A defining moment for non-financial disclosures
We have until midnight on 11 June to provide input into arguably one of the most important elements of the European Commission’s ‘European Green Deal’ – the review of the Non-Financial Reporting Directive (NFRD).
Some may disagree – and, fair enough, other areas like the new Climate Law are very important. However, the NFRD is the foundation on which sustainable investing sits in Europe! Long-term investors need relevant, comparable, consistent, and verifiable non-financial information across markets to price environmental, social, and governance (ESG) risks and opportunities accurately. Non-financial disclosures are the bedrock of the efficient and sustainable allocation of capital.
As well as being extremely valuable in their own right, they underpin other vital elements of the EU’s broader sustainable finance work, such as the EU Taxonomy and sustainability disclosures in the financial sector.
It is for these reasons that LGIM has not taken this topic on an issue-by-issue basis. Instead, we have prioritised transparency as a strategic long-term theme that guides our engagements with companies and policymakers globally.
Too often investors can focus on the end goal rather than thinking about how we get there, which is why this is the first in a series of pieces on how we remove obstacles to a sustainable financial system by improving transparency across the investment chain.
So, for our friends in Brussels, perhaps you might think about the below when considering how to strengthen the NFRD...
• The global economy. Companies and their supply chains span markets, as does the impact they either have on the society and the environment, and indeed vice versa (the Commission calls it the ‘double materiality’ concept). The same goes for investors: we need to take these global sustainability-related risks and opportunities into account and ensure the efficient allocation of capital. We therefore need to have access to relevant, comparable, consistent and verifiable non-financial disclosures globally, not just in Europe.
• International coordination. We need to be conscious of the risks that this regulatory proliferation poses to shaping a more sustainable global economy. With regulation moving at varying speeds – Europe taking an early lead, followed by Asia, whilst the US has been somewhat lagging behind (although all that could change if the latest advice by the SEC’s Investor Advisory Committee is heeded) – we could end up with a mismatch and complex regulatory environment that adds unnecessary burdens on issuers. We need international coordination in this space, perhaps with guidance from the Organisation for Economic Co-operation and Development, with the Commission seizing the opportunity to harmonise the NFRD with other jurisdictions. And if the Commission decides to create a new European standards body, then careful consideration should be taken as to how this fits in the international architecture.
• Standardisation of ESG information. One way in which we encourage the Commission to achieve this efficiently is by building on existing disclosure standards, such as the Sustainable Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI). Both are well established and used widely, not just in the EU but across markets. We believe these two complementary frameworks together cover the ‘double materiality’ concept:
-- SASB by encouraging disclosure of material ESG factors where they are ‘reasonably likely to affect the financial condition or operating performance of a company’. This framework adopts a financial and sector approach to the definition of materiality.
-- GRI by encouraging disclosure by companies of their impact on critical sustainability issues such as climate change, human rights, governance and social well-being. This framework adopts a stakeholder approach to the definition of materiality.
• Reporting. Requiring financial and non-financial information to be combined in one single report will not be enough. For a real integration of ESG considerations within corporate strategies, the Commission should mandate that companies align with the recommendations of the ‘Integrated Reporting’ Framework. This calls for ESG information and data to be presented in an integrated manner within annual reports, so companies can demonstrate the link between ESG and their financial and strategic information.
• Scope and alignment. We can’t justifiably say private firms or small and medium-sized enterprises should still be exempt. The Commission also needs to consider how the NFRD aligns with disclosure regulations in the financial sector so there is no disconnect.
• Ticking boxes. We cannot allow this to be a box-ticking exercise; companies must explain how they have defined what is material to them and what they have done.
• Assurance. We believe that non-financial information, given its financial materiality, should be audited to the same degree of rigour as traditional financial information. This is essential to ensuring that companies’ non-financial disclosures are verified and therefore reliable for investment decisions.
• Other frameworks. The Commission needs to take into account other disclosure frameworks that are more limited in scope, particularly on climate change. This means explicitly mandating the use of Taskforce on Climate related Financial Disclosures and the Climate Disclosure Standards Board.
In essence, we need a global regulatory environment that will mandate the disclosure of relevant, consistent, comparable and verifiable non-financial information across markets. Policymakers need to give investors the tools to access non-financial information in a way that can more efficiently integrate them within investment decisions and lead the allocation of capital towards more sustainable companies.
This isn’t the Sermon on the Mount, but the Commission has a real opportunity to lay some solid foundations for sustainable investment.