Capital markets have grown increasingly complex and globalized over the years, leading to increased complexity of risk management. This has led to a growing need for enhanced disclosure by companies in order to provide investors with information that enables them to understand risks related, among other things, to environmental, social and governance factors (ESG). And that is why it’s time to start caring about ESG disclosures.
These new ESG disclosure obligations will carry additional burden for midsize and small-cap businesses that may lack the required resources to adequately address all of these concerns. The new ESG disclosure obligations are primarily designed to help investors better understand risks related to environmental, social and governance factors. Midsize and small-cap firms usually have a more limited budget for disclosures as compared with larger companies which can devote more resources towards this area. The new regulations could impose substantial burdens on smaller firms.
What are ESG risks?
ESG risks are relevant to the general business of the company, but these risks will vary across different companies depending on their industry and exposure. For instance, exposure to ESG related factors is higher for companies in industries such as manufacturing or oil refining than for companies operating in industries such as retail. In addition, the risks will vary from industry to industry depending on the social issues that are of concern in a given country or region. The new ESG disclosure obligations for companies require enhanced efforts need to collect and disclose relevant information about material ESG exposures.
For example, a clothing company is likely to have a greater focus on social issues such as fair labor conditions in the supply chain and company governance policies related to principles of corporate responsibility. The costs associated with complying with these new ESG disclosure obligations increase for companies that have many different products or operate across diverse industries or countries due to the need for more extensive research, analysis and reporting-related efforts.
Why should companies disclose these risks?
In order to comply with the ESG disclosure obligations, companies will need to conduct a more extensive research and analysis. In turn, this process requires a significant amount of test and information gathering about the company’s operations and risks it faces to ensure that any material risks are appropriately reflected. This process can be labor-intensive for smaller firms which usually have a more limited budget for disclosures to investors as compared with larger companies who might have a greater capacity.
The responsibility for complying with these new ESG disclosure obligations increases for companies that have many different products or operate across diverse industries due to the need for more extensive research, analysis and reporting-related efforts. These additional costs associated with complying with these new ESG disclosure obligations may also affect a company’s ability to finance its operations and capital expenditures, as well as have an impact on the company’s stock price.
How will this affect a company’s success?
A lack of proper ESG Reporting will hold back companies from being successful by creating doubt. Doubt creates hesitation from investors and government resources. Reduced resources going into research or development dwindle because there are less funds for it. Investors want to invest in companies with long term success so this could hold back the long term success of the company. These new ESG disclosure obligations may affect a company’s ability to finance its operations and capital expenditures, as well as have an impact on the company’s stock price.
Which industries are most affected by the new ESG disclosure obligations?
There will be a significant number of companies who will not be able to comply with the new ESG disclosure obligations. It is estimated that there are more than 50,000 public US firms that could miss the deadline for compliance on this new ESG disclosure obligation. A similar situation is expected in other parts of the world. The largest compliance burden will be on midsize and small-cap firms. These firms typically lack the resources and budget required to complete all of these disclosures adequately and will need assistance from third parties in order to comply with the new ESG disclosure obligations. Some industries include:
- Water utilities
- Food and beverage companies
- Home improvement retailers
- Alternative energy producers and distributors
- Mining and metals companies
They will need to provide details regarding their impact on the environment and society in areas such as:
- Their policies and processes related to environmental, social, and governance matters. This could include:
- Disclosure of any potential climate risks Disclosure of certain key considerations for ESG related investments
As of right now, it is not clear what the impact on companies will be. There are many factors that could affect the decision process including positive news stories about ESGs having an effect on company performance. This new set of disclosure rules is likely to cause a further decrease in small-cap stocks over time.
What is ESG?
ESG stands for environmental, social and governance factors. This refers to concerns stemming from a company’s impact on society and the environment. In many cases, this includes areas such as climate change risk.
What are the new ESG disclosure obligations?
The new ESG disclosure obligation will require companies to provide disclosures about their impact on society and the environment. This includes areas such as climate change risk, issues related to water usage, considerations for purchasing certain environmentally-friendly products, etc. The requirements changed under section 1504 of the Dodd-Frank Act.
What is the Frank Dodd Act?
The Frank Dodd Act is a Federal Law in the United States, passed in 2010. The act was put into law with the intention to reform Wall Street and help avoid future economic crises like the one that occurred in 2008.
