This article is a revision and adaptation by Sustentia of the original written by Frank Bold, within the framework of the Alliance for Corporate Transparency (ACT), for publication in Spain. It is the second in a series of monthly articles to be published with the aim of spreading the word about the importance of sustainability reporting., and the regulatory changes underway in the European Union in this regard for 2021. First of them outlined the next political developments for this year, including the 10 key changes expected in the proposed reform of the EU Non-Financial Information Directive. Our next post will address the connection between the Non-Financial Information Directive, the Taxonomy and Regulation for the disclosure of sustainable finance. Opinions included are those of the authors in this article, and they do not necessarily have to represent the opinion of other members of the Alliance for Corporate Transparency (ACT).

Summary of content:

• The importance of corporate governance in sustainability: the reason for the European Commission's proposals
• The need for a strategic approach to climate change and human rights.
• How can companies better inform about the “G” of ASG.
• Three Essential Elements for Disclosure of Information on Corporate Governance Matters.

 

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In 2021, The European Commission will present two intertwined legislative proposals that seek to promote the integration of sustainability into business strategies. The first, the reform of the EU Non-financial Information Directive (NFRD), has as purpose guarantee the transparency of companies' results in terms of sustainability to improve corporate accountability and enable sustainable financing (see our previous article here). The second, the sustainable corporate governance initiative, clarify the obligations of companies to identify, prevent and mitigate serious impacts on human rights and the environment, as well as what the responsibility of Council oversight on risk management, sustainability strategy and objectives.

This combination of transparency and governance incentives, together with the push of responsible investors, reinforce market pressure for companies to raise the consideration of sustainability among the priorities of management and the Board of Directors, while giving companies considerable flexibility in how they do it.

The EU Commissioner for Justice, Didier Reynders, explained the second initiative launched this year, during a recent act organized by Frank Bold and the CDSB (Climate Disclosure Standards Board), stating that “environmental degradation and climate change are creating risks for companies and their supply chains. The transition creates great opportunities and the companies that get ahead of the game will benefit the most. We want to ensure that business decision-making shifts to a sustainability mindset at all levels.”

Access to the right data is the key for companies and their Boards of Directors to take into account material risks and opportunities in sustainability in their strategic decision-making, including those related to the transformation of the European economy towards a low carbon model.

According to CNMV report on the supervision of the annual financial reports for the year 2019, “The Report on the status of non-financial information of companies has become a relevant document within the annual information of listed companies. Also, as part of the management report, included in the annual report to be prepared and published by issuers of securities in regulated markets, is under the supervisory competence of the CNMV ".

Today, a large majority of companies show no signs of taking these data into account, as evidenced by the state of sustainability information from a strategic business perspective. For example, analysis of non-financial reports (sustainability) of 1.000 large EU companies conducted by the Alliance for Business Transparency revealed that, average, only the 22% of Spanish companies explains what sustainability issues are addressed by the Board of Directors. In a similar way, Spanish companies that describe how they analyze their performance in terms of sustainability or how this performance affects the remuneration of managers represent between a 15% and a 16%. These are results that are repeated in the most recent research carried out by the Alliance for Corporate Transparency (ACT) about 300 European companies, that shows the need to continue promoting change (just a 12% of Spanish companies reported on remuneration based on ESG criteria and a 14% described the sustainability issues addressed by the Board of Directors and a 7% provided information on the participation of workers' representatives in the definition of the sustainability strategy).

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The importance of corporate governance in sustainability: the reason for the European Commission's proposals

The management associations, business organizations and investors increasingly recognize the urgency of the climate crisis and the need to fully integrate sustainability and respect for human rights in companies' business models and risk management. The sustainability crisis and the challenge of ensuring recovery from the COVID-19 crisis are of unprecedented scale and urgency, as highlighted Commissioner Reynders, who also stressed that “companies that get ahead of the game will benefit the most”. According to an estimate by the European Commission, it will be necessary to redirect at least half a billion euros of additional investment per year from normal activities (business-as-usual) to sustainable. The risks and opportunities related to the readjustment of finances and markets are, therefore, equally unpublished. The rapid transition of markets to criteria of sustainability in investment requires quality and useful information between the actors to avoid unintended effects, and achieve the defined objectives.

