Peeling back the layers
We asked Matt Chapman, Better Business Reporting Group at KPMG, about the greater insight investors are now demanding about ESG in corporate reporting.
Q: How is ESG reporting practice developing?
ESG reporting is maturing as it moves into the mainstream of corporate reporting. In the past it was perhaps enough that companies could demonstrate an interest in the right topics. However, more pointed questions are being asked now. If a company’s prospects are affected, then investors need to be able to assess potential effects and understand the company’s strategy and progress managing the matter. That information belongs in an annual report, whether it relates to an ESG factor or any other operational matter.
Managing the development of ESG reporting requires a focused approach. That means providing more information on the specific ESG factors that drive the company’s success and less on those that have a peripheral impact. Investor-focused frameworks such as those provided by TCFD (on climate factors) and SASB (on a range of ESG factors) can help companies deliver this, but they require thoughtful application rather than slavish disclosure.
For preparers, this means that subject matter expertise needs to be combined with knowledge of the company’s wider strategy and success factors, and an understanding of exactly what information would affect an investor’s decisions.
Q: How should annual reports address climate risks?
KPMG’s publication, Climate in the annual report discusses how companies can approach IFRS and strategic report requirements in their annual reports.
The starting point for addressing climate reporting should be an understanding of where the company’s risks and opportunities lie. That may seem obvious, but the volume of climate-related disclosure requirements can drive companies towards a checklist approach.
There are of course explicit climate disclosure requirements such as carbon emissions that need to be met by law. However, it’s the implicit requirements that are likely to be the most significant for a climate-exposed business. If climate is a material issue, then the Companies Act requirements covering the business model, risks, strategy and progress should drive the front-end disclosures that investors need to assess the issue. We believe the TCFD recommendations may help companies meet these requirements.
In some cases, financial statement effects (for example, asset impairment) or disclosure may be relevant. Where a disclosure is required by IFRS, information is treated as material if it could reasonably be expected to affect investors’ economic decisions. ESG matters will often raise questions over the long-term sustainability of the business model – typically a substantial proportion of a company’s value. So, ESG factors may be material even if they are not expected to crystallise for several years.
Q: What about the quality of ESG information being reported?
Although there’s plenty of investor recognition that ESG factors can be important to the investment case, there’s also a great deal of frustration with the sheer volume and vagueness of many ESG disclosures. Lack of reporting clarity is often assumed to reflect a lack of strategic clarity. Common signs include the following:
• Over-aggregation: It’s great if your firm-wide staff retention rates and employee engagement scores are stable, but investors really need to know whether you’re holding onto key personnel who will deliver future growth, such as R&D or design teams.
• Missing track record: A low lost-time injury rate could mean little on its own, but as part of a steady five-year decrease, it can provide genuine insight.
• Isolated discussion: A net zero carbon commitment may help to address long-term climate risk exposures, but it can also entail significant trade-offs for the wider business. Investors need to assess both the positive and negative implications of the choices being made on their behalf.
The reality is that many companies’ ESG reporting systems are in the early stages of development and typically rely on manual intervention and complex spreadsheets. However, that is starting to change. Boards are responsible for the accuracy of market-relevant information whether it relates to an earnings number or a measure of ESG performance. So we are seeing audit committees paying much more attention to the quality of material ESG information and benchmarking it against the controls and reporting standards set for financial information.
Q: What role could auditors play?
Firstly, some ESG information may feature in the audited financial statements, for example because it’s needed to understand a key accounting estimate or judgement.
Information in the strategic report is not audited, but the auditor will nevertheless read the other information and consider whether it is materially misstated or inconsistent with the financial statements or their audit knowledge if an issue is identified. In this case, companies will typically choose to amend their strategic reports prior to publication, so the auditor’s contribution may not be visible to users.
Companies are increasingly asking the auditor to go further, requesting assurance over specific non-financial disclosures in the annual report. Typically this will start with private assurance to give the board greater confidence over the process behind those disclosures, and often leads to public assurance opinions where the quality of reporting systems/processes supports this.
One regulatory approach to the question of wider assurance would be to place the cost-benefit judgement over the value of assurance in the hands of investors. For example, the Brydon Review into the quality and effectiveness of audit, published in December 2019, called for mandatory independent assurance over non-financial KPIs linked to directors’ remuneration. Additionally, the review advocates for investors to have a right to request extended assurance over other non-financial information – for example, if they have concerns over the quality of information they are receiving. Increasingly, both of these areas include ESG measures such as indicators of climate exposure, water usage or health and safety metrics.
Matt Chapman