Sustainability reporting – who's doing what, and why your investors care

Download the transcript – Regulation, reporting, and the value question: ESG in a shifting landscape

As sustainability regulation accelerates across global markets – from ESG disclosures to tax incentives – the rules of the game are changing fast. This is already reshaping corporate behaviour and investor expectations, as businesses worldwide are beginning to stop viewing ESG reporting as a compliance burden, and instead see it as a lever for innovation, accountability, and investor trust.

Katharina Neureiter MBA2021, Co-Head of Global Sustainability at the global investment firm The Carlyle Group, describes how her company tackles this complex issue. Her sustainability team is divided into three pillars – risk mitigation, value creation and market shaping. The latter is a horizon-scanning pillar, looking ahead: “What are the big topics coming up?” In the last three to four years, she says, the industry has galvanised around what net zero means for private equity. How do you codify value creation, social issues, physical climate risk? “What are the topics that are meaningful to our investors?”

New regulations are coming into effect all the time, points out Sergei Guriev, Professor of Economics and Dean, London Business School – but it’s a disparate landscape, with different rule-making bodies that aren’t joined up. “The EU's corporate sustainability reporting directive took effect a few years ago. Now SAC in the US Securities and Exchange Commission has its own rule adopted a year ago and disclosure is supposed to start this fiscal year. The UK landscape is also evolving.” No wonder investors need guidance.

Addressing the challenges around disclosure regulations is a challenge, but that’s not to say it’s insurmountable. As an investment firm, The Carlyle Group is required to disclose both its own activities and those of its portfolio companies. “Regulatory pressure is only a part of it,” says Neureiter. “A lot of the conversations I have with our investors are around how you integrate physical climate risk and how you underwrite that. Some of our companies are very mature and they can report their carbon footprint to us. Others are small and this is very new, and then we need to estimate their carbon footprints on their behalf.”

In addition, sustainability has become an issue for the CFO office, she says. “Before, they didn't really have to pay that much attention to it. But with the ISSP and in certain jurisdictions where ESG data has to end up in financial statements, suddenly the CFOs are like, what am I actually reporting against?” CFOs are also conscious of their brand reputation. “What's my narrative here? What am I saying? Am I better? Are they better?” There's a huge educational piece.”

Marcel Olbert, Assistant Professor of Accounting at LBS, Assistant Professor of Accounting at LBS, has looked at the trade-offs between ESG, disclosure and financial performance in his extensive research into multinationals’ behaviour. “Regulation does drive change,” he insists. “Sunlight is the best disinfectant. Transparency regulation has driven the biggest change, for example in emissions reductions. More direct interventions, such as taxes on carbon, have real effects on corporate behaviour across the globe.”

Now CFOs are having to track not just profits, but also the impact on people and the planet. “The debate about impact investing versus financial returns is not settled yet,” he says. “Private equity firms don't always face regulatory requirements to publish. This gives us, as a research community, a chance to see what's happening in this space.”

Olbert and his colleagues, including Florin Vasvari, Professor of Accounting at LBS, set out to see how much voluntary ESG reporting is there in the private equity industry overall globally. They have found a huge increase in it over the last 20 years, mostly driven by investor demand. “Private equity firms are providing more voluntary ESG information, for example, on their websites. That's how we measure it. If they receive more capital from investors who have signed up to the UN Principles of Responsible Investing, UNPRI. That's the business case for ESG reporting information.”

Publicly listed companies have a higher degree of regulatory exposure, Neureiter contends. Private equity companies are very often in the value chain of large public companies that have set net zero targets and need to consider their Scope Three emissions. “So the biggest driver we actually see is public companies pushing it down into the companies we'd be working with.”

The Carlyle Group has carried out an analysis across its portfolio and found that in Europe, Asia, and the US, about 60 companies, about 14 billion of their revenue is tied to those type of ESG requests from their customers. That's about a third. AstraZeneca, for example, requires its value chain to have climate targets. “So very quickly, they came to us and said, how do we set our climate targets? Can you help? We see that domino effect very prominently in a portfolio.”

This is backed up by the data, says Olbert. “We can learn something very important for policymakers here. There is more ESG reporting among the private companies and ESG firms if they act in environments where there is already mandatory reporting requirements on the large public firms. There's a spillover of reporting requirements. Maybe we don't need to overshoot with regulating the whole economy and each legal entity independently of the size because we have these positive externalities that address the big fish.”