The need for effective governance and oversight by the highest governance body of the company, as well as an integration of sustainability in these issues, is proportional to the magnitude of the challenges companies face. This is especially relevant when the risks and impacts are related to the company's business model., as this will in turn require major changes in strategy and financial planning.

The International Corporate Governance Network (ICGN for its acronym in English) is updating its Global Governance Principles and, as George Dallas highlighted (your Policy Director) in a event held in february 2021, there will be a “great emphasis on board issues to develop understanding of not just how ESG factors affect them, but about how your company impacts society in a broader context (…) this, at the same time, leads to the need for good information and metrics to guide both executives, as well as the directors of the boards of directors, as well as to give clues to investors in terms of where the opportunities and risks may lie“.

As stated by Juanjo Cordero, partner of Sustentia and coordinator of the ACT study on 1.000 companies, at the presentation in Spain of Report of the Alliance for Corporate Transparency about the data disclosed by 1.000 European companies, “The reports focus on presenting general policies and commitments (80-90% for key issues such as climate, human rights and the fight against corruption), but no concrete goals, policy outcomes with respect to these objectives and specific information on risks and impacts (20% on average)”. This shows that currently the information that reaches both directors, boards of directors and investors needs to improve in quality to be useful in strategic decisions in sustainability.

Another aspect that is considered relevant to guide the corporate governance strategy of companies is associating the remuneration of the people on the Board and Senior Management with the company's sustainability objectives.. In this sense, the Code of Good Governance of the National Securities Market Commission (Cnmv) states that “The variable remuneration of executive directors must be established on the basis of criteria that are related to their performance and to financial and non-financial factors., that are measurable and that promote the sustainability and profitability of the company in the long term ".

However according to Study of the Observatory of Corporate Social Responsibility in IBEX35 companies in the year 2019, focused on the analysis of Corporate Governance, This relationship between sustainability objectives and Board remuneration is not evident. The OBRSC study states that according to its analysis of the IBEX35 companies "Most of the companies analyzed do not contemplate non-financial aspects in their variable remuneration systems, therefore, the stimulus to the achievement of non-financial objectives (social and environmental) may be affected ".

As the research of the Alliance for Corporate Transparency shows on the sustainability reports of companies, the problem is that sustainability information is often invisible to company decision makers, which makes it impossible for them to make fully strategic decisions.

Also, from the point of view of investors and funders, sustainability information is of little value if it is not clear how the company uses it and how it is reflected in the strategy. Larry Fink, founder and CEO of BlackRock (the largest asset manager in the world), in his well-known annual letter to the CEOs, directly asks the companies in its portfolio to “publish a plan on how their business model will support a net zero emissions economy, of CO2. We ask you to report how this plan fits into your long-term strategy, and how it is reviewed by your board of directors“.

In a similar vein, Rients Abma, CEO of Eumedion, an organization representing the interests of institutional investors with investments in Dutch listed companies, also underlines that “the risks and opportunities of sustainability will affect the company's ability to create long-term value, as well as to promote the sustainable success of the company in the long term. Therefore, adequate and well-informed oversight of the Board on these matters, as well as the presentation of meaningful reports on the execution of that duty are extremely important for institutional investors”.

In the Spanish context, according to the 6th ESG Investment Observatory, both large investors and shareholder proxy advisors, known as "proxy advisors", in the future they will take more into account the reporting of non-financial information, so far not analyzed in depth by the market.

In recent years it has begun to be seen that legislative advances, in particular the transposition of the EU Directive on Non-Financial Information (Law 11/2018), linked to the interest of investors, have led to greater participation of shareholders' meetings and Boards of Directors in sustainability matters. As reported by the 6th ESG Investment Observatory, during the general meeting of shareholders of 2019 by AENA, A resolution was approved by which the company will be in charge of drafting a Climate Action Plan for approval at the meeting the following year. For his part, Different companies such as Ferrovial have begun to include the approval of the non-financial information statement on the agenda of the general shareholders' meeting (according to the research carried out by the Alliance for Corporate Transparency, in 2019 just a 9% of the analyzed Spanish companies reported the approval by the shareholders' meeting of the non-financial information statement).

