Is your nonfinancial performance revealing the true value of your business?

By

Mathew Nelson

EY Global Climate Change and Sustainability Services Leader

Leading a purpose-driven team that shares a common passion for creating positive impact. Workplace diversity and equality advocate. Engineer. Father of two boys. Australian Football League fan.

9 minute read 30 Mar 2017

Our survey looks at the links between nonfinancial performance of companies and its role in decision-making by institutional investors.

Investors around the world reveal broad support for the environmental, social and governance-related themes expressed in a 2016 memo from Laurence Fink, Chairman and CEO of BlackRock, to the leadership of the world’s largest companies. Investors strongly support Fink’s call for an annual board-approved strategy statement for public companies.

They agree that environmental, social and governance (ESG) factors present risks and opportunities that have been neglected for too long. Yes, say investors, sustainable returns require a sharper focus on corporate governance and on environmental and social factors.

Disclosure and scrutiny of nonfinancial information will continue to grow in importance in the years ahead. The Paris Climate Conference agreement will lead to an increase in disclosures about companies’ climate practices and risk management strategies, say investors. They report that recent environmental and social scandals have driven them to re-evaluate nonfinancial disclosures and look more closely at available information.

Nonfinancial performance plays a pivotal role in the investment decisions, for most of the surveyed investors and for a greater percentage of investors than in previous years. Despite the increasing importance placed on nonfinancial performance and disclosures, most of the surveyed investors evaluate environmental and social factors on an informal, not structured, basis.

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Chapter 1

Investors see long-term financial benefits in companies with high ESG ratings

Why handling ESG issues well is often a sign of operational excellence

Fink, whose BlackRock has US$4.6 trillion under management and US$200 billion in sustainable investment strategies, also made a point that mirrors the argument made by many investors who track ESG performance: handling ESG issues well is often a sign of operational excellence at a company.

Our survey of investors found broad support for ESG-related themes expressed in the Fink memo. More than 80% of the survey respondents agreed with four statements related to Fink’s points:

  • CEOs should lay out long-term board-reviewed strategies each year.
  • Companies have not considered environmental and social issues as core to their business for far too long.
  • Generating sustainable returns over time requires a sharper focus on ESG factors.
  • ESG issues have real and quantifiable impacts over the long term.

Institutional investors have developed a greater appreciation for the value of ESG factors in the past several years. Three years of survey data, interviews with investors, and recent events and global initiatives offer evidence that ESG information plays an increasingly influential role in investment decision-making.

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Chapter 2

What motivates companies’ nonfinancial reporting?

The biggest motivating factor for most surveyed companies remains building their corporate reputation with customers

If investors want more issuers to report on their ESG activities, what motivates companies to disclose that information?

According to our surveyed investors, the biggest motivating factor for most companies remains building their corporate reputation with customers, followed by complying with regulatory requirements. Investor demands play a role as well, along with the incentive of improving stock valuations, but to a much lesser degree.

The risk of stranded assets

One ESG-related risk of particular concern to investors is stranded assets, due to changes in regulation, social expectations, disruptive technology or environmental conditions. Twenty-nine percent of survey respondents reported that they had decreased their holdings of a company’s shares due to the risk of stranded assets within the last 12 months, and 33% were likely to monitor holdings closely in the future.

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Chapter 3

Investors expect COP21 will stimulate ESG reporting

COP21 has changed the conversation from whether or not changes will come, to what can be done to adapt.

Following the 2015 Paris Climate Conference — also known as COP21, for the 21st meeting of the Conference of Parties — representatives of 195 nations agreed to the first-ever universal, legally binding global climate deal that will limit global warming to below 2 degrees Celsius from pre-industrial levels.

It will require the parties to achieve zero net carbon emissions globally by mid-century. The COP21 agreement will likely cause a significant shift in global economic policies, even beyond what was put forward by nations in Paris. It will reshape financial and economic markets toward zero-emissions technologies and renewable energy sources and away from emissions-intensive products and services.