Due to this new ESG disclosure obligation, investors will be able to weigh environmental, social and governance factors when deciding whether or not they want to invest in the company. The goal is to help provide more transparency about how firms manage these issues so that investors can make better decisions.
The three main components of the new ESG disclosure obligation:
1. Issue and Company-Specific Disclosure: Firms will have to disclose their ESG policies and initiatives as well as potential risks and opportunities related to ESG factors.
2. Material Trends Disclosure: Firms will have to disclose if there are any material environmental or social trends that have a direct impact on the company’s earnings, financial condition, liquidity, capital resources or competitive position.
3. Sustainability Report Disclosure: Companies must include an analysis of both their economic and non-economic factor performance in a sustainability report.
Why do ESG disclosures matter?
Issues such as climate change can have a significant impact on established businesses established, especially the insurance industry which is a major concern for many people. If firms are not transparent about how they handle these matters then investors could lose their trust in them and take their money elsewhere.
In addition, there has been a significant financial impact from complying with the ESG disclosure obligation in other countries such as Australia and the United Kingdom. Since 2012, more than half of all listed firms have had to disclose their environmental policies in order to comply with France’s “Loi sur la Transparence”. This law is similar to those proposed in the U.S. and can benefit investors as well as firms by making it easier for them to find the information that is relevant to their investment decisions.
In Canada, the Canadian Securities Administrators (CSA) published a new disclosure framework for environmental, social and governance (ESG) factors recently. This includes rules that will require firms to disclose how they manage these issues since it is expected that investors and other stakeholders would find this information useful. A national regulatory exemption was added which allows more time for small and medium enterprises (SMEs) to comply with the new disclosure rules.
Although some critics believe that voluntary disclosure should be enough, others argue that such information is only useful when it has been required by law because otherwise there would not be any enforcement to ensure that the company follows through with their promises.
How do ESG disclosures affect midsize and small-cap companies?
Firms in general may have a more limited budget for such matters as compared with larger companies, which could potentially lead to lower cost of compliance and increased risk of noncompliance, making it difficult to manage the ESG disclosure obligation. Smaller firms might not have the resources to hire experts that can help them manage their materials, create policy or identify relevant trends for their firm.
Furthermore, they might not be able to provide an analysis of how certain environmental and social factors may affect their performance because it is harder for smaller companies to collect data related to such matters. This can make it more difficult for investors to compare apples to apples in the performance of companies at different scales.
Midsize and small-cap firms may instead be forced to limit their focus on only the environmental and social issues that affect them directly, leading to less information about these ESG factors in general and potentially leading some investors away from these firms.
What are the consequences of noncompliance?
If a midsize or small-cap company does not comply with their ESG disclosures, they could be subject to legal sanctions such as being forced to correct their filings or being required to pay money for damages caused by misconduct. However, it is unlikely that there will be significant punishment for non-compliance given that it is not in the best interest of either companies or regulators to punish smaller groups.
Additionally, the ESG disclosure obligation does not eliminate any existing regulatory requirements. Companies will still need to comply with all federal regulatory requirements in order to avoid problems such as violations of state securities laws.
What are the consequences for investors?
The new ESG disclosure obligations are designed to provide more information to investors about how these environmental issues affect a company’s risk profile. Less transparent firms may lose their trust from some investors, leading them to avoid those companies altogether or divest from certain stocks if they believe that the firm is not treating these ESG factors with the appropriate level of concern. Some firms may be able to better portray their commitment to environmental and social responsibility as a result of these disclosure rules, which could make those businesses seem more attractive in the eyes of investors.
However, other investors may prefer not knowing about ESG factors because they believe that it distracts them from making investment decisions based on concrete criteria. The lack of consensus about the benefits of ESG disclosure means that there is no clear way to predict how these new requirements will affect investment strategies moving forward.
What are other implications?
Although the goal of these transparency rules is to provide investors with more useful information about environmental and social factors, it can also make it harder for a firm to attract new employees who may be drawn to organizations that place a high value on ESG factors.
For example, small-cap firms that work with chemicals could lose some prospective employees if they do not disclose information about how they manage hazardous substances and improve recycling efforts in their facilities. Also, the lack of such disclosure could lead to these organizations gaining a reputation as unsupportive of environmental initiatives, which could deter some potential employees.
As another example, investing in sustainable energy may become more difficult for small-cap firms if they are not able to report on the success of their efforts to produce efficiency gains through renewable sources. This can lead to them missing out on potential opportunities to grow their businesses by focusing on the environmentally friendly projects that could help them attract new customers.
