ESG is different. It encompasses all these factors and yet is focused on its material impact on the business. The aim of quality managers and board members may, ultimately, be the same – to work more efficiently and with a reduced impact on the environment and society – but the language they employ to describe and achieve these goals can be very different. Quality managers are concerned with improving sustainability to reduce risk while the board is interested in ESG because it is a vital part of what an investor will consider – it is part of its materiality.
Greenwashing – putting an environmentally friendly spin on business practices – is no longer acceptable to the new primary drivers of change – the financial markets. Instead, senior management must find an effective way to quantify their company’s operations against set environmental, social and governance (ESG) criteria.
Active engagement by corporate boards stems from a profound change in the way financial markets are approaching sustainability and CSR. Investors are no longer solely focusing on financial statements. Instead, they are taking an integrated approach to investment decision-making that involves financial information and ESG. This approach is gaining support from government authorities.
Improving labor standards and human rights records, reducing resource use, carbon footprints, emissions, etc. These are concepts we all understand and recognize as important. Multiple standards now exist to help businesses drive positive outcomes in each of these areas, providing the metrics that quality managers have traditionally focused on when looking to improve sustainability and CSR.
Materiality considers all aspects of a business that may affect opportunity and risk. Investors have traditionally focused on financial materiality because their primary interest has been the ‘bottom line’. But things are changing, with investors and regulators now becoming interested in non-financial materiality, and ESG materiality has become a primary concern for businesses.
Understanding business materiality has multiple advantages. It enables the reporting of non-financial issues to improve investment decisions, risk and opportunity assessment, enhancing stakeholder engagement and helping to future-proof a business against regulatory and legal changes.
The sea change for business leaders is that ESG materiality cannot be considered less important because it is now completely intertwined with financial materiality. Negative ESG-related actions will harm performance and financial condition.
The ESG Framework
Effective materiality analysis requires the correct ESG framework. However, there can be no one-size-fits-all approach because every business is different. Each company will have its own materiality criteria based on factors, such as industry type, where it operates and stakeholder demands. This will affect the approach an organization takes, allowing them to set the agenda and direction for their ESG journey. The company’s approach must be clear, verifiable and defendable.
Several well-established ESG frameworks exist. These include the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), OECD Due Diligence Guidance for Responsible Business Conduct, Corporate Human Rights Benchmark (CHRB) and ISO 26000. Some are more like traditional standards (ISO 26000) while others are not (CHRB). However, they all cover similar issues – emissions, environmental damage, labor standards, pay equality, etc. – and will help a company to improve the way it approaches sustainability and CSR.
Choosing which ESG framework is best depends on a variety of factors, such as alignment with objectives (e.g. is there a focus on reducing emissions?), jurisdiction, competitor choice, etc. Each provides an organization with a scaffold on which to build and report on their ESG objectives.
Figures published in June 2021 by the International Federation of Accountants (IFAC) showed that 91% of organizations reported some form of sustainability information. However, to be effective in terms of investor engagement, this information needs to come with assurance, and only 51% of those organizations provided this for their disclosures. Of this 51%, only 63% were conducted by an auditing company or affiliate. The majority (88%) of the reports with assurance were limited, meaning the assurance only related to defined facets (e.g. emissions) of the sustainability report1.
Assurance adds value because it creates trust in ESG reporting. Verification against a recognized standard will optimize an ESG report’s value. The dominant standards for assurance in the marketplace are currently the International Standard on Assurance Engagements 3000 (ISAE 3000) and AccountAbility’s (AA) AA1000 Assurance Standard. ISAE 3000 primarily focuses on assurance procedures and AA1000 focuses on the quality of reporting processes.
Adopting AA1000 avoids the need to expend resources on creating tailored guidelines. The flexibility built into its framework enables it to be adopted by businesses of all sizes and industries – its scope can be customized to the company’s needs.
AA1000 demonstrates an alignment with the AA principles:
Inclusivity – people should have a say on the decisions that impact them
Materiality – decision-makers should identify and be clear about the sustainability topics that matter
Responsiveness – organizations should act transparently on material sustainability topics and their related impacts
Impact – organizations should monitor, measure and be accountable for how their actions affect their broader ecosystems
It emphasizes the need for organizations to engage effectively with stakeholders, identify material sustainability issues and demonstrate the existence of a responsible business strategy. Achieving this enhances trust, reputations, stakeholder attraction and, when tied to financial lending, can reduce capital costs.
The ramifications of failing to achieve assurance against a recognized standard can be costly. Companies approaching ESG assurance for the first time, and those moving between standards, should always complete gap analysis as part of pre-assurance. This will identify areas that need improvements before the assurance audit, reducing the possibility of negative consequences.
Until now, corporate engagement in ESG assurance has been driven by investors, but things are changing. In April 2021, the EU issued a proposal to strengthen sustainability reporting and assurance through the Corporate Sustainability Reporting Directive (CSRD). If adopted, this will fundamentally change the way companies of all sizes need to approach ESG, bringing regulatory requirements into closer alignment with financial sector demands.
This represents an opportunity for small- and medium-sized enterprises (SMEs). They can set their own ESG agenda by choosing a framework and assurance standard that closely fits their needs. Early adoption also means they will benefit from reduced long-term costs and an increase in credibility among stakeholders.