Even if the challenging targets set out in Paris are met, companies will still likely be impacted by the physical impacts of a changing climate, and investors are increasingly asking them to set out how they’re adapting to the expected changes.

According to our poll of investors, 27% of all survey respondents expect COP21’s “below 2-degree” goals to lead to dramatically increased disclosures of company climate practices and related risk management strategies, with the majority (58%) expecting COP21 to moderately increase such disclosures. Just 15% of global investors expect little or no change in disclosures.

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Chapter 4

Investors demand more from company ESG reports

The quality of reported ESG information is getting better, but there still is room for improvement

Surveyed investors reported that the most useful source of nonfinancial information for making investment decisions was a company’s own annual report — deemed “essential” by 31% of survey respondents and “very useful” by 32%. The second-most-useful source was an integrated report — “essential” for 18% and “very useful” for 39%.

While the annual report is held in highest regard for nonfinancial disclosures, 60% of the investors in our survey believe that companies don’t disclose ESG risks that could affect their business and that they should disclose them more fully.

The quality of reported ESG information is getting better, with a range of research providers supplying more robust indicators and analysis, but there still is room for improvement. Large-cap multinational companies are getting better at ESG reporting, but the quality of reporting drops off significantly with medium- and small-cap companies.

It is worth noting that corporate sustainability reports have yet to prove essential for investors. Despite broad support and widespread adoption of sustainability or CSR reports by companies in concept, our findings suggest they aren’t delivering on their potential. Fewer than half of respondents (44%) view company sustainability reports as very useful or essential. An effective sustainability report, free from prevailing short-term-orientated financial reporting objectives, has the potential to widen the discussion to other sources of company capital (such as natural, social, human) with real impacts on perceived value.

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Chapter 5

The appeal of ESG analysis in risk management

One of the key benefits provided by ESG analysis for investors is risk avoidance and measurement

When asked if certain disclosures would make them change their investment plan, 39% of the investors in our survey said that a risk or history of poor governance would force them to rule out an investment immediately, while 32% said they would do the same due to human rights risk from operations, and 20% said limited verification of data and claims would rule out an investment.

The top reason for reconsidering an investment, at 76% of survey respondents, was risk or history of poor environmental performance, followed by risk from resource scarcity at 75% and risk from climate change at 71%.

The surveyed investors reported using nonfinancial information fairly uniformly across all stages of their investment decision-making: examining industry dynamics and regulation, examining risk and timeframe, adjusting valuations to account for risk, making asset allocation and diversification decisions, and reviewing investment results. The examining industry stage had the greatest combined percentage of investors “usually considering” and “often considering” nonfinancial information.

The survey also showed that investors have high regard for board and audit committee oversight, which are typically viewed as keys to good corporate governance and risk management. Both mandatory board oversight and audit committee oversight were important to investors we surveyed: similar numbers said both types of oversight were “essential” or “very useful.”

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Chapter 6

ESG goals and preferences are evolving

The types of ESG information that investors seek have evolved from the early days of nonfinancial reporting

Years ago, investors would often emphasize worker health and safety information from companies in heavy industry, such as the mining or oil and gas sectors, and liabilities associated with safety performance. Today, the information is still important, but companies release the information and manage the risk in the course of normal business, and the investors’ focus has shifted to other ESG issues, such as changing societal expectations, impacts of disruptive technologies, changing demographics, scarcity of water and other resources, climate change, and post-financial-crisis executive pay.

The way that investors use ESG information is also evolving. Where investors previously favored an approach that strictly separated the ESG and financial aspects of portfolio management, and with separate teams of analysts, now more investors are integrating ESG factors into their normal investment analysis.

Investors are also taking a more in-depth view of risk and potential opportunities from ESG considerations. The most important nonfinancial issue for investors in the survey was in relation to “good corporate citizenship and issuers’ policies on business ethics,” with 35% of respondents calling the issue “very important” and 57% saying it was “important.”

Client demand for more information was nearly on the same level, with 31% calling it “very important” and 60% “important.”

