Accountants are increasingly expected to report on facets of the businesses they operate in that do not form part of a traditional annual report. We unpack what ESG is and how it could affect you.
What is ESG reporting?
Environmental, social, and governance reporting tries to capture costs and benefits that don’t make it into conventional annual reports.
Although not standardised, these could include aspects like a company’s air emissions, the measures a firm takes to prevent bribery and corruption or money spent on community outreach.
The idea of ESG reporting is not new, but it’s picked up momentum in the last few years, particularly after the Paris Climate Accords.
Which companies currently do ESG reporting?
Large listed companies are mostly expected to provide this kind of reporting explains Earl Steyn, CEO of Draftworx. “If a company has R100 million turnover, you don’t see any ESG happening, and you don’t even see integrated reporting. Typically private companies haven’t adopted ESG yet.”
Are there any ESG regulations in South Africa?
Not yet. However, at the end of 2021, the JSE published draft corporate disclosure guidelines on sustainability and climate-related risks and opportunities. At this stage, they’re voluntary.
Why should I care about ESG?
ESG may soon care about you. Although ESG reporting is currently voluntary and done mainly by large listed companies, experts believe it will become more widespread.
Steyn believes that over time this pressure will trickle down to smaller companies. “Let’s say I’m a small company. I want to do work with Nedbank or ABSA. They may say, ‘Fantastic, we would love to bring you on, but we need to know your ESG rating because it affects our ESG rating.’
“These small companies won’t have the ability to hire a full-time ESG specialist. So you may see little practices specialising in ESG, and they’ll be able to now prepare or audit your financial statements, and also assist consulting wise.”
How do South African firms’ ESG reporting practices compare to the rest of the world?
Not well. Many JSE firms don’t yet bother with ESG reporting. A paper published by academics at Stellenbosch University looked at the ESG reports of listed firms between 2011 and 2016 and found that firms tend to do well at publishing information regarding the governance part of ESG. However, the environmental practices were the least disclosed aspect of their ESG.
Jones Gondo, a senior credit strategist at Nedbank, explains that the lack of ESG reporting makes it challenging if you’re an institutional investor with a mandate to purchase a diverse portfolio of South African ESG compliant shares.
“On Nasdaq, you’ve got more than 2000 stocks to start with. If you don’t want to filter it down to companies with a decent ESG score, you’re going to go from 2000 to say 800 stocks. In those 800, you’ve got a spectrum of telecoms to consumers, to banks and so on.
“But take South Africa, we started with 141 stocks in the JSE, and it’s dwindling. When you do the ESG screening, you’re left with about 20 to 25 stocks, mainly banks and resource companies.”
Gondo wrote in a recent paper that investors concerned with environmental impact are more likely to play the role of activist shareholders. “Through active ownership, investors can exert influence over investee companies’ ESG practices, policies and outcomes via engagement and proxy voting on shareholder resolutions, while maintaining benchmarks.”
But isn’t ESG reporting just another way to greenwash profits?
The lack of standards and infancy of ESG reporting leaves room open for this possibility.
“There are some complexities around ESG that we need to sort out with time,” says Steyn. “One company that makes bombs and drops bombs for a living might acquire the gunpowder or the chemicals through sustainable methods and will definitely have good governance. They might be incredibly investor-friendly, but you don’t measure that other impact. I think that’s something that’s kind of being worked out.”
Are firms that have better ESG scores more profitable?
It’s complicated, according to the authors of Assessing the business case for environmental, social and corporate governance practices in South Africa. They found that when you break ESG into its three elements and look at their correlation with different corporate financial performance (CFP) measures, it tends to vary across sectors.
For example, the study found that, “consumer services firms that performed better in disclosing their social considerations (S-scores) earned higher returns in excess of their cost of capital.” However, there was a significant negative relationship between E-scores and accounting-based earnings per share.
The reason for this is also sector-specific says Ruth Johnson, one of the authors. However, “Environmental initiatives are sometimes expensive to implement, which could be the reason that improved consideration and disclosure of such initiatives would lead to a decrease in earnings.”
There may also be positive aspects to environmental disclosures. “In another study I conducted looking at ESG reporting and the cost of capital, I found that the Consumer Goods sector benefits from a lower cost of capital overall when disclosing more environmental aspects.”
Will ESG reporting become compulsory?
Gondo believes it will. Not necessarily because of regulation or because the JSE makes it compulsory, but because – in its absence – South Africa will likely miss the goals it agreed to at the Paris Climate Summit.
Technological improvements also mean there is an incentive for CFOs to get ahead of the problem. “I think the way data collection and big data is going, in about 12 to 18 months, I won’t need your reporting for me to estimate some of your measures. We can impute a result for your company on my Bloomberg screen. So I will have data, whether I can trust it or not is a different story, but the fact is that analysts are going to start making investment decisions about the stock based on the data they see.
“And your challenge is to make sure you’ve got some sort of narrative that can explain that alternative data,” concludes Gondo.