How can midsize and small-cap firms prepare?
Businesses that are affected by these ESG disclosure requirements should prepare for these changes by doing more thorough research into which factors they need to report on. They should also consider their existing level of expertise in the areas that are most important to their current or future business models.
For example, a midsize pharmaceutical company should devote more resources towards researching how social factors could impact their financial performance if they plan to manufacture drugs for mental health treatment where there is one big player with substantial market power. The healthcare firm would also need to report on ESG issues more frequently because they have a larger number of interactions with their stakeholders as opposed to a mining company which might only have occasional contact with the community where it operates.
In addition, smaller companies may need to outsource some aspects of compliance so that employees can focus on running the business and allow external parties to handle the reporting requirements.
How can firms prepare their employees?
Employees who are likely to be involved with ESG disclosures should receive training on the new requirements, which can help them better understand how these changes will affect their day-to-day work. These workers also need to learn how the company wants them to respond when they are presented with questions about ESG issues by their supervisors or investors.
What are the required ESG metrics for compliance?
To become compliant, firms need to disclose information about their environmental, social, and governance performance. The specific metrics required for compliance are extensive because they are meant to provide investors with a comprehensive picture of how these organizations are operating. These metrics include issues related to the firm’s investments in research and development on ESG factors, whether its workforce has received specific training on how to manage ESG issues, and whether its board of directors has an active committee that monitors these concerns.
What are some factors investors consider when reviewing ESG metrics?
Investors will evaluate the effectiveness of a firm’s current ESG policies by looking at how it has performed in recent years. They may also examine changes that the company has made to improve its policies on a consistent basis. In addition, these stakeholders often consider the company’s ability to adapt in the future when they are looking at whether it is making sufficient progress on ESG factors that have been identified as being potentially problematic for its operating model.
Social metrics include:
- Diversity in the workforce
- Employment practices and standards
- Pay equity
- Philanthropy and community involvement
Environmental metrics include:
- Environmental impact of products, services, facilities, and operations
- Energy use and energy mix for producing power or heat
- Greenhouse gas emissions from company activities or supply chain
- Water use and management practices
Governance metrics include:
- Proportion of female employees in supervisory roles
- Percentage of executive officers who are female or minorities
- Expense for lobbying activities, if any
What is the goal of a firm’s CSR efforts?
The goal of many companies’ CSR efforts is to adapt and change their business model or operations – to be more environmentally conscious, for example – in order to improve the company’s brand reputation as well as its social license to operate. For others, the goal may simply be to mitigate damage from an existing reputation problem. In prior years, however, without formal sustainability reporting requirements, CSR efforts were less frequently tied directly to an objective business metric.
Today, the situation is changing. In addition to evolving consumer expectations and new regulatory trends, investors are demanding more from companies around topics such as social capital and governance policies – policies that can affect a company’s business performance.
The driving force behind this evolution is the increasing recognition that there is value to be realized by making good on the promises of sustainable development, specifically through improved business performance.
What are ESG disclosures?
These are measures taken to reduce a company’s environmental impact or improve its social conditions. For example, many companies may have lowered their energy consumption or encouraged recycling as part of their CSR efforts.
These measures, however, are better described as CSR practices than as ESG disclosures since they do not relate directly to a company’s overall environment, social and governance (ESG) risk profile – that is, how these issues may affect the company over the long term.
Why are there new ESG disclosure obligations?
The new ESG disclosure obligations are intended to help investors better understand risks related to environmental, social and governance factors. These disclosures will also allow companies to benchmark their CSR practices against other companies in the same sector.
What is the difference between ESG and CSR?
ESG refers to environmental, social, and governance factors. CSR refers to corporate social responsibility factors. CSR is a subset of ESG and focuses mainly on environmental and social factors. These factors may include, for example, workplace safety and diversity training.
The new ESG disclosure obligations are primarily designed to help investors better understand risks related to environmental, social, and governance factors. Currently many of these issues are communicated in the traditional sense using “extra material” that is not required by securities regulators (the SEC or similar bodies). The materials are typically called corporate social responsibility (CSR) reports. These reports often encompass environmental, social and governance factors, but they are not required by law or filed with any government agency.
What are costs associated with ESG disclosure compliance?
