Coalitions of stakeholders in the business world agree that combating climate change stands as a crucial long-term measure. But those actions are next-to-moot if investors can’t assess and benchmark their effects with standard sustainability reporting.
In a context in which society is demanding initiatives to combat climate change, the debate on corporate sustainability reporting is more pressing than ever. The growing demand for this alternative type of reporting has led to two important developments.
First, the view that sustainability reporting should be mandatory is gradually gaining ground (unlike financial information, non-financial information is reported on a voluntary basis).
Second, there is a growing perception that we need to improve the consistency and comparability in sustainability reporting.
The Imperative of Standardized Sustainability Reporting
This issue is especially important considering the multiplicity of private organizations issuing standards and recommendations for sustainability reporting. Notable examples are the Sustainability Accounting Standards Board, the Global Reporting Initiative, the Climate Disclosure Standards Board, the International Integrated Reporting Council, and the Task Force on Climate-related Financial Disclosures (established by the Financial Stability Board).
As a result, there have been calls for the International Financial Reporting Standards (IFRS) Foundation to establish a global set of internationally recognized sustainability reporting standards. Such calls are based on the its track-record and expertise in standard-setting, and its relationships with global regulators and governments around the world. The foundation is currently seeking public consultation on whether – and how – to carry out this complex task. The European Union has already taken a step forward by introducing Regulation (EU) 2019/2088 on sustainability‐related disclosures in the financial services sector.
The regulatory debate on sustainability reporting should be framed around three questions:
What kind of (non-financial) information should firms be required to disclose?
The question is not trivial, as the current regulatory regime already requires firms to disclose any “material” information (that is, anything that could affect their financial results). Granted, some corporate activities could be beneficial for shareholders while having a negative impact on society and the environment (pollution is one example). To account for this and for the potential effect of climate risk on financial performance, some have introduced the concept of “double materiality” (see, for example, European Commission’s Guidelines on Reporting Climate-Related Information).
How should regulators enforce sustainability reporting standards?
A consistent and comparable set of standards would not be useful if firms do not implement it correctly. Because public enforcement is subject to important limitations (e.g., resource constraints), it is important to understand whether there are alternative forces potentially shaping managers’ reporting incentives. Social pressure is an important one; a growing number of consumers are sensitive to environmental and social issues. The higher social sensitivity towards sustainability could also result in an increase of shareholder activism. Beyond altruistic reasons, investment funds could pressure firms to disclose non-financial information because, by doing so, they attract or retain clients that care about sustainability.
The debate on how to enforce sustainability reporting standards should also consider that climate risks and sustainability issues are difficult to measure and longer term in nature. As a consequence, it is hard to know for regulators and investors whether a piece of such information is material. This means, among other things, that it would be difficult to verify in court that a firm withholds sustainability information.
How will mandatory sustainability reporting affect firm behavior?
On the positive side, it is possible that, for example, the need to disclose carbon emissions would induce firms to decrease those emissions. “Sunlight is the best disinfectant”, as the old saying goes. But an increase in transparency regarding sustainability issues could also have unintended consequences. To begin, processing and producing sustainability information is expensive, and firms will probably pass on this cost to consumers. Moreover, the responses to publicly disseminated information are sometimes difficult to foresee. For example, a recent study on the public disclosure of patient health outcomes at the level of the individual physician and/or hospital documents that the reporting mandate induced doctors and hospitals to decline to treat more difficult, severely ill patients.
In sum, the response to the growing demand on sustainability reporting needs to be judicious and well thought-out. If regulating financial reporting is complex, the standardization and enforcement of non-financial disclosures is likely to be even more problematic. But we will figure it out; the demand for sustainability reporting cannot be ignored.