Graphic: Conceptual framework on the publication of information, strategy and corporate governance in sustainable finance.

 

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Additional Information: Frank Bold & CDSB recently hosted a webinar on how the EU Sustainable Corporate Governance Initiative and the EU Non-Financial Reporting Directive reform can focus on helping businesses and financial markets develop and connect sustainability strategies, goal setting, transition plans and reporting obligations. Full recording of the webinar “Sustainable corporate governance and non-financial information: find a path to policy coherence” and summary (in English) of the key points here. Policy Recommendations of Sustainable Corporate Governance the Frank Bold (in English).

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The need for a strategic approach to climate change and human rights

Regarding the risks of climate change, It is essential that energy producers, manufacturers with high intensity of greenhouse gas emissions and banks and investors urgently map out their long-term transition plans to survive - and ideally prosper- in the face of the great market changes that are coming. A recent study CDP showed that European companies had identified 1,22 trillion euros in new low-carbon business opportunities, for example through increased demand for electric vehicles and green infrastructure. The value of these opportunities is more than six times the cost of the investment, of about 192.000 millions of euros. However, the Alliance for Corporate Transparency (ACT) discovered in his investigation of 2020 about 300 European companies that less than 17% explains business opportunities related to sustainability challenges.

A fundamental step for companies to prevent or mitigate risks and impacts related to sustainability is the adoption of objectives and mechanisms to monitor progress and results..

Alberto Carillo Pineda, co-founder of the Science Based Goals Initiative (Science-based Targets Initiative), confirmed that a growing number of companies are asking their suppliers to set science-based goals (SBT for its acronym in English), and noted how this would be a key component to accelerate its adoption and institutionalize the practice. Also, stressed that other actors and initiatives are pushing towards the same goal “All of these are necessary ingredients to create an enabling environment., make the use of SBT common practice, as well as the adoption of sustainability goals and strategies that are in line with planetary limits, and our goals“. The Alliance research positively noted that, in the last two years, has been an increase of 20% in companies reporting science-based targets. In the study, it can be observed that the improvement of information is mainly concentrated in Spain, with a 41% of companies that disclose this type of information, which would show that the explicit requirement to report included in the Spanish transposition of the NFR Directive improves in practice the dissemination of the climate goals of companies.

A strategic approach to sustainability governance is also necessary in cases where companies are linked to serious human rights and environmental impacts through their value chains.. Market mechanisms and the law will increasingly require companies to assume their responsibility in this area.. To achieve the objectives set in the European Green Deal (European Green Deal), it is necessary to mitigate the serious impacts of companies on society and the planet, instead of perpetuating the current model of outsourcing and dissolving responsibilities through global supply chains. These systemic problems include: large-scale deforestation and land grabbing linked to agricultural products such as soybeans, beef and palm oil; exploitation of labor in clothing and footwear supply chains; or the abuse of technologies by the clients of ICT companies, among other human rights risks.

Theo Jaekel, Ericsson Corporate Responsibility expert, is very clear in its support for EU plans to introduce mandatory due diligence requirements: “We have to go beyond disclosure and move to risk management. It is important to see this type of legislation as an opportunity, and not as a burden, because it can clarify what the responsibility of companies is like throughout the value chain compared to the current uncertainties about the scope of responsibility and what we can actually expect from companies. If done correctly, will alleviate these worries“. Regarding the supervision and management of sustainability issues by the boards of directors, Jaekel sees this as a crucial part of integrating due diligence requirements, and not an issue that must be resolved by modifying the duties of the directors. “The objectives we set at the group level, including environmental and human rights objectives, are approved by management and the board of directors, and its results are periodically reported to the council“.

John Ruggie, author of the United Nations Guiding Principles on Business and Human Rights, recently explained the relationship with human rights due diligence as follows: “By making human rights due diligence mandatory, with penalties for non-compliance, as the European Commission intends, becomes a legal responsibility not only for the management, but also for the supervision of the Board of Directors”. In this context, the investors, as well as the main reporting frameworks, expect more and more transparency about the supervision by the Board of Directors of the due diligence and materiality determination processes, and on how the results of these processes are reflected in the strategy of the company as a whole.

