The State of Integrated Reporting and Materiality
The last 7 years we have witnessed a tremendous attention for Integrated Reporting (IR). Although it is fair to say that IR is here to stay, I increasingly hear the question whether IR has really done much for the quality of ESG disclosure by corporations (beyond the consequences of mandatory ESG disclosure).
What makes integrated reporting better than regular standalone CSR reporting? At first glance, one would think there should be no difference. Integrated Reporting is roughly defined as the provision of information by companies about a their financial performance along with their social and environmental performance in one single report - in contrast to reporting profit & loss, balance sheet, and cash flow information in the annual report and the "rest" in a stand-alone sustainability or CSR report. How can supposedly the same information affect the ("rational") user of the information differently when it is presented in a different report?
The fact is that information in Integrated Reports might tell people more about a companies' commitment to specific sustainability issues. The regular reporting on those issues in a report as important as the annual report also creates implicit obligations for companies to track performance on ESG issues internally so that external reporting is accurate. Many stand-alone sustainability reports contain a lot of anecdotes about a firm's sustainability practices, but there is little coherence across yearly reports, and quantifiable information is often lacking. By switching to IR, if implemented properly, companies will have to think carefully about which ESG issues deserve closest attention in terms of monitoring and performance measurement, i.e., which are worthwhile reporting on accurately externally. The natural economic incentive for companies is to focus on those issues that matter to users of that information, and in particular capital suppliers. This is why advocates of integrated reporting claim that IR requires a company to better think about the link between ESG issues and corporate strategy: IR not only helps the firm to improve on the reporting of "material" ESG information but inherently also requires it to identify sustainability issues that it is genuinely equipped to address in order to achieve a competitive advantage. Those are the issues the firm wants to set targets on, measure progress on, and be able to consistently report on. IR ideally thus transmits information to the financial market about which ESG issues a company deems important in the pursuit of better business results.
In principle, ESG issues in Integrated Reports should thus matter to investors? Do investors care about this information? At the moment, there is little empirical evidence on the added value of IR to investors, relative to stand-alone reporting on sustainability. A study from the field of accounting suggests that firms which issue a stand-alone sustainability report have a lower cost of capital, however depending on whether the reporting firm is already perceived a relatively sustainable. But it remains unclear to me what the direction of causality behind these results is...it might be possible that firms with a lower cost of capital are more likely to engage in sustainability reporting. (In an unpublished study I co-authored back in 2007, and which other authors later re-confirmed, we found that companies with better CSR ratings on certain ESG issues also have a lower cost of capital, so not only disclosure but also ESG performance relates to external financing costs.) As for IR, there are not enough IRs yet to provide reliable statistical evidence on the added value of Integrated Reporting from a financial market's point of view. One study suggest that IR affects a company's investors base, attracting more-long-term investors (but other studies also found this is the case for firms that issue stand-alone sustainability reports). As far as I can judge, the jury's results are still not out....
But at the same time, a really cautionary note is appropriate: in my view, it is impossible to judge IR because companies have a long way to go when it comes to translating ESG risk and opportunities in a structured and systematic way to common company value drivers.The fact is that most companies are NOT providing truly integrated reports. Reading IRs that are currently published gives me a strong feeling that companies simply "add" ESG information - that they would otherwise have disclosed in stand-alone sustainability reports - to their annual report, and yet they hardly express how the reported ESG issues affect a company's financial performance, let alone quantify any such effect. (Practitioners sometimes use the phrase "combined reporting" to indicate that ESG disclosure is not really "integrated" in the way originally envisioned by IR's advocates.)
Conceptually, I would say that IR has the potential to improve a company's commitment to strategically relevant ESG issues, and through IR the investment community may ultimately learn to allocate financial capital to those firms that are best suited to deal with today's sustainability challenges...but companies still have to make a giant leap forward in explaining their assessment and management of financially material ESG issues. Guidance from SASB's materiality map (TM) on financially relevant topics and associated accounting metrics (broken down by by sector) should help firms in identifying strategically relevant ESG issues and set an ESG agenda that lays the foundations for target setting and reporting. (Admittedly, companies could go beyond reporting on material topics and demonstrate efforts to quantify the financial impact of their social and environmental impact.) In the end, the quality of reporting comes down to the quality of data and information. A recent study by the Sustainability Accounting Standards Board (SASB) suggests that most (U.S.) firms are still hardly reporting on material ESG issues along informative metrics.