How Would ESG Reporting Impact Business Financial Performance?

In July 2023, the European Union (EU) unveiled a landmark directive that mandates ESG (Environmental, Social, and Governance) disclosures for major public companies, starting from January 1st, 2024.

Under this new rule, businesses listed in Europe will be required to detail ESG-related risks, opportunities, and impacts as fundamental elements of their business strategies and decision-making processes, with phased timelines between 2024 and 2026.

This legislative move is the EU’s response to longstanding concerns over the absence of standardized ESG reporting frameworks and the limited comparability of ESG ratings.

While the EU regulations are expected to drive more meaningful ESG incorporation, some challenges remain–companies may take time to transition from basic compliance to embedding ESG thinking throughout their operations, and more work is still needed to develop consistent ESG metrics and methodologies.

Nevertheless, the regulatory push indicates a growing momentum for ESG investing and reporting globally.

What is New in the Sustainability Reporting Standards?

This EU Directive aims to bolster businesses’ commitment towards ESG matters, in order to steer economic growth in a sustainable manner (European Parliament, & Council of the European Union, 2022).

In response, businesses must promptly familiarize themselves with the revised reporting standards (see key takeaways),  adopt appropriate digital reporting systems, and refine data analytics and metrics—all within the defined timeframe. Some key aspects of this directive are shown below.

• Business Strategy Alignment: Companies are required to disclose the ESG-associated risks, opportunities, and impacts in their business model, policies risk management, and relevant KPIs. This ensures the integration of ESG considerations into their strategy and decision-making process.
• Financial Reporting Integration: ESG reporting will become a fundamental component of management reports, providing relevant information about the sustainability of financial performance.
• Implementation Timeline: Initially, the legislation targets large public companies—those with a minimum net turnover of 40 mln EUR, a balance sheet value exceeding 20mln, and staffing over 250 employees in the financial year. Within two years, the requirements will extend to Small and Medium Enterprises (SMEs).
• Extraterritorial Scope: The directive also encompasses non-EU businesses generating a minimum net turnover of 150mln EUR within the EU.

From Disclosure to Performance

While this new legislation marks a significant shift in the corporate approach towards ESG matters (i.e., from previous voluntary engagement to the now de facto requirements), this change is also driven by the shift of consumer taste and investor preference towards more sustainable business solutions.

To illustrate, a 2015 Nielsen Global Survey on Corporate Social Responsibility revealed that more than half of global consumers, particularly millennials, are willing to pay extra for sustainable products, a surge of more than 10% compared to the previous year.

Moreover, the unprecedented COVID-19 pandemic further hastened the implementation of this reporting mandate.

The reason? Heightened public awareness and growing preferences for sustainable and resilient business practices, from business models to overarching strategies.

As a response, corporations have amplified their social responsibility efforts, by launching campaigns and introducing new business offerings, to improve their sustainability credentials.

Yet, there has been an ongoing debate for the past 50 years regarding the efficacy of these corporate ESG engagements.

Questions arise: Do these endeavors, whether voluntary or mandated, genuinely drive better business outcomes?

Or do they merely serve as impression management tactics to obscure misbehaviors (Eliwa et al., 2018)?

Compounding these concerns are challenges such as the lack of valid, consistent, and comparable ESG data (Serafeim & Yoon, 2022, Wong et al., 2021).

This makes gauging corporate performance all the more complex.

Therefore, the extent to which ESG disclosures translate into tangible business and financial outcomes remains an open question.

A Non-linear Correlation between Disclosure and Performance

Conventional wisdom suggests that if the market has a greater appetite for sustainable products and services, it should reward businesses that actively pursue ESG strategies through increased sales, profitability, and market valuation.

However, the relationship between a corporation’s ESG disclosures and its financial return is not always linear.

A 2018 study involving nearly seven thousand companies from the US, China, and Japan observed a nonlinear relationship between ESG disclosure scores and corporate efficiency (such as revenues, return on asset (ROA), or market valuation).

While governance disclosure, including aspects like ethics, shows the strongest positive effect on corporate efficiency; social (e.g., employee career development) or environmental disclosures (e.g., corporate environmental policies) exhibited a less strong correlation (Wong et al., 2021; Xie et al., 2018).

These nuanced findings might arise from the use of different metrics, or types of ESG disclosures, among other factors.

However, despite the uncertainty in financial returns, some investors are reportedly open to accepting marginally lower returns due to the non-financial advantages of holding sustainable assets (Pastor et al., 2021). But does it mean that ESG investing generally performs less than traditional stocks?