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How can companies better inform about the “G” of ASG

Information on matters related to corporate governance in matters of sustainability is addressed in the main reporting standards, as the GRI, the SASB and the CDSB, as well as in the references made by the World Benchmarking Alliance. Recommendations of the Working Group on Climate-Related Financial Disclosure (TCFD for its acronym in English), the standard for climate reporting endorsed by the international investment community, as well as by the European Commission, includes board-level governance of climate-related risks and opportunities as one of the four main areas of disclosure. In the same way, The United Nations Guiding Principles on Business and Human Rights require the participation of the highest level of a company's government in discussing its main challenges, human rights policies and objectives, as well as in monitoring the progress made.

The EU Directive on non-financial information requires companies to disclose strategic information, but does not provide clear guidance on how to determine what information is important, and how to select the relevant data and metrics of existing initiatives and standards. Today sustainability reporting initiatives as a whole include more than 5.000 widely divergent key performance indicators. This, combined with the rating agencies' own questionnaires, supply chain investors and buyers, makes it very difficult for companies to approach reporting and sustainability from a strategic perspective.

As a reaction to these problems, the reform of the EU Non-financial Information Directive (see our previous article here) will aim to help companies by clarifying the information to be submitted on governance and integrating sustainability into business strategy. The Working Group of the European Project on Non-Financial Reporting Standards, dependent on EFRAG, has recommended in its final advice to the European Commission that future EU information standards should include a standard on “Strategy”, structured in three components: a) General strategy of the company; b) Risks, material threats and opportunities in sustainability; y c) Sustainability governance and organization. This general standard should be supported by thematic standards, (for example on weather-related information), that address implementation (policies and actions) and performance measurement (measured achievements and progress by key result indicators – KPI).

Graphic: Reporting areas proposed by the EU Standards Working Group (source EFRAG).

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Three Essential Elements for Disclosure of Information on Corporate Governance Matters

In the three areas of information related to strategy and corporate governance, There are several categories of information critical to the success of a company's sustainability strategy and reporting. These are already expected by the main sustainability information standards, and the big investors, but they will be more and more relevant, at the time of reporting, for the companies, especially those at the top of value chains:

1. Business strategy and supervision of the board of directors

The law gives the members of the Board of Directors a wide margin of maneuver when considering sustainability when making decisions on behalf of the company. In this sense, The following information is essential to understand how a company integrates sustainability at a strategic level, as well as for the boards of directors to have access to relevant and pertinent data:

• Strategy approved by the Board of Directors to address the most outstanding sustainability issues, specifying: a) Measurable objectives (goals) high-level prevention, or mitigation, of the risks and impacts of each outstanding issue identified by the company. b) Financial resources approved for the implementation of the strategy.
• Reviews from the sustainability of the business model, the strategy, and the financial planning of the company.
• Progress report on meeting the objectives, sustainability goals and challenges, signed by the Council.

There are two requirements set out in the Law 11/2018, transposition of the EU Directive on Non-Financial Information that endows the Statement of non-financial information with an importance and formality that until now did not have the majority of the sustainability or CSR reports that had been published. On the one hand, non-financial information, like the annual accounts, must be signed by all company administrators, who will answer for its veracity. And it must also be presented as a separate item on the agenda for approval at the General Shareholders' Meeting..

According to the CNMV report of the 2019 in its exercise of supervision, “... some issuers (around the 45 % of the companies subject to substantive review), in addition to publishing the EINF required by law, publish separate corporate social responsibility or sustainability reports, usually later. Not on all occasions, these documents are submitted to the formulation of the Board of Directors., to the vote of the general meeting of shareholders or to the review by an independent third party ". Report on the supervision by the CNMV of the annual financial reports and main areas of review for the year 2019

2. Determination of double materiality and due diligence

Integrating sustainability into business strategy is based on a good understanding of what sustainability issues are material, and therefore significant. The EU Non-Financial Information Directive is based on the perspective of the “double materiality”, which provides guidance to companies on how to identify the issues that:

