ESG disclosures are coming for small and medium enterprises

Until recently, corporate sustainability reporting was essentially reserved for the very largest, publicly-listed companies around the world. After all, they were the ones receiving pressure to provide information on their material environmental, social, and governance (ESG) issues. This pressure came with the rise of responsible (sustainable) investing, from institutional investors who were themselves seeking to integrate these issues into their fundamental analysis and stock selection processes. It came in the form of direct requests (read: engagement) and increasingly in the form of questionnaires from third-party ESG ratings using various, often opaque, methodologies, with all the complexities, challenges, and shortcomings that we have come to know. Large companies did oblige with increasingly fulsome annual sustainability reports, however these were more akin to communications brochures than disclosures, since they were neither structured nor standardized, nor externally assured.

To make sense of all of this and to bring sustainability reporting on par with financial reporting, regulators and standard setters are stepping up and the world of corporate sustainability reporting is quickly evolving towards regulated, standardized, audited, and digitized disclosures. In the European Union, this is precisely what the Corporate Sustainability Reporting Directive is prescribing. Elsewhere around the world, jurisdictions such as Australia, Brazil, Canada, China, Japan, Nigeria, and are mobilizing to adopt or otherwise use the IFRS Foundation’s Sustainability Disclosure Standards (also called ISSB Standards). Even the US Securities and Exchange Commission is expected to release its long-awaited climate disclosure rules this spring.

This whirlwind of change is sweeping up not only large companies, but small- and medium-sized enterprises (SMEs) as well in two important ways.

1. The financial value chain

There are now 5,372 signatories to the Principles for Responsible Investment, with more than US$121 trillion of assets under management. As these institutional asset owners mature their sustainable investment practices, they are pushing for more to be done throughout the investment value chain, including from private equity and alternative asset managers that typically deploy capital into smaller, private companies and that in turn are asking their portfolio companies for more ESG and sustainability-related information. Similarly, banks seeking to abide by the Principles for Responsible Banking are also pushing for accountability from their borrowers, many of them smaller, private companies.

The various constituents along the financial value chain are asking for more information from their portfolio companies because they need to demonstrate what they are doing in terms of ESG integration and how their portfolios are performing on key sustainability-related metrics. Their ability to raise funds depends on it. In turn, this may well affect the portfolio companies’ cost of capital, as well as their access to ‘sustainability driven’ capital. One might be tempted to say information is money.

So, it’s no surprise to see multiple finance industry initiatives designed to facilitate ESG disclosures from smaller, private companies. For example, the ESG Data Convergence Initiative (EDCI) is a private equity market initiative with more than 375 General Partner and Limited Partner members, enabling asset managers to collect a core set of ESG metrics from their portfolio companies in order to create a critical mass of meaningful, performance-based, and comparable private company ESG data. Similarly, the ESG Integrated Disclosure Project (ESG IDP) is a private credit and syndicated loan market initiative that has developed a reporting template to collect consistent and comparable key ESG indicators from private companies. More recently, financial market infrastructure provider SIX Group launched an SME Sustainability Assessment Solution software solution for banks to measure the sustainability performance of their small and medium-sized enterprise clients, and to assess climate and sustainability risk trajectories linked to their loan books. 

We can certainly expect more of these initiatives to spring up as the sustainability-related information needs of investors and lenders across the financial value chain continue to grow. The problem with these disparate initiatives is that they create multiple different requests for information (read: questionnaires). And they’re not the only ones…

2. The commercial value chain

The two main sets of sustainability reporting standards emerging today — the IFRS Sustainability Disclosure Standards (IFRS SDS) and the European Sustainability Reporting Standards (ESRS) — have many things in common, not the least of which is their requirement for companies to consider their material impacts, risks, and opportunities across their value chain.

• IFRS S1 states that “an entity shall disclose information that enables users of general purpose financial reports to understand the current and anticipated effects of sustainability-related risks and opportunities on the entity’s business model and value chain.”⁽¹⁾ 

• ESRS 1 states that “the information about the reporting undertaking provided in the sustainability statement shall be extended to include information on the material impacts, risks and opportunities connected with the undertaking through its direct and indirect business relationships in the upstream and/or downstream value chain.”⁽¹⁾

As larger companies in scope of the CSRD regulation and those keen to get a jump start on applying the IFRS SDS turn their attention to complying with the new disclosure requirements, we are seeing a new trend unfold with companies seeking to collect data from their suppliers by using — you guessed it – questionnaires. More and more suppliers, many of which are smaller, private companies that had flown under the radar of sustainability reporting pressures, are now receiving multiple distinct requests for information, sometimes with very tight deadlines.

