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The importance of materiality, or why we should rethink the terminology of non-financials

The importance of materiality, or why we should rethink the terminology of non-financials

The EU-Action Plan comes not a moment too soon

Kristina Jeromin

Since the outbreak of the financial crisis, the market has become more and more insistent that companies publish not only traditional financial indicators, but that they also disclose relevant environmental, social and governance aspects – so called ESG data. ESG factors account for a considerable share of enterprise value. Even if a growing number of institutional investors, analysts as well as rating and research agencies are placing greater importance on this data in their decision-making progress, there is a lack in the overall understanding about these important extra financial figures. Even though publication by listed companies has recently been made mandatory by the EU, changing the perspective of backward looking, classic financial reporting into a more future-oriented one is a long process that still needs to be driven forward.

The potential of a holistic database

The integration of core business-based ESG data allows a more holistic and, above all, a forward-looking measurement of company value. This is because climate and other environmental risks, social factors and aspects of corporate governance are playing an essential role in risk assessment for the financial sector. The disclosure of this data and awareness of these topics will also become crucial for companies, as they can identify risks along their value chain and manage these accordingly in order to ensure medium and long-term business success. We can see a strong correlation between companies’ financial performances and how well they manage their ESG agenda. ESG issues should be considered more as drivers of innovation and new business – and not to forget, to provide more transparency about possible cross-sector risks to ensure greater stability on capital markets.

The growing relevance for investors

It is no wonder in this scenario that issues relating to a responsible and future-proofing “license to operate” in the context of investment analyses and decisions are being discussed in more detail than ever before. Fiduciary duties must certainly be considered a link here, as these always arise when there is a transfer of legal power governed by law or contract. These fiduciary duties were highlighted more closely in the 2017 study Fiduciary Duty in the 21the Century published, among others, by the UN Global Compact and the Principles for Responsible Investment (PRI) with the involvement of various industry experts on corporate sustainability. Fiduciaries should act with due care and diligence in the interests of their beneficiaries, ensure the profitability of the investment and impartially balance the conflicting interests of different beneficiaries. Moreover, they should not act for the benefit of themselves or a third party.

Additionally, financial reports must, as highlighted above, contain a holistic and forward-looking view of both positive and negative effects of a company’s core business, and include all relevant information that could affect the company’s added value. This would enable investors to meet their fiduciary duties, and gauge the extent to which companies recognise opportunities and risks, including them in their value creation and preservation.

The cautious way in which ESG information is being taken into account in the investment process is due, among others, to the partially justified doubts about the data’s reliability, its lack of standardisation and thus impaired comparability. Although we, for example, already have valid quantitative environmental aspects data available that enables investors to look at a company’s CO2 strategy to prepare financial forecasts on that basis, operationalising and thus quantifying qualitative data on social and governance aspects proves more difficult. This also ties in with the lively discussion on all respects of verifiability of such data.

Naturally, all these difficulties ought to be acknowledged and taken seriously; however, it is not quite comprehensible that in times of digitalisation it is still difficult to develop a basic structure for a database capable of tracking current and future corporate value in a comprehensive manner.

Despite the momentary challenges, such holistic and prescient comprehension of corporate responsibility and its associated flexibility will establish itself as the norm.

The whole discussion has currently reached its peak in light of the new EU-obligation for listed companies.

As of 2018, the EU CSR directive requires large companies to disclose certain information on the way they operate and manage social and environmental challenges. Companies have to include this information in their annual reports. Unfortunately, the European Commission officially entitles ESG-data as so called non-financial statements. Opposite to the framing of the EU terminology, this data needs to be considered as extended key financial figures and should therefore not be labeled as “non-financial”. The directive itself was a good first step in the right direction, and the new EU-Action Plan on Sustainable Finance gives an even more positive outlook as it is not only about disclosure standards, but addressing a broader scope of sustainable finance. The EU-Action Plan is for example highlighting the importance of ESG-data within the analyses and management of risks on the company and the investor side.

The ambitious EU-Action Plan on Sustainable Finance

The Action Plan, presented by the European Commission in March 2018 and based on recommendations of the HLEG, aims to do the following:

  • Establish an EU classification system –or taxonomy – to define what is sustainable and identify areas where sustainable investment can make the biggest impact
  • Clarifying the duty of asset managers and institutional investors to take sustainability into account in the investment process and enhance disclosure requirements
  • Create EU labels for green financial products on the basis of this EU classification system to allow investors to easily identify investments that comply with green or low-carbon criteria
  • Require insurance and investment firms to advise clients on the basis of their preferences on sustainability
  • Incorporate sustainability into prudential requirements for banks and insurance companies; exploring the feasibility of recalibrating capital requirements in relation to sustainable investments
    AND
  • Enhance transparency in corporate reporting by revising the guidelines on non-financial information to further align them with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD).
    This last point is a valuable step in emphasizing the importance of extra-financial data and the need for establishing these as an essential addition to the classic financial.

The need of changing the perspective about “non-financials”

The EU-Action Plan comes not a moment too soon. Looking ahead and facing the upcoming challenges such as the climate change, but also migration, progressing digitalisation and the establishment of social standards, deeply affecting the way we work, move, invest, produce and consume, it is surprising that we still speak of ESG information as non-financial. High funding requirements will be needed globally for the sustainable reorganisation of whole branches of industry, the achievement of the 2-degree goal and the realisation of the United Nations’ Sustainable Development Goals, but also, for example, financial compensation of damage as a result of climate change.

In order to take account of these changes in the near term, there will have to be a rethink in the financial industry– the fundamental inclusion of sustainability criteria in the entire financial sector is essential. Resetting the focus will also mean acting with an appropriate and accurate wording. We therefore also need to rethink the terminology of “non-financials” and frame the conversation around ESG differently, simply because these figures already are and will be even more of significant financial interest.

Kristina Jeromin is Head of Group Sustainability at Deutsche Börse, Managing Director of the Sustainable Finance Cluster Germany, and a member of the board at econsense, the Forum for Sustainable Development of German Business.

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