1. already have or may have future financial risks and impacts for the company; o
2. represent the areas in which the company causes, contributes or is directly linked, for business relationships, to serious impacts on people or the environment throughout its value chain (Determining these issues is the first step in the human rights and environmental due diligence process., on which solid guidance already exists, and that will be covered in detail in one of our next articles)

In this regard, the key information is as follows

• A description of the process, and the principles applied by the company, to determine your material issues, including information on how affected stakeholders were consulted (in accordance with human rights due diligence, Businesses should specifically engage with people who are at risk of harm from the way a business conducts its business, rather than general categories of stakeholders as customers, comunidades, etc.. The need and priority in incorporating people in these consultations, as well as subsequent commitments, should be understood as proportional to the risk and severity of the damage / impact caused).
• A description of the sustainability issues determined by this process along with an explanation of why the issues are considered material, both from a financial point of view, how impactful.
• Details of the company's exposure to risks, or of the implication in impacts, on human rights and environmental issues.

The supervisor of listed companies, the CNMV, considers priority in its Review of the Non-Financial Information Statement 2020 the materiality analysis of non-financial information and its adequate breakdown, emphasizing again the double materiality and the influence of the stakeholders in their evaluation and determination. In this sense, as indicated by the CNMV in its report on the supervision of the non-financial information statements of 2019 among other areas for improvement that “Explanations on how to determine what information is material and the criteria and methodology used should be expanded, indicating among other topics:

• If internal and external factors are considered and what are their sources of information.

• How the information needs of stakeholders identified as significant are taken into account in their analyzes, making explicit what they are and describing how they contribute to the value chain and position themselves in it, and the main dialogue tools used.

• How the evaluation of materiality has been reflected and is consistent with the operational and strategic plans.

• The contemplated time horizon. According to the European Commission it should be the long term.

• The severity and probability of impact of each financial and non-financial aspect, and its cross effects, in the sense of how it is considered that social and environmental materiality end up having an impact on the financial position and results of the entity.

• How sectoral issues affect the analysis.

• Materiality analyzes should be updated periodically and, otherwise, explain the reasons why such an update is not necessary.

• Issuers should explicitly indicate whether the dual perspective of materiality is taken into account in their analysis for all non-financial issues., including explanations about it. "

Today, according to studies developed by the Alliance for Corporate Transparency (ACT), most of the companies analyzed report on issues that are not relevant, nor from a financial perspective, nor from the impact, and do not provide information on the materiality determination process. Normally, companies fill their reports with information on philanthropy, volunteering and other CSR activities that are additional, instead of being tied to your business. Company reports often suggest that the topics covered are selected because the company perceives them as expected by its stakeholders., or because they have done a generic stakeholder consultation, but they do not explain if those topics are material, nor why.

"Rarely in company reports is materiality reported relating it to specific risks or impacts associated with the business model, or to consultations with holders of rights at risk or affected by it. Nor is it frequent for companies to report on their materiality or on how global risks and challenges, such as the effects of global warming, affect the business model., the violation of human rights or the increase in inequality " affirms Carlos Cordero Partner-Director of Sustentia.

The double materiality perspective of the Non-Financial Information Directive in the context of climate-related information. Fuente: EU.

3. Sustainability governance and organization

To ensure and demonstrate to investors that sustainability is built in, the main international standards, like TCFD, three priority elements stand out:

• A description of how the determination of sustainability issues based on a dual materiality approach is integrated into the broader risk management system of the company. Companies must demonstrate that these systems not only reflect sustainability risks for the company itself, but also the risks it poses to affected stakeholders.
• An explanation of how the company's sustainability goals and KPIs are integrated into the performance incentives of the company's management.
• An assessment of the technical knowledge available to the Board to monitor the implementation and review the content of the company's sustainability strategy. This experience must be proportional to the complexity of the challenges the company faces., and can be guaranteed by members of the Board with experience in the matter or through an advisory committee made up of experts and independent directors.

The degree to which sustainability issues are embedded in a company's governance tools is seen in its ability to influence business decisions. To the extent that company leaders assume social and environmental issues as the priority axes of their mandate, there will be a real transformation that contributes to generating a sustainable and inclusive economic development.