Without sanctions, sustainability disclosures lack impact

Analysis by Charl de Villiers (Professor of Accounting) University of Auckland, Waipapa Taumata Rau.

As of last year, New Zealand’s largest companies and financial institutions have been required to disclose their climate-related risks and opportunities in their annual reports and regulatory filings.

This follows a global trend for businesses to be more upfront about their social and environmental impact. Companies are increasingly expected to provide safe and environmentally friendly products, and ensure all their activities are socially and environmentally responsible.

But does requiring businesses to report these things actually push them to make better decisions around climate and sustainability? While it is too early to tell from the New Zealand experience, a decade of data from Europe offers a better insight.

Our new research examining the effect of the European Union’s sustainability reporting regulation (Directive 2014/95/EU) on business performance suggests reporting is not always enough.

If New Zealand (and other countries) want businesses to take their impact on the climate seriously, our research suggests reporting requirements need to include sanctions for companies that fail to achieve basic environmental standards.

Regulating disclosure

Disclosure requirements related to social and environmental issues have two main objectives.

The first is to provide investors with the information they need to decide where to invest. The second is to enable the rest of society to understand the social and environmental impacts of business on everyone’s lives.

In discussing these issues, terms such as ESG (environment, social and governance), sustainability, triple bottom line, and integrated reporting, are often used interchangeably.

While this can be confusing, they all really just refer to anything that relates to the natural environment or society.

Since 2014, the European Union has had a directive requiring businesses to disclose their social and environmental performance.

Several studies have shown investors find social and environmental disclosures useful for their decision making. In research published last year, we found investors were prepared to pay for additional environmental disclosures.

But whether these reporting requirements improve companies’ social and environmental performance is, perhaps, the more important question.

The EU directive our study examined requires large companies to report their performance on non-financial matters, including environmental issues, social and employee matters, human rights, anti-corruption and bribery.

We looked at the social and environmental performance of companies between 2009 and 2020 using information contained in ESG databases.

The 358 European companies included in our sample didn’t meaningfully improve after the directive. Nor did they improve when compared to the 470 companies in the United States in our sample.

This was a surprise, considering Europe is often perceived as placing a greater emphasis on social responsibility, while business in the US is associated with a strong investor focus.

An ineffective directive?

It is possible the EU directive did not have a major impact on social and environmental outcomes due to the absence of meaningful sanctions for companies that didn’t comply.

EU directives usually leave detailed implementation up to each country,. In this case, few countries have significant sanctions. Prior research has shown that a lack of meaningful sanctions often results in poor outcomes.

According to the data, the social and environmental performances of both the European and US companies are steadily improving – just not as a direct response to the EU’s reporting requirements.

That said, the sum total of legislation enacted both in Europe and the US is probably still improving companies’ environmental and social impact. And this must be something to applaud.

Sustainability reporting requirements, along with meaningful sanctions for companies that do not comply, can play a role in ensuring our economic system works for everyone.