April 10, 2022

Sustainability reporting: What it tells investors (and what it won’t)

Investing in companies making significance contribution towards Environmental, Social and Governance (‘ESG’) growth. What are the benefits of the ASX, ASIC and many other regulatory bodies are considering mandatory inclusion of ESG. Where can you learn more about a company's ESG contribution?

Today’s investment analysis and decision-making approaches have evolved significantly from the pure focus on company financials and business growth prospects, which many past practitioners spent copious hours modelling and forecasting to support their investment decisions. Naturally, business fundamentals are important to understand when investing, but today’s operating landscape means there are additional factors of both risk and opportunity that can offer new insights into a company’s future financial sustainability.

This growing appreciation for the impacts on the environment, how individual employees are treated, how a company is governed and the influence these factors have on a company’s earnings, has increasingly shown the importance of Environmental, Social and Governance (‘ESG’) analysis, alongside traditional financial analysis.

Company annual reports remain one of the key information sources for investors to review and validate their investment decisions. Thanks to the combined advocacy of shareholders, governments and special interest groups over consecutive years, increasingly more annual reports now include dedicated sections which specifically address practices, initiatives and outcomes under the ESG realm. The ASX, ASIC and many other regulatory bodies – both here and overseas – have mandated or are either in the process of, or at least considering mandatory inclusion of ESG-related information in annual reporting to inform investors as to how a company is responding to such factors. To assist companies, the ASX has devised a list of eight key principles as part of their Corporate Governance Principles and Recommendations which all listed entities report against annually.

“A listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks”.

ASX Corporate Governance Council Principles & Recommendations (3rd Edition) – Recommendation 7.4

However, achieving the targeted level of disclosure remains a work in progress for many companies. According to a 2015 report on sustainability reporting by the Australian Council of Superannuation Investors (ACSI), 13% of ASX200 companies failed to provide any meaningful reporting on sustainability factors, while a further 17% provide only a rudimentary level of disclosure. It is fair to say that some improvements have been made since this research, with ACSI’s 2022 publication of ESG Reporting Trends suggesting just over half of the 200 largest listed companies now provide “comprehensive” reporting on ESG factors. But the bigger question is on quality.

“Companies that provide insightful ESG disclosure can broaden their potential appeal to providers of long-term equity capital”

Australian Council of Superannuation Investors, ‘ESG Reporting Guide for Australian Companies’ 2015

Each Annual Report will generally include a Chairman’s Report and CEO report; some may also include a Corporate Social Responsibility (CSR) Report which provides the opportunity to address non-financial developments. But astute investors are wise to question whether this represents a comprehensive capture of ESG information. Are there other indirect clues into a company’s performance on sustainability? How much of the information is implicit and what can it mean for future earnings?

Through our analysis of numerous annual reports, we have found that reviewing these in conjunction with a collection of additional sources can deliver broader insights into the importance a company places on sustainability across various aspects of its operations. In our view, companies that take a holistic rather than a tokenistic approach towards developing sustainable business practices and processes, are more likely to improve their future growth prospects.

The clues from within and beyond

Given the limitations of annual report content, we have identified a broad range of information sources which we believe can provide meaningful insights into a company’s ESG practices, with relevance to the industry they operate in. These are outlined below.

The Environment

Disclosures relating to environmental impacts are particularly important for companies in the natural resources, manufacturing or agricultural sectors. Sources of additional insights include:

·      Company reports on its principal activities via media, partnership or direct sources

·      Environmental reports – from the company or independent organisations linked to the company’s activities

·      Statements on environmental policy

·      Research and development initiatives to reduce waste and promote efficiency

People and society

Companies operating in service industries such as technology, banks, insurance or human capital should have a clear focus on areas such as:

·      Training

·      Health and Safety measures

·      Diversity

·      Community engagement and philanthropy

·      Legislative disclosures - Workplace Gender Equality Agency (WGEA) reports, Modern Slavery Statements, Whistleblower Policies and minimum standards form employment

Leadership and governance

Company management and its culture can be key determinants of future success or failure across all industries. Pay close attention to clues emanating from:

·      Board composition – gender and experiential diversity, complementary skills and independence

·      Directors’ meetings– frequency, division of responsibilities and action on resolutions

·      Remuneration –policies to promote fairness, transparency and accountability

·      Committee structures – functional groups with appropriate experience to cover areas such as Audit and Risk, Compliance, Nomination and Remuneration. Check the company’s website for its Corporate Governance Statement, Customer Charter, Code of Conduct, Anti-Bribery and Corruption policies to validate the structures in place.

Today’s investment decisions for tomorrow’s success

Corporations in Australia have come a long way in terms of addressing ESG issues and acknowledging their impact - both upon the company’s operations and the environment it operates in. But performance is not consistent across the market and there is room for improvement.

Annual reports are an important source of ESG insights, but investors should look well beyond statutory releases to obtain deeper insights into both risks and returns; challenges and opportunities that become evident through other reporting mediums.

At NAOS we spend considerable time to understand these areas using our ESG assessment process to evaluate and rate each company. We use this process to complement our interactions with companies to not only hold them to account, but to foster greater engagement, advocacy on best practices, and cooperation through periods of material changes for the company.

As long-term investors, we maintain a close interest in longer-term environmental and societal developments and their impact on each company’s earnings sustainability. We are acutely aware of the potential negative impacts on a company’s social license to operate, should it fail to manage ESG risks appropriately. We continue to focus on areas of risk a company may either overlook, or inadvertently identify from other sources of enquiry. Look deep enough into the lens of ESG performance and you realise that risks and opportunities are in no short supply.

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