Ultimately, the solution at scale will be to standardize disclosures throughout the value chain, in order to make the information widely available, comparable, and reliable right from the source. The good news is that this is exactly the intention of the CSRD, with upcoming standards for listed SMEs and voluntary standards for private SMEs. (Incidentally, it is also the intention of the IFRS SDS, which are designed to be used by companies of all sizes, based on the principle of preparing disclosures commensurate with the skills, capabilities, and resources that are available to them.)

In fact, the EU’s rationale for creating the voluntary standards for small- and medium-sized enterprises is to enable them to respond to information requests from their business counterparts, oftentimes in the form of supplier questionnaires and third-party ratings. In a recent press release, EFRAG stated that:

“[The VSME exposure draft] proposes a simple reporting tool to assist non-listed micro-, small- and medium-sized enterprises (non-listed SMEs) in responding to requests for sustainability information that they receive from business counterparts (i.e., banks, investors or larger companies for which non-listed SMEs are suppliers) in an efficient and proportionate manner as well as to facilitate their participation in the transition to a sustainable economy. Based on market acceptance, the VSME exposure draft is expected to standardise the current multiple ESG data requests (which represent a significant burden on non-listed SMEs), by reducing the number of uncoordinated requests they receive. This is expected to support them in having better access to lenders, investors and clients.”

In addition to a public consultation, EFRAG will be conducting a field test for both standards, which will focus on feasibility, costs, challenges, benefits, and usefulness of the individual disclosures and suggested improvements to the exposure drafts. The importance of this test cannot be underestimated because implementing these standards — or rather the changes to business practices and information collection they bring about — will represent a step change that requires resources in time, people, and money. The reality today is that most small- and medium-sized enterprises do not have those resources readily available. (One might argue that larger companies don’t either!)

We can’t do it without SMEs

A recent Accountancy Europe conference on Supporting SMEs with sustainability information waxed philosophical about there being no SMEs without a transition [to a low carbon economy and, one can surmise, sustainability more broadly] and no transition without SMEs. This may be true, given that small businesses represent roughly 90% of all companies and are responsible for 50% of employment worldwide, as well as up to 40% of GDP in emerging markets. They are thus important contributors to addressing system-level issues and achieving a state of sustainability, and by the same token stand to benefit themselves from addressing risks and opportunities associated with their activities. The faster they adopt proportionate mandatory (available), standardized (comparable), and audited (reliable) sustainability reporting practices, the better for everyone.

‍

----------

‍⁽¹⁾ Notice that both IFRS SDS and ESRS have very similar definitions of value chain:

IFRS SDS define value chain as “the full range of interactions, resources and relationships related to a reporting entity’s business model and the external environment in which it operates. A value chain encompasses the interactions, resources and relationships an entity uses and depends on to create its products or services from conception to delivery, consumption and end-of-life, including interactions, resources and relationships in the entity’s operations, such as human resources; those along its supply, marketing and distribution channels, such as materials and service sourcing, and product and service sale and delivery; and the financing, geographical, geopolitical and regulatory environments in which the entity operates.” (Appendix A)

ESRS define value chain as “the full range of activities, resources and relationships related to the undertaking’s business model and the external environment in which it operates. A value chain encompasses the activities, resources and relationships the undertaking uses and relies on to create its products or services from conception to delivery, consumption and end-of- life. Relevant activities, resources and relationships include: a) those in the undertaking’s own operations, such as human resources; b) those along its supply, marketing and distribution channels, such as materials and service sourcing and product and service sale and delivery; and c) the financing, geographical, geopolitical and regulatory environments in which the undertaking operates. Value chain includes actors upstream and downstream from the undertaking. Actors upstream from the undertaking (e.g., suppliers)  provide products or services that are used in the development of the undertaking’s products or services. Entities downstream from the undertaking (e.g., distributors, customers) receive products or services from the undertaking.” (CSRD Annex II)