Higher Financial Return, Brown Stocks, or Green Stocks?

Traditionally, higher risks have been associated with higher returns owning to risk premiums.

Here comes the question: Can green or socially responsible assets, with their risk mitigation orientation (e.g., hedge against climate risk) outperform traditional assets?

While some findings suggest mixed results (Pastor et al., 2021), others provide insights into the benefits of green investments.

A 2021 study of more than six thousand non-financial companies from 15 European countries found a positive correlation between the company’s ESG disclosure with its ESG performances as well as its market valuation (Eliwa et al., 2021).

One primary reason is a reduced borrowing rate from lending institutions, which view environmental and social disclosures as indicators of the borrower’s reliability and trustworthiness.

Additionally, rising consumer preference for eco-friendly products and an increased investor inclination towards green stocks, have also propelled the growth outlook of the ESG investing market.

By 2019, ESG portfolio capitalization in major markets surpassed 30 trillion USD.

This surge is largely attributed to the belief that ESG practices enhance portfolio performance, mitigate associated risks, and drive business resilience.

This trend was particularly evident during the challenges posed by the COVID-19 pandemic (Broadstock et al., 2021).

However, if stock markets are incorporating companies’ ESG performances into price evaluations, how efficient is the stock market in making such assessments?

How Efficient is the Sustainability Market?

While both policymakers and market participants have taken commendable strides in ESG matters, there remains substantial potential for enhancement, especially concerning its efficiency.

A primary challenge is the absence of a unified reporting standard.

This, combined with disparate ratings from different rating agencies, complicates the comparison of assets and cast doubts on the utility and credibility of the ESG rating.

The lack of valid measurements hinders the market’s ability to incorporate ESG news into stock prices.

This, in turn, affects the predictability of the ESG market, as well as investors’ capacity to establish a direct cause-and-effect relationship between ESG activities and performances (Serafeim, & Yoon, 2022).

Other challenges were also observed in the data availability, varying data sources, diverse country contexts, and abnormal impacts of events like the COVID-19 pandemic.

Therefore there is a prevailing sentiment that a more extended observational period is crucial to draw more definitive conclusions.

Looking Ahead

As we look ahead, the Sustainability Reporting Standards issued by the European Union in mid-2023 call for a paradigm shift for listed businesses in Europe.

Companies will need to go beyond merely adhering to regulations and, more importantly, embed ESG/integrated thinking into their strategy, business models, and eventually day-to-day activities.

Yet, as companies navigate this new landscape, uncertainties remain.

Given that performance metrics are still in flux, the true impact of enhanced ESG disclosures on business excellence and financial resilience is an unfolding narrative, one that the global business community will keenly watch and learn from in the years ahead.

Ready to make your business more sustainable and gain a competitive edge?

At Taze Consulting, we specialize in financial transformation for businesses. 

Contact us for a no-obligation chat about your needs.

References:

Broadstock, D. C., Chan, K., Cheng, L. T. W., & Wang, X. (2021). The role of ESG performance during times of financial crisis: Evidence from COVID-19 in China. Finance Research Letters, 38, 101716. https://doi.org/10.1016/j.frl.2020.101716

Eliwa, Y., Aboud, A., & Saleh, A. A. (2021). ESG practices and the cost of debt: Evidence from EU countries. Critical Perspectives on Accounting, 79, 102097. https://doi.org/10.1016/j.cpa.2019.102097

European Parliament, & Council of the European Union. (2022). Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, Directive 2006/43/EC and Directive 2013/34/EU, as regards corporate sustainability reporting (Text with EEA relevance). https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022L2464

Pastor, L., Stambaugh, R. F., & Taylor, L. A. (2021). Sustainable investing in equilibrium. Journal of Financial Economics, 142(2), 550–571. https://doi.org/10.1016/j.jfineco.2020.12.011

Serafeim, G., & Yoon, A. (2022). Stock price reactions to ESG news: the role of ESG ratings and disagreement. Review of Accounting Studies. https://doi.org/10.1007/s11142-022-09675-3

Wong, W. C., Batten, J. A., Ahmad, A. H., Mohamed-Arshad, S. B., Nordin, S., & Adzis, A. A. (2021). Does ESG certification add firm value? Finance Research Letters, 39, 101593. https://doi.org/10.1016/j.frl.2020.101593

Xie, J., Nozawa, W., Yagi, M., Fujii, H., & Managi, S. (2018). Do environmental, social, and governance activities improve corporate financial performance? Business Strategy and the Environment, 28(2), 286–300. https://doi.org/10.1002/bse.2224