Criticism of ESG is growing. There is dissatisfaction in the business community about the increased regulatory burden, while various specialists are questioning the effectiveness and reliability of ESG as a measure of (the improvement of) social performance. We largely agree with that criticism, and moreover expect that the introduction of CSRD will suffer a similar fate. So how should you deal with this as an organization?
In this article, we provide an overview of the issues with CSRD – and ESG in general – and tell you a bit more about our take on it. For we believe that sustainability reporting is incredibly valuable and indispensable in the transformation to a more sustainable business, but always as a means, and not as an end in itself.
Increased regulatory burden for businesses
The EU Corporate Sustainable Reporting Directive (CSRD) requires companies with annual sales of €50 million to report on the ESG topics most relevant to them. The larger the company, the greater the reporting burden. ESG accounting must be set up, requiring external advisors to guide the process. With that comes additional pressure on auditors, as they must audit ESG reports in addition to financial reports.
And this is a problem in the eyes of the business community, as evidenced by the reaction of VNO-NCW and MBK-Nederland. More rules lead to higher costs and limit the freedom to do business. In itself a logical thought, because as an entrepreneur you want the freedom to determine yourself how you run your business and how you dedicate yourself to a better world.
Increased risk of climate lawsuits
The CSRD will lead to more transparency. And more transparency is going to lead to more insights into the (negative) social effects of business processes. A few examples on mandatory reporting:
- The number of internal corruption cases
- The gender pay gap
- The CO2 emissions of the entire value chain
So suppose you have a large supermarket chain. Then you report not only the CO2 emissions from the distribution centers, the stores and all your transportation, but also on the CO2 emissions from all the products you sell and the customer’s use of your products. For example, the degree of recycling of the packaging or the CO2 emissions of the customer’s journey to your store. This kind of information gives the company itself, as well as stakeholders, a much better understanding. Entrepreneurs can use these better insights to improve their social impact, or ESG performance. Some entrepreneurs also fear that this increased level of transparency will lead to an increase in mass claims, along the lines of the climate lawsuit against Shell.
ESG ratings can mislead
For larger companies, annual interaction with ESG rating agencies has become a standard process. These ratings provide a company rating on ESG in the same way these rating agencies provide their company ratings with respect to financial performance.
And that’s where things go wrong. ESG is an evolving field, and this is especially true for transparency and reporting. According to Harvard Professor George Serafeim, the leading researcher in the field, ESG ratings give the wrong impression: the ratings are not so much about actual performance on ecology, social conditions and Good Governance, but much more about the level of transparency on ESG.
So it may be that a company with obvious serious wrongdoings in its supply chain – such as a major polluter or a violator of labor law – will still get a high ESG rating, provided the reporting on this is good enough. That’s why the EU is calling for more rules on how these ratings are arrived at. And that’s where it goes wrong again as we argued in the Financial Daily. Because a transparency and ESG ratings is not an end but a means to achieve social impact.
CSRD and ESG: transparency as a goal?
With all the focus on transparency on E, S and G, and the CSRD, it seems as if this is the goal. Transparency is, of course, an adequate means of increasing a company’s actual ESG performance. The assumption here is that more transparency leads to better performance. An assumption that in theory is also true. There are several solid studies that also support this assumption. Especially in the long term, significant improvements are seen, for example, in the reduction of CO2 emissions. This is why the EU also made the CSRD as part of the Green Deal.
We too expect that more transparency on ESG will eventually lead to better ESG performance. In the short and medium term, however, we expect the focus to be on the reporting itself and improving this reporting. We also expect that many companies will actively direct their CSRD reporting to create the most positive image possible. This will make CSRD and ESG transparency an end in itself, and that cannot be the intention.
Greater focus on ESG risk transparency leads to corvee
Identifying and mitigating risks is an important aspect of the ESG approach. And the focus on transparency further enhances this aspect. This is all the more so as we notice in practice that internal responsibility for ESG is shifting to the finance department. This shift of responsibility will lead to a tension between ESG risk management based on the CSRD and seizing opportunities to make impact. Because of this approach, the CSRD is also increasingly seen as corvee. And corvee has never led to successful change.
What also does not help here is the enormous influence accountants have on the implementation of the CSRD. An accountant has had one of the longest educations in the Netherlands and knows everything there is to know about auditing companies financially. An accountant is well-equipped to perform audits, but not about everything. There are limits to the accountant’s knowledge and expertise, and ESG is one such limit. Still, auditors will be and remain leading, even when auditing the CSRD. And to then still deliver quality and mitigate risks, checklists and manuals will be used. Indeed: that in turn leads to more corvee.
CSRD and ESG transparency as a means to realize real impact
We see CSRD and thus transparency on ESG as a further professionalization of something we used to call Corporate Social Responsibility (CSR). So CSRD is part of that professionalization effort, but it must remain a tool.
We use the CSRD and the ESRS as a practical framework to create a shared language. This language is understood both internally and externally. We then make substantive choices based on the analyses in this language and not purely transparency-driven choices. For example, the outcome of a materiality analysis is input for determining the ESG strategy. But the ESG strategy is not determined solely by materiality. A GAP analysis does not just include the GAP between reporting requirements and current reporting practices. A GAP analysis goes further and also looks at the GAP between ESG strategy and realization. As far as we are concerned, a good CSRD implementation is not publishing an ESG annual report, but achieving ESG goals. That way, an organization can really improve its ESG performance not only in the long term, but also in the short and medium term. RealImpact, in other words. Empact.