organizations and corporates, posing hence a global paradigm for steering sustainability across all economic actors.

Challenges and the Way Forward

Notwithstanding EU’s leading stance towards sustainability and the proliferation of international disclosure standards, there are varying caveats and limitations to be taken into consideration. First, a major challenge in ESG reporting concerns the lack of reliability, consistency and comparability of ESG data. In the absence of global ESG disclosure obligations, financial-sector organizations and corporates can choose whether to disclose non-financial information or not. Even in the event of deciding to report on sustainability, they can adopt varying international standards, generating hence incomparable outputs. Moreover, the lack of data with regard to particular ESG-related issues further hinders clarity and comprehensiveness of data based on which organizations’ decision-making can rely.

Second, it is noteworthy that the lack of ESG data, or the lack of consistency and reliability of these data intersects all actors engaging with ESG data across the value chain of data. Put differently, given that one actor’s decision-making is conditional upon another’s actors reporting or rating, it is very likely that inconsistent data will result in ‘bad’ financial decisions with adverse impacts on the environment and/or people. What is more, the vast majority of ESG-related information disclosed is self-assessed and often undergoes limited internal impact MRV process. As a result, reporting self-assessed ESG data based on diverse frameworks and metrics coupled with the lack of robust MRV systems pose significant challenges in ESG reporting and its reliability.

Third, ESG data providers rely either on corporates’ ESG self-reporting, or on ESG data packages gathered by data collectors. It is thus notable that due to the interdependence of actors related to ESG data, the lack of consistency and verification of ESG data can result in diverging ESG ratings. In practice, divergence in ESG ratings from varying rating agencies concerning the same corporate is a common phenomenon, highly attributed to the lack of verified and consistent data. Importantly, many financial institutions do not have the resources and the capacity to analyze ESG data, and hence rely on external actors. Therefore, considering that ratings are taken as a quasi-requirement for any investment, profound divergence in ratings demonstrate the need for standardization in the use of frameworks and metrics.

Overall, fragmentation and the lack of standardization is mirrored in ESG evaluation approaches among varying actors, as well as in the diverse input and the quality of output resulting from ESG assessments. Undeniably, the EU legislation on sustainable finance has paved the way for disclosure standardization among EU member states. However, today’s challenge lies in how to access a considerable set of raw data that is verified and can provide reliable information regarding organizations’ non-financial performance.

Chrysa Alexandraki is a PhD researcher at the University of Luxembourg in Public International Law, specializing in International Law. After completing her bachelor studies in Law at the Aristotle University of Thessaloniki, she obtained her LL.M. in Public International Law, with a specialization in International Environmental and Energy Law, from the University of Oslo, Norway. During her LL.M. studies, Chrysa conducted research at PluriCourts, the Centre for the study of the legitimate roles of the judiciary in the global order. Chrysa is a qualified lawyer and she has practiced law both in Greece and in the UK. Her PhD project focuses on the role of law in shaping the climate-finance obligation and analyses the mechanics of climate finance from a legal perspective.

Professional link:https://wwwen.uni.lu/recherche/fdef/research_unit_in_law/dtu_rems/people2/chrysa_alexandraki