Neureiter seeks to mitigate the risks for firms but also flip them into opportunites, highlighting cost savings, avoided losses such as fines, and opportunity capture. If you are first to reformulate some products to get ahead of the regulations, you can get ahead of your competitors. Finally, it’s worth considering your adaptive capacity, which is about innovation and driving ahead, such as launching new green pricing power, new markets that you can access where your competitors are struggling.

She gives the example of a billion-revenue chemicals company in Spain that had a decarbonisation target already. Increasing this further generated about £26 million of economic value within three years. ESG-linked financing meant better terms for meeting the decarbonisation targets, which led to direct energy cost savings as well as operational savings. They also slightly reformulated some products, improving their margins.

To what extent do investors actually trust what companies voluntarily report? Can they have confidence in the reported metrics, when everyone is aware of greenwashing?

It’s the elephant in the room, Olbert concedes – but his research finds reasons for optimism. “We looked at whether private equity firms who voluntarily and publicly talk a lot about their ESG strategies actually invest in more sustainable outcomes. We find broad evidence that at least on average for the whole global sample, this is the case. The business case is obviously also risk mitigation. If you have a safer workplace in your manufacturing plant in the long run, that should lead to higher cash flows. Overall, we also see a kind of reputational risk mitigation when it comes to ESG issues. And that's something I think investors also care about.”

The current uncertainty factors into all of this, of course. The economic policy uncertainty index that economists refer to is at a record high right now, says Guriev – higher than during COVID, higher than during the global financial crisis. “We are at an unprecedented juncture, and part of that is a debate about business and sustainability, and the different governments’ attitudes to ESG reporting.”

Olbert points towards the pioneering work of Alex Edmans, Professor of Finance at LBS, which offers 10 principles to fundamental shift the way sustainability is practised – Rational Sustainability. The narrow focus on ESG often means companies lose sight of the bigger picture. “There are social realities,” says Olbert. “If you have a single mom on a zero-hour contract, that’s probably not very good for her mental health.”

Olbert suggests companies go back to basics. “We're not telling anyone to abandon a fiduciary duty on behalf of other objectives. We are saying, before risk mitigation, what do your customers want, and how do you run a better business? Focus on that, which protects you in any environment.”

Voluntary reporting is not enough, because of “externalities” such as pollution which have a wider effect than on the firm itself. Regulation creates a financial incentive for firms to change their behaviour. “Transparency regulation is not a direct intrusive pricing mechanism, so it gets more nuanced – and it's quite costly for companies,” says Olbert. “That’s why policymakers try to strike the balance and impose size thresholds: only companies above a certain size should disclose on a mandatory basis.”

To tackle the bewildering reporting landscape, which makes it difficult to compare like for like, Neureiter’s team came up with the ESG Data Convergence Initiative, where core metrics – carbon emissions, renewable energy, health and safety, employee participation, and board diversity – are collected in the same way and reported in a harmonised format. The metrics are verified and audited by an external body, then shared with investors. About 9000 private companies are now participating in this scheme.

Some companies are inevitably avoiding regulation by relocating activities to different jurisdictions, for example to Africa, as carbon prices increase in Europe. Perfect global harmonisation in the current political environment is unlikely. So the EU is developing avoidance regulation, like carbon board adjustment mechanisms. “If we cannot get all countries on the same page to raise corporate and other taxes to a certain level then we can try to work with a minimum tax rate such that given countries apply a top-up tax rate if your firm engages in regulatory arbitrage and moves abroad,” says Olbert. In the future, he suggests, jurisdictions will think about measures to level the playing field for the businesses in their home jurisdiction.

While policymakers continue to figure out how to regulate fairly and collect meaningful, comparable data in the context of a fragmented political landscape, business leaders are increasingly exploring how to use sustainability to create value and new opportunities. Neureiter’s three-pillar approach is a good place to start: Where can you save costs through sustainability – by using LED lighting and reducing your energy footprint, for example? How can you avoid incurring losses, such as regulatory fines? And where can you change and innovate, and perhaps gain access to new markets where your competitors are struggling?