Small and mid-cap companies must take a far more strategic approach to environmental, social and governance (ESG) tasks, urges a new report. 

Published by ESG consultancy SIFA Strategy, ESG: At a Crossroads warns business owners not to fall into a trap of “data for data’s sake”, which will not help them properly embed ESG into their companies.

In particular, the report calls for businesses to carry out clearer and more robust materiality testing, whereby owners assess the inwardly financial and external impacts of their company. 

That process should not be seen as a tick-box exercise to meet emerging standards and regulations, the report notes. Instead, it must help management to better understand and communicate to all stakeholders where their core ESG efforts are being made and where value-creation opportunities lie.

Critical task

SIFA Strategy Director and Co-founder Ben Morton says that, in recent years, his team has worked much more closely with finance directors and financial controllers when advising companies on ESG.

“If we look purely at the ‘E’ side of things, companies are having to think more carefully about factors such as capital expenditure – both to minimise emissions and comply with regulations. So, we’ve seen the involvement of finance teams and internal audit committees grow much more prominent,” Morton explains.

Along the way, gauging materiality – in other words, establishing which ESG sub-topics are most relevant to a company’s impacts – has become a far more critical task.

“To a large extent, you’re dictated to by jurisdiction,” Morton says. “For example, the International Sustainability Standards Board standards, which the UK plans to make an endorsement decision on this year, favour single materiality – or topics with internal, financial impact. In the EU, meanwhile, the Corporate Sustainability Reporting Directive follows double materiality, which also looks at companies’ external impacts.”

However, don’t just do what the regulations tell you, Morton urges: “Take account of the material topics and priorities that are most important to your own, specific business model. That way, you’re not just going through a checklist. Make sure you get your finance teams involved, so you can assess the financial thresholds of a range of topics and understand what’s really material. That will help you to think more strategically about ESG.” 

Purpose and scope

Morton’s fellow Director and Co-founder, Fergus Wylie, believes it would be unhelpful for business owners to draw a rigid line between single and double materiality when looking at their business models. “Often, what’s deemed to be outwardly material is also financially material – or will become so over a period of time.”

With that in mind, Wylie urges companies to bring the finance function into their materiality assessments from the word go. “It’s incredibly difficult to have gone through the process and then bring finance in,” he warns. 

“A lot of the time, when companies examine materiality purely through the lens of an impact scale, that tends to be run through the sustainability team. Re-engineering the findings for the finance team and securing their buy-in is very challenging.”

Materiality testing should begin with a working group and the more senior that group is, the more effective the testing will be, Wylie believes. “Having an accountant in there is key. At the ‘define purpose and scope’ stage, you should take stock of any relevant data you already have, and look at how it’s linked to financial metrics across your various topics. That way, you’re not reinventing the wheel.”

For example, when it comes to the ‘S’ of ESG, many companies will already have quite an advanced picture of how they are looking after employees in health and well-being training. The finance function can then analyse the metrics base of that data and highlight which areas meet the threshold for financial materiality.

Breaching thresholds

Taking another ‘S’ factor, training and development of staff, Wylie says the potential impact would typically be higher staff retention or lower staff turnover. “You must understand what sort of metrics you have around retention and turnover. Are they beginning to breach materiality thresholds or not?”

The answer will vary from one business type to the next, but a company would have to assess the probability of a breach – potential, or actual? If it’s potential, what sort of timeframe could it occur in? And at what scale?

Wylie explains: “Let’s say a company reneges on its training and development of staff and employees begin to leave. Does that start to look like it could become financially material? For some companies, not at all. 

“Even though turnover goes up, they may have relatively low headcounts and levels of expertise, so it won’t breach the threshold. But if we turn to, say, a large tech company with lots of staff and high levels of expertise, those exits do become much more financially material.”

SIFA is currently advising a company where the finance director also serves as chair of the ESG committee. “As well as taking the ESG message through the audit committee, that FD represents key issues at board level,” Morton says. “So, not only are they involved with thinking about the various elements of ESG, they also have all the relevant figures to hand. This goes to show how accountants and finance professionals have become critical to this field.”

Laura Woods, ICAEW’s Technical Manager, Corporate Reporting, says: “A holistic approach to materiality assessments is crucial to be able to have confidence in a comprehensive outcome. This absolutely includes input from the finance function. Whether companies are seeking to disclose information that is financially material or go further in their disclosures, the underlying materiality assessment must be just as extensive.”