FSN: The Operating and Financial Review - are environmental issues a significant issue for shareholders?

The Operating and Financial Review - are environmental issues a significant issue for shareholders?

22nd August 2005
For many finance directors the reporting of environmental KPIs is outside of their training and business experience yet it is an important requirement of the mandatory OFR. In order to shed light on this critical area, FSN has joined forces with Trucost plc, the pre-eminent environmental research consultancy appointed by The Department for Environment, Food and Rural Affairs (Defra) to help produce new environmental reporting guidelines for UK business.

In the first of a series of editorial contributions for FSN, Dr Richard Mattison, Head of Strategy at Trucost plc explores the significance of environmental reporting for shareholders, the hidden challenges of reporting environmental KPIs and where Finance Directors can get help.

The Operating and Financial Review

New reporting regulations, called the Operating and Financial Review (OFR), came into force on the 1 st April 2005 and apply to all GB quoted companies. The regulations mandate a new style of reporting designed to provide shareholders, and other stakeholders, with a broader and more balanced view of the business. Any issue that is significant or material to a company's current or future prospects should be discussed. For the first time in UK Company Law non-financial issues, such as environmental, social and employee factors, will have to be considered in addition to more traditional financial issues. Similar regulations require large, non-listed companies to produce an Enhanced Directors' Report that includes non-financial issues.

The Accounting Standards Board was asked by the Government to define a Reporting Standard for OFR reports. Companies that comply with the Standard automatically comply with the OFR regulations. The Standard states that significant matters should be reported in a Key Performance Indicators (KPIs) format, and defines 7 criteria that must be met. The Standard does not define which KPIs are relevant for which businesses, as it is the ultimate responsibility of the directors to ascertain what is material to their business and therefore which KPIs should be reported in the OFR. This makes sense when considering traditional financial indicators, which businesses routinely measure and use to inform their strategies: directors are already familiar with the range and suitability of traditional financial indicators for their business. Reporting on environmental, social and employee issues, however, will be new for many directors and could present significant challenges for many companies. With environmental issues, for example, it can be difficult to determine which are more important than others, especially for non-experts. Many directors will be tempted to dismiss these issues as intangible or too difficult to measure. The regulations stipulate, however, that the absence of disclosure is not sufficient: an OFR report would have to state that a company had no environmental issues that were significant to its current or future prospects for success if it chose not to report on environmental matters entirely. This would be a difficult statement for the majority of businesses to make, given the fact that all business activities have either a direct or indirect impact on the environment, such as waste or electricity consumption.

Environmental reporting

The big question is, how can businesses determine which environmental issues are significant, and conversely which ones are immaterial, relative to the size of their operations. Are 50,000 tonnes of carbon dioxide emissions, a greenhouse gas, significant for a £400m business? Will energy use, and the greenhouse gas emissions resulting from this, become a material issue in light of the recent EU Emissions Trading Scheme that has increased costs for some suppliers (and therefore potentially for some buyers)? It is clear that many companies will require further guidance in order to develop appropriate non-financial indicators.

The Department for Environment, Food and Rural Affairs (Defra) have recently commissioned Trucost plc, an environmental research consultancy, to produce new environmental reporting guidelines for UK business, with a specific focus on reporting environmental KPIs. The guidelines map out 25 KPIs for 56 business sectors to help companies define what could be significant to their business type. The guidelines also state that for 80% of business sectors 5 or less KPIs would be significant. Elliot Morley, Environment Minister, said: " The recent growth in environmental reporting has led to a number of different approaches and this has led to reports of varying quality, depth and rigour. Defra has produced this new generation of guidelines which aim to help businesses address their most significant environmental impacts and report on these in a way that meets the needs of their shareholders and other stakeholders. These guidelines seek to set a standard which will give business some assurance that it is has reported its environmental performance to an appropriate minimum level of accuracy and detail."

The guidelines have been designed so that, for the majority of KPIs, standard business data can be used to estimate or calculate environmental KPIs. For instance, greenhouse gases, acid rain precursors and other damaging gas emissions can be estimated from fuel use data by using international conversion protocols. The guidelines also give recommendations as to the way in which these KPIs should be reported, and gives advice as to how to investigate the impact of key suppliers.

The future of company reporting?

The OFR has the potential to radically change the way in which UK plc reports, and could present a significant opportunity for well prepared and well managed companies. Most people accept, however, that it is not easy to work out how best to report on non-financial issues in a way that will appeal to shareholders. Many of the largest companies already produce lengthy environmental or Corporate Social Responsibility reports, and will probably be able to use the information in these reports for their OFR. Most companies, however, will be producing this type of information for the first time next April. It is important that these companies assess what information is required now, so that the appropriate data gathering processes can be implemented in time for the reporting period. Whilst some companies will opt for the bare minimum it is clear that there is increasing demand from investors for more transparent reporting. Nick Robins, Head of Socially Responsible Investment Funds at Henderson Global Investors, said: "Carbon is set to become a critical factor in business strategy, for example, influencing the pattern of corporate acquisitions and divestments. There should be no surprise when the first carbon-driven profits warning is issued. For investors, getting standardised, comparable carbon data from companies is now an imperative, particularly in the UK , with the new Operating and Financial Review disclosure requirements."

Forward-looking companies will use their OFRs to differentiate their reporting from their peers to attract capital. It is clear that it is not in the interests of investors to call for companies to measure a huge range of environmental issues; this could increase costs and needlessly consume management time. What is important is that businesses have the tools to consider what is key to their company, including environmental issues. There is a growing expectation by many stakeholders, mainstream investors included, that the majority of businesses need to be better prepared to meet the challenges and seize the opportunities of the future from an environmental perspective.

The Prime Minister has noted that climate change is the biggest risk facing the UK economy. Identifying and measuring the appropriate environmental KPIs is the first step to ensuring that environmental issues are factored into business strategy and that companies are adequately prepared for the future. The new Defra reporting guidelines from Defra will provide directors with a good place to start.

Dr Richard Mattison is Head of Strategy at Trucost plc, an environmental research consultancy that provides services to companies and institutional investors.

See http://www.trucost.com/defrakpi.html for more information.

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