Understanding ESRS and ESG Ratings

Course Overview

• The course is structured around five key questions.
• The 5th key question is how to quantify sustainability.
• Dr. Nico Lehmann is the course coordinator and sustainability lecturer.

Learning Objectives

• Introduction to sustainability reporting standards, specifically the European Sustainability Reporting Standards (ESRS).
• Introduction to ESG ratings, including the ESG rating industry and its limitations.
• To understand key questions about how sustainability can be quantified through group discussion.
• Vopak Case Prep: Answering the third set of questions for the case preparation.

Topics

• Recap of previous lectures
• European Sustainability Reporting Standards (ESRS).
  • Focus on ESRS1 General Requirements, ESRS E1 Climate Change, and ESRS Social and Governance
• ESG Ratings
  • Analyzing the industry, business models, evidence, and regulation
• How to quantify sustainability
• Exit ticket and references

EU Regulatory Landscape

• The EU regulatory landscape includes voluntary and mandatory sustainability reporting frameworks.
• Voluntary frameworks include GRI Standards and SASB Standards.
• Mandatory frameworks include the Non-Financial Reporting Directive and the Corporate Sustainability Reporting Directive.

Transition from NFRD to CSRD

• The scope of sustainability reporting is extended from 11,600 EU firms under NFRD to 49,000 EU firms under CSRD.
• The presentation of information must be in digital format (XHTML).
• Mandatory assurance is required, starting with limited assurance and potentially moving to reasonable assurance.
• Binding reporting standards are set by ESRS (developed by EFRAG).
• Implementation timelines vary based on the type of company - PIEs, other large firms, listed SMEs, and Non-EU

EFRAG and ESRS

• In 2020, the EC asked EFRAG for advice on adopting CSRD and developing ESRS
• ESRS standards were adopted by the EC on July 31, 2023.
• The European Financial Reporting Advisory Group (EFRAG) is a private association established to advise the EC

Current Set of ESRS

• ESRS 1 explains general requirements stipulated by the CSRD:
  • Provides basic principles of disclosure, presentation structure, and transition options
• ESRS 2 outlines cross-cutting disclosure requirements applicable to all topics.
  • Including governance, strategy, impact, risk, opportunity management, metrics, and targets
• Disclosure Requirements are provided on topics like government, strategy, impact, and metrics/targets
• There are sector-specific standards in development
• The standards for non-EU entities, listed SMEs, and voluntary guidelines for non-listed SMEs are forthcoming.

ESRS 1: General Requirements

• Qualitative characteristics of information include relevance and faithful representation
• Faithful representation includes comparability, verifiability and understandability
• Key stakeholders are affected stakeholders and users of sustainability reports such as investors, lenders, business partners, and regulators

Double Materiality Approach

• ESRS requires a double materiality assessment as key role in preparing and assuring CSRD/ESRS
• Considers financial materiality (outside-in) and impact materiality (inside-out)

Sustainability Matters Covered in Topical ESRS

• When performing a materiality assessment, the different sustainability matters covered in topical ESRS should be considered.
  • Climate Change encompasses climate change adaptation and mitigation or energy
  • Pollution relates to air, water, soil, living organisms, substances of concern, water and marine resources like water consumption
  • Biodiversity and Ecosystems: direct impact drivers of biodiversity loss

ESRS E1: Climate Change

• Disclosure requirements are provided for climate change strategies, performance in incentive schemes, and transition plans for mitigation.
• Companies should report policies related to climate change mitigation and adaptation, along with action plans and resources
• Targets should be set for climate change mitigation and adaptation

Reporting Gross Scope 1-3 & Total GHG Emissions

• The Greenhouse Gas Protocol is the basis of carbon disclosure
• Scope 1 emissions are from sources owned or controlled by the company.
• Scope 2 emissions are from the generation of purchased electricity consumed by the company.
• Scope 3 emissions are a consequence of the company's activities, occurring from sources not owned or controlled by the company.
• Full value chain emissions are included.

ESRS S1: Own Workforce

• The standard is related to working conditions, equal treatment, and work-related rights
• Considerations should be made for policies, engagement, and processes to remediate impacts
• Metrics and targets should be related to managing material negative impacts, diversity indicators, health and safety, and compensation

ESRS G1: Business Conduct

• Standards in governance includes integration of sustainability-related performance in incentive schemes
• Policies are required for corporate culture and business conduct
• Metrics and targets look at confirmed incidents of corruption or bribery, engagement to exert political influence, and payment practices.

ESG Ratings

• The ESG rating industry has a fast-growing market with over 100 vendors.
• There have been 20+ acquisitions over the last ten years
• There are 10+ vendors with global visibility/coverage
• Two main business models include active and passive raters.
  • Active raters request info from firms via surveys.
  • Passive raters pull information from public sources.
• Full data access from larger providers can cost up to $50,000.
• 65% of investors use ESG ratings at least once a week
• ESG ratings are the most useful information source on a firm's ESG performance

Refinitiv ESG Ratings

• Refinitiv has 150+ research analysts
• It collects CSR data across from 400 different ESG input factors
• Refinitiv uses public sources to collect ESG input factors
• Refinitiv has been named a top 5 rating vendor

ESG ratings

• Key concerns about ESG ratings include transparency, reliability, comparability, and conflicts of interest.
• Some critics say ESG investing is a scam
• There is low correlation between various ESG ratings due to differences in scope, measurement, and weight.

EU Regulation of ESG Ratings

• The EU is regulating ESG ratings with an entry into force date of July 2, 2026.
• The scope includes ESG rating vendors operating in the EU.
• Regulations include
  • Separate E, S, and G ratings
  • Info about raters' perspective
  • Separation between business activities and rating activities
  • Additional transparency requirements of sources
  • Supervisory fees

Why Investors Buy ESG Ratings

• Investors buy ESG ratings because of different economic incentives
• The usefulness of ESG ratings in measuring G ratings isn't always equal to direct G data
• Information is often processed from analyst information which includes information, processing, forecasts, validation and stock recommendations.
• There is a forecast dispersion and consensus estimates, so investors are not fully reliant.
• ESG is preferred for access to data, good specialization and it helps with access to reported company data.

This lesson covers ESRS (European Sustainability Reporting Standards), ESG rating agencies, and the challenges of quantifying sustainability. It explores the limitations of relying solely on ESG ratings and the complexities involved in assessing a company's sustainability performance. It also touches upon information sources on a firm's ESG performance.