In 1993, Germany’s Daimler Benz AG listed its shares on the New York Stock Exchange for the first time. In the same year, it announced an after-tax loss of around DM 1.84 billion according to US accounting rules. However, according to German accounting rules, it had calculated earnings of DM 615 billion. This was not fraudulent reporting or audit fraud. Different accounting rules resulted in different balance sheets for the same organisation in the same year. These differences were eliminated in 2001 with the introduction of International Financial Reporting Standards (IFRS). This harmonised financial accounting and reporting.
Today, another topic is being discussed in corporate reporting. This time, a corporate reporting process that includes environmental, social and governance issues, called Sustainability or ESG reporting, needs to be harmonised.
Sustainability Reporting
Sustainability reporting means voluntary or mandatory disclosure of non-financial performance of companies to external stakeholders. In its most familiar form, it refers to the reporting of environmental, social and governance information.
Investors have started to look at sustainability practices in order to assess whether organisations can survive crises. On the other hand, customers also place sustainability as a condition in their purchasing decisions. To respond to this need, compatible sustainability measurements and reporting standards are needed. Legal regulations are being adopted that make sustainability reporting a legal responsibility for companies of a certain size, thus creating a de facto situation for value chain partners.
For example, in November 2022, the Council of the European Union adopted the Corporate Sustainability Reporting Directive (CSRD). This directive aims to make companies more accountable and transparent to the public about their social and environmental impacts. According to the regulation, which will be implemented in 2024, over 50000 companies doing business in Europe will be subject to more stringent sustainability reporting standards. In 2021, the IFRS Foundation announced the formation of a new standard setting board: The International Sustainability Standards Board (ISSB). This board is currently working to develop non-financial sustainability reporting standards for companies.
Companies will face more stringent sustainability reporting requirements from now on. Therefore, they need to switch to sustainable business models and report this. Reporting processes that were previously voluntary are becoming mandatory for large listed companies in the first place.
Financial Materiality and Double Materiality
Financial materiality refers to the reporting of any element that may have an impact on the company’s finances. Double materiality, on the other hand, is used to describe concepts beyond the immediate financial impact and issues that will cause environmental and social impact.
Sustainability reporting, which has been legalised in Europe, must be based on the principle of double materiality. In other words, the report must answer the following two questions: “How will the company’s activities affect society and the environment?” and “How will the company’s activities be affected by sustainability issues?”
On the other hand, the US-based ISSB standards are based on financial materiality. Criticisms of financial materiality point to the risk of excluding a company’s social and environmental impacts. The numerous “greenwashing” scandals that have made the news in recent years show that many companies have a very narrow perspective on sustainability. This, in turn, points to the narrowness of these companies’ perspective on “materiality”.
Scope 1, 2 and 3 Emissions
Reporting of Scope 1, 2 and 3 emissions in sustainability reporting is also becoming more stringent. That’s why companies are starting to turn to their value chains, especially their suppliers, and ask about their carbon footprint. For example, if you are a transportation company, your Scope 1 carbon emissions will be reported as Scope 3 emissions for your customer. As your Scope 1 reporting becomes stronger, your customer in your value chain will be able to strengthen their Scope 3 reporting. In this case, many companies will not be able to escape strict reporting rules, even if the laws in their geography do not require it.
For this reason, it is important for companies to create their strategies especially according to the “Double Materiality” principles and prepare their reports accordingly. Since investors will be evaluating industries according to the highest standards, manufacturers’ efforts to achieve sustainability transformation according to the highest standard, even if it is not yet legislated, will undoubtedly move them forward in the competition.
Leading in Sustainability Reporting
As sustainability reporting standards tighten, we see company leaders finding themselves at a crossroads: Complying with regulations but waiting for legal processes to finalize sustainability reporting? Or to take a leading role by adapting to emerging standards as soon as possible?
Of course, the first thing to do is to comply with the law… However, stopping there and not rushing to move forward may cause many opportunities to be missed.
Becoming More Sustainable
Becoming more sustainable requires a transformation. Of course, many companies will only be able to optimize their sustainability transformation to a certain degree. For example, an agricultural enterprise can reduce water consumption, land use, pesticide application and emissions. However, unless it carries out a systemic transformation in its business model and production and consumption patterns, it will not see a major change in its sustainability indicators. A similar agricultural enterprise could make a massive change in its business model by switching to vertical farming, enabling it to reduce water consumption by 95%, eliminate pesticide use, and reduce emissions by 90% compared to traditional methods. Thus, it can attract more investors’ attention.
It is important in this transformation that companies that only worry about calculating their carbon footprint are actually open to developing new business models and creating new values by taking into consideration concepts such as circularity, ecosystem protection and respect for natural values.