The costs associated with the new disclosure obligations are two-fold. First, the company has to pay internal resources to develop and implement ESG practices. Second, companies are expected to produce reports related to their disclosures for investors. For example, when it comes to reporting on climate change, an article in the “Wall Street Journal” noted that this includes “monitoring energy use in facilities around the world and disclosing the greenhouse gases associated with making products in factories,” which can be resource-intensive.
ESG disclosures and your supply-chain
One area that may require a lot of attention will be your company supply-chain. ESG disclosures usually require information on all of the company’s suppliers and how they are reducing their environmental impacts.
ESG disclosures and operations in different countries
It is also important to disclose your operations in different countries under an ESG perspective. This means that you have to identify if there are any social or human rights issues with regard to the country in which you operate and how it might affect your business. For example, if a company is working in a country with a high level of corruption, it should report this to investors.
ESG disclosures and your organizational structure
Another important area is your organizational structure and governance. You have to prove that you have set up internal processes for managing ESG issues. In addition, you also have to disclose the composition of the board of directors, key management personnel and their roles in ESG issues.
ESG disclosures and products or services you provide
Another important area for ESG disclosure is your product or service portfolio . You have to disclose any hazardous substances that are used during the production process, as well as information on what steps you are taking to reduce the negative environmental impact of your products or services.
Disclosures and legal compliance
It is important to disclose if you are complying with the environmental, social and governance-related laws in each country where you operate. In addition, it is also good practice to disclose what industry standards apply in the countries in which you work . You have to prove that you are complying with laws that are relevant for ESG issues.
Disclosures and financial performance
It is also important to disclose the results of your company’s work in terms of environmental, social and governance-related areas . It would be best if you could compare this information with previous periods, as well as with competitors or companies within the same industry . For example, if you are the first company within your industry to implement a new environmentally friendly production process, you can disclose this information.
ESG disclosures and due diligence
The obligation to conduct ESG related due diligence for all its business relationships will also be an important issue. This means that you have to carry out a due-diligence process on how your suppliers are managing their
ESG disclosures and social media
As part of the ESG compliance, many companies are also disclosing their use (or not) of social media such as Facebook and Twitter . It is important to remember that if any of these activities come under scrutiny for whatever reason then it needs to be disclosed to the shareholders.
In terms of geographical locations, smaller firms may have a more limited investment in their business operations in certain countries because it may not be a priority for them. However, they still must disclose any negative impact on the overall ESG compliance. Moreover, companies which have a larger international presence will have to pay more attention to what happens in other countries because it has more impact on them. The social media aspect is an interesting one because it might be that smaller companies are not as active on these platforms as others which means that there may be less negative press surrounding their actions.
ESG disclosures and mergers and acquisitions
Another area where you need to consider this disclosure obligation is when you are doing mergers or acquisitions. Even if ESG compliance is not an area of focus for the company that you are buying, it might be something that is high on the agenda of your new business partners.
In summary on the new forthcoming regulations
In summary, the challenge for SMI’s and SME’s in complying with these new ESG disclosure standards is that they may lack the required resources to adequately address all of these concerns. But the benefit for those that address this sooner than later are that they will be positioned better than their competitors when these new regulations begin to take effect.
Caveats and Disclaimers
We have covered many topics in this article and want to be clear that any reference to, or mention of disclosure regime, institutional investors, international integrated reporting council, sustainability accounting standards board, global reporting initiative, esg data, public companies, disclosure related, existing disclosure requirements, companies disclose, carbon disclosure project, voluntary disclosure, disclosure requirements, public company disclosures, investment advisers, corporate governance, sec filings, capital constrained companies, sustainability reporting, esg risks, comparable disclosures, third party data providers, companies disclosures, material risks, climate related, corporation finance, sustainability reports, reasonable investor, esg information, esg issues, regulation s k, voluntary nature, material information, esg performance, climate risk, information disclosed, regulation s k items, other disclosures, individual companies, capital markets, investment decision, public company, ongoing basis, new disclosures, reporting standards, commission guidance, company’s judgment, private ordering, most companies, provide investors, many companies, esg topics, voting decisions, other factors, actual results, climate change, new rules, disclosure, disclosures, same topics, standard setters, accounting standards board, risks, investors, esg reporting or data in the context of this article is purely for informational purposes and not to be misconstrued with investment advice or personal opinion. Thank you for reading, we hope that you found this article useful in your quest to understand ESG.