Given that nonfinancial performance periodically played pivotal roles in their investment decisions, a surprisingly small percentage of the investors in our survey reported that they conduct structured reviews of environmental and social factors.

Of the surveyed investors, 51% said that their evaluation of environmental and social impact statements and disclosures was informal. That compared to 26% who said their evaluation was structured and methodical and 22% who conducted little or no review.

When asked why they don’t consider nonfinancial issues in their investment decision-making, 42% of the surveyed investors answering the question said that nonfinancial measurements are seldom available for comparison with other companies, and the same number said the information is often inconsistent, unavailable or not verified. Only 16% said that nonfinancial disclosures seldom have a financial impact or are material.

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Chapter 7

What next?

With institutional investors using nonfinancial information more often in their decisionmaking, what should reporters do next?

We believe the actions split into three main areas:

1. Meet your investors’ and prospective investors’ expectations

  • Take a long-term view: Meet investor needs by informing them of the most material environmental, social and economic aspects that could impact your company’s ability to generate value over the longer-term — and what steps you are taking to manage them.
  • Consider the global megatrends: Understand what could be shaping and disrupting your industry over the coming decades. Balance current risks with future opportunities to show investors your business model is future fit.
  • Address climate risks: With a legal framework to decarbonize the global economy by mid-century, investors expect you to significantly rethink your climate disclosures. Not only will you be expected to report on the direct impacts of your business on greenhouse gas emissions, you’ll also likely be required to articulate the potential physical impacts of climate change on your assets and supply chain, and how your current business model will be sustained in a zero-carbon future.
  • Allocate capital and infrastructure to ESG: Investors agree that environmental and social aspects of performance are fundamentally important and for too long have been overlooked. Evaluate the adequacy of your allocated capital to put processes and procedures in place to address ESG issues and regulations.

2. Seize the opportunities to tell your organization’s performance story

  • Trust the evidence: Academic research now reveals that companies with strong sustainability performance outperform their peers and the market in general. Investing in understanding the opportunities of managing environmental and social risk could pay dividends.
  • Set the agenda: Investors understand just how important ESG information is to your business’s performance but still largely review this information and data informally. This provides an opportunity for your company to lead the way in highlighting your understanding and management of the risks and opportunities you face.
  • Engage your stakeholders: Involve a broad cross-section of your stakeholders in determining what aspects of your business are of most importance and keep them informed on progress.
  • Engage your board: Investors tell us they expect the board to have signed off on your strategy and disclosures. Engaging the board in the process early should provide the governance expected of you and minimize the likelihood of heading in a direction inconsistent with their expectations.
  • Connect your reporting: Consider how you can make your reporting more connected, or integrated. This will seek to avoid the risk of producing disparate reporting that doesn’t align or, at worst, creates contradicting disclosures.

3. Address the essentials

  • Materiality matters: Avoid being seen as “greenwashing” in your sustainability disclosures by applying a robust materiality process. A well-considered report should be able to articulate the environmental, economic and social risks and the opportunities most important to your stakeholders and the ability of these risks and opportunities to impact your business now and into the future. Focusing on the positive, but ultimately less material aspects, may undermine your credibility with readers.
  • Be transparent: Investment decisions are being made on the ESG performance of your business whether you report on them or not. Transparency on challenges you face and how you are managing them will be more beneficial than producing a report that just highlights the positive aspects of your performance. Reporting on ESG aspects should also be a challenging process. If not, you should question whether you’re actually telling investors something they don’t already know. 
  • Value third-party assurance: Having independent verification as part of your reporting process is important, as over two-thirds of all investors say it is very useful or essential. Coverage of material issues, data and information will add significantly to the credibility of your reporting not just with investors but all stakeholders.

 

Summary

Nonfinancial performance plays a pivotal role in the investment decisions for most of the surveyed investors and for a greater percentage of investors than in previous years.

About this article

By

Mathew Nelson

EY Global Climate Change and Sustainability Services Leader

Leading a purpose-driven team that shares a common passion for creating positive impact. Workplace diversity and equality advocate. Engineer. Father of two boys. Australian Football League fan.