Aristotle had a fairly dim view of business and toil, which he cynically described as merely utilitarian − a necessity but not enriching or ennobling human life.
These days few would question that businesses make huge contributions to human life in the form of paying taxes, providing employment, and creating investment opportunities and goods and services. South African businesses lent a helping hand during COVID-19, and they are doing so again now to assist with power shortages, dysfunctional ports and rampant crime. But globally businesses have also earned a reputation for causing pollution, soil degradation, carbon emissions, the displacement of local communities, water scarcity, inequality and other social and environmental ills in the pursuit of profits.
There has been much toil in recent years to ‘ennoble’ business, a case in point being ESG, the very au courant acronym for environmental, social and governance. ESG is a framework against which companies are held to account for their performance and practices on governance, social and environmental matters, the idea being that increased disclosure would result in increased accountability which ought to put businesses on the path towards sustainability.
The issue is that using ESG as an accountability framework is workable only if companies provide ESG information that is comprehensive, comparable and reliable. Since there is a lack of established standards for non-financial reporting, companies’ reports in this respect are currently done piecemeal and lacking consistency. Hence the slew of sustainability reporting regulations and standards which are now well underway, including by the US Securities and Exchange Commission (SEC), the European Financial Reporting Advisory Group (EFRAG), and the International Sustainability Standards Board (ISSB).
This proliferation of activity is in no small measure thanks to the impetus provided by the growing urgency of climate change and the demands from investors for information that will assist with a more comprehensive analysis of how the range of ESG risk factors may affect their portfolios.
As is the case with most human endeavour, even these laudable developments are not without controversy. On the one side of the divide is the rallying by conservative politicians in the US against ‘woke’ ESG investing since it is believed to be harmful to capital markets and ordinary investors. On the other side are those who are of the view that ESG and sustainability standards do not go far enough.
As to the former, President Joe Biden exercised his first presidential veto to reject a proposal to prevent pension fund managers from making investment decisions on factors like climate change. No argument there as ESG is not the destroyer of capitalism but simply a common-sense investment strategy for the de-risking of portfolios. The latter criticism of ESG and sustainability standards deserves more of an explanation.
The sustainability reporting standards by the SEC and ISSB frame materiality of information − which determines what gets reported − from the perspective of the providers of financial capital, that is investors and lenders. Consequently, ESG or sustainability risks are considered for how they may potentially have an inward effect on the cash flows or enterprise value of the company. Outward impacts by the company on people and the planet are not accounted for in determining materiality and therefore need not be disclosed under the standards. That is, unless the risk is likely to turn inward such as for example, when an outward impact by the company on the environment becomes an inward issue through regulatory intervention or taxation.
By contrast, the European Corporate Sustainability Reporting Standards call for disclosure based on double materiality, meaning that companies need to disclose both inward and outward impacts. In this instance it is assumed that the users of sustainability disclosure extend beyond the providers of financial capital to multiple stakeholders.
Limiting sustainability disclosures to financial materiality has rightfully been questioned as it seemingly lets companies off the hook for reporting the negative consequences of their business operations on society and the environment. The counter argument is that since both the SEC rules and ISSB standards require an assessment of sustainability risks not only in the short term but also over the longer term, it increases the likelihood that the outward ESG impacts of today may turn into inward risks and financial losses for the company in the future. Outward risks will be caught by casting the materiality net over the longer term and therefore, so the argument goes, regardless of the take on materiality, the different ESG and sustainability standards should result in similar disclosures.
Is this then where we can agree that arguing over definitions of materiality is a mere ideological debate which unfairly detracts from real progress made in the transitioning towards more transparency?
Not so, according to Carol Adams and Frank Mueller, professors of accounting at Durham University Business School, who point out the practical consequences of the differences in conceptual framing. What constitutes the ‘investor perspective’, financial materiality and in what time frame are left wide open to the judgement and interpretation of the reporting organisation. Translation: reporting organisations have leeway to pick and choose what they disclose. This is the exact opposite of what reporting standards are meant to achieve.
This reminds me of my erstwhile law professor who in his characteristic roll of the ‘r’ in Afrikaans was fond of impressing upon his students: You get your concepts and theories wrong, and reality avenges itself. He has been proven right in this instance.
The reality is that companies are hosted by the larger societal system and ultimately humanity and all life on earth depend on the earth systems. The perspective of the investor expressed in terms of finances, cash flow and enterprise value is not representative of this reality. Societal and environmental stakeholders − and the providers of financial capital for that matter − deserve company disclosures that inform them on both inward and outward impacts.
This is a step closer to Aristotle’s conditions for harmony between business and human life.
Ansie Ramalho, Professional Non-executive Director and Chairperson of the King Committee on Corporate Governance