How the middle market is reporting on ESG

Alex Kotsopoulos, a partner and leader of RSM Canada's environmental, social and governance (ESG) advisory practice, focuses on helping companies integrate sustainability factors into their strategy and operation. He recently answered questions about the evolution of reporting on ESG practices. What follows is a conversation that has been edited for brevity and clarity.

Where do Canadian businesses stand when it comes to ESG reporting?

Canadian firms have embraced sustainability reporting in a significant way, across industries.

For example, several Canadian mining and energy companies, which can face some more acute ESG-related risks, were early adopters of integrating sustainability into their business models and reporting. Some have developed rather sophisticated approaches.

Canadian pension funds, which are some of the largest in the world, have also played an important role in proliferating sustainability reporting and integration throughout the economy and have actively integrated ESG into their investment mandates. As long-term investors, pension funds are of course highly incented to incorporate ESG and particularly climate risk considerations into their investment and risk management approach.

Is anything holding back Canadian firms in this area?

Unlike the European Union, a mandate requiring broad-based ESG disclosures does not exist in Canada. However, large financial institutions are starting to align very closely with the Task Force on Climate-related Financial Disclosures (TCFD).

Canada, too, will be substantially affected by the Securities and Exchange Commission's expected climate disclosure rule, which aligns with the TCFD, given the number of cross-listed companies and degree of integration between the Canadian and U.S. economies.

It seems likely that the International Sustainability Standards Board (ISSB) will become the global gatekeeper of non-financial reporting. Do you welcome this?

A common framework for non-financial reporting will ultimately help address criticisms of greenwashing—falsely promoting environmental soundness—and enable better comparability of ESG disclosures across companies.

However, I think it is important to note that despite incorporating a number of reporting frameworks into a common framework, the standards will be primarily focused on ESG-related risks in relation to enterprise value. In other words, the disclosure of ESG data will be focused on those topics which are viewed as affecting a company's financials. Some ESG ratings and scoring agencies have been criticized for focusing only on ESG risks relating to financial impacts.

I do not necessarily view the ISSB as a gatekeeper as its framework is expected to focus on—in some sense—a narrow definition of materiality.

Are businesses prepared for non-financial reporting?

Larger companies have made significant progress regarding non-financial reporting and ESG integration. Middle market firms have also made great strides as noted in RSM's Middle Market Business Index ESG Special Report. However, as the regulatory environment in Canada and the United States and non-financial reporting are integrated into a company's financial reporting, companies will need to increase the sophistication and controls around their sustainability disclosures. Indeed, we have found that even large companies are struggling to establish the right processes and controls around their ESG disclosures.

How can middle market firms best prepare for non-financial regulations?

Companies must understand what is required from a regulatory perspective versus what stakeholders and investors are expecting in terms of ESG disclosures.

If a company has not yet initiated an ESG program, it should get started as soon as possible. In Canada and the United States, regulators are focused on climate disclosures aligned with the TCFD. Accordingly, middle market firms should focus initially on the TCFD, which includes developing a company's carbon inventory.

How are middle market firms currently engaging in non-financial reporting?

Middle market firms are generally not prepared to fully adhere to the ISSB framework. Many, particularly smaller, middle market firms are still in the early stages of developing their ESG programs and reporting structures.

It is important to note that as sustainability reporting becomes more institutionalized, even private firms that are suppliers to larger public companies may be required to disclose various ESG-related data to their
downstream customers.

As we transition to net zero, how is the auditor's role changing?

Auditors will play a critical role in helping companies establish and assess progress against a company's net-zero goal. Investors and other stakeholders will increasingly look at how a company is tracking against its stated target. Auditors will need to understand, and I would suggest at a detailed level, the mechanics of carbon accounting and be comfortable assessing financial results in the context of a company's carbon inventory and other non-financial metrics.

Auditors in many respects will play an important role in protecting against greenwashing and maintaining the integrity of non-financial report standards.

What advice do you have for middle market firms that are initiating or modernizing their ESG programs?

I would view ESG and sustainability as an opportunity and I think it is important not to lose sight of that. ESG provides middle market firms with an opportunity to engage with their stakeholders in ways that can generate shared value across their ecosystem thereby lowering business risk, increasing brand loyalty and boosting productivity.

Companies that do this well will be more resilient in the face of what appear to be some significant economic headwinds over the next year.