Aristotle had a fairly dim view of business and toil, which he cynically described as merely utilitarian; a necessity, but not enriching or ennobling of human life.
These days few would question that businesses make huge contributions to human life: they pay taxes, and provide employment, investment opportunities, and goods and services. However, they’ve also earned a reputation for causing pollution, soil degradation, carbon emissions, the displacement of communities, water scarcity, inequality and other social and environmental ills in the pursuit of profits.
There has been much toil in recent years to “ennoble” business — a case in point being ESG, the au courant acronym for environmental, social and governance. It’s a framework against which companies are held to account for their performance and practices. The idea is that increased disclosure will bring increased accountability, putting businesses on the path to sustainability.
The issue is that ESG is only workable as an accountability framework if companies provide information that is comprehensive, comparable and reliable. But a lack of established standards for nonfinancial reporting means companies’ reports in this respect are piecemeal and lacking in consistency. Hence the slew of sustainability reporting regulations and standards, including from the US Securities & Exchange Commission (SEC), the European Financial Reporting Advisory Group and the International Sustainability Standards Board (ISSB).
This proliferation is in no small measure thanks to the growing urgency of climate change and demands from investors for information about how ESG risk factors may affect their portfolios.
As is the case with most human endeavour, these laudable developments are not without controversy. One the one side of the divide are conservative US politicians who argue against “woke” ESG investing, claiming it is harmful to capital markets and ordinary investors. On the other are those who believe the standards don’t go far enough.
As to the former, US President Joe Biden has vetoed a proposal that would prevent pension fund managers from making investment decisions on factors such as climate change. No argument there; ESG is not the destroyer of capitalism but a commonsense strategy for derisking portfolios. But the criticism around sustainability standards deserves more of an explanation.
The sustainability reporting standards by the SEC and ISSB frame materiality of information — which determines what gets reported — from the perspective of the providers of capital (investors and lenders). Consequently, ESG risks are considered in terms of their inward effect on cash flows or enterprise value. Outward impacts on people and the planet are not accounted for — unless the risk is likely to turn inward, such as when an outward impact on the environment becomes an inward issue through regulatory intervention or taxation.
By contrast, the European Corporate Sustainability Reporting Standards call for disclosure based on double materiality: companies must disclose inward and outward impacts. It is assumed that the users of sustainability disclosure extend beyond the providers of financial capital.
My erstwhile law professor was fond of impressing upon us that, if you get your concepts and theories wrong, reality avenges itself
A myopic view
Limiting sustainability disclosures to financial materiality seemingly lets companies off the hook in terms of reporting the negative consequences of their business operations. But the counterargument is that because the SEC rules and ISSB standards require an assessment over the short and longer term, they will take into account that the outward impacts of today may turn into inward risks in the future. Outward risks, in other words, will be caught by casting the materiality net over the longer term. So ESG and sustainability standards should result in similar disclosures.
Is this a mere ideological debate that unfairly detracts from real progress made in the transition towards more transparency?
Not so, say Carol Adams and Frank Mueller, accounting professors at Durham University Business School. They point out the practical consequences of the differences in conceptual framing. What constitutes the “investor perspective”, financial materiality and in what time frame is left open to the interpretation of the reporting organisation. Translation: reporting organisations have leeway to choose what they disclose — which is the exact opposite of what reporting standards are meant to achieve.
This reminds me of my erstwhile law professor, who was fond of impressing upon us that, if you get your concepts and theories wrong, reality avenges itself.
The reality is that companies are hosted by the societal system which in turn ultimately depends on earth systems. Expressing investor perspectives in terms of finances, cash flow and enterprise value isn’t representative of this reality. Societal and environmental stakeholders — and the providers of financial capital — deserve company disclosures that inform them about inward and outward impacts alike.
This is a step closer to Aristotle’s conditions for harmony between business and human life.
* Ramalho is chair of the King committee on corporate governance in South Africa and a professional nonexecutive director
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