4.1.1 Mandatory and voluntary instruments

In this chapter I introduce some of the arguments for which one can support or oppose mandatory sustainability reporting. The arguments supporting mandatory sustainability reporting come in response to the shortcomings of voluntary sustainability reports. The latest developments in the EU, e.g the Non-financial reporting Directive, show that there has been a growing demand for mandatory sustainability reporting. The argument at the origin of the debate of mandatory or voluntary sustainability reporting is that, if not required to report, companies may either not do it or provide incomplete and/ or inaccurate information.1 Establishing a minimum set of disclosure requirements could lead to the reduction of the incompleteness of the information reported, including negative performance, to facilitate comparability of information disclosed and to increase fair competition among companies and investors. Moreover, stronger enforcement and accountability are expected.2

On the other hand, supporters of the voluntary approach mention the “one size does not fit all”, it may hinder innovation and competitiveness, rigidness of regulation and it becomes a “ticking the box” exercise. The answer to these arguments may lay on the promotion of a “report or explain” approach (European Commission’s current approach), which allows for innovation and fair competition while giving flexibility to the reporter organizations to choose the reporting tools and to provide an explanation when they decide not to report on certain issues.3

Hard law arises from the legislator, which is responsible for creating mandatory regulations. These mandatory laws assemble legal rights and legal obligations to the designated parties, which are accountable in case of breach of the legal obligations and consequently, subject to sanctions. Soft law is a set of rules of conduct which in principle have no legally binding force but which nevertheless may have practical effects (Francis Snyder, 1995).4 Guidelines and codes of conduct are examples of soft law instruments. These instruments are commonly used by the European Commission, as a method of promoting flexibility and mutual learning in European and International law.5 There is also an “in between” hard and soft law system called “comply or explain”. The “comply or explain” reporting system does not apply sanctions for breach.

The choice of hard and soft law instruments is controversial and it has been subject of debate. Objections to the use of soft law have been identified in the literature, among others, the lack of clarity and precision to provide predictability and a reliable framework for action, its lack of effect but may be a “hidden” way to enlarge the EU’s legislative hard law competence. Soft law is a device that is used to have an effect but it avoids normal systems of accountability. On an EU context it undermines the EU legitimacy because it creates expectations but cannot bring about change.6

Hard-law has also been subject of criticism and some of the objections identified in the literature are: the tendency towards uniformity of treatment while many current issues demand tolerance for significant diversity among member states; the assumption of a fixed condition based on prior knowledge while situations of uncertainty may demand constant experimentation and adjustment; the difficulty of changing it while in many cases frequent change of norms may be essential to achieve optimal results; and the fact that when actors do not internalize the norms of hard law, enforcement may be difficult, however, if they do, it may be unnecessary.

The Global Reporting Initiative (GRI), in their “Carrots and Sticks” report of 2010, state that “an emerging emphasis on a combination of (complementary) voluntary and mandatory approaches” is becoming increasingly perceived as the most appropriate way forward – with certain minimal reporting requirements on specific sustainability issues, coupled with voluntary approaches that allow organizations to work within.” Later in 2013, the “Carrots and Sticks” report, found that at that time, 72% of sustainability reporting policies were mandatory, as compared to 62% in 2010 and 58% in 2006.7 Arabesque Asset Management Ltd. found that in 2005, only 300 companies published sustainability reports, compared to around 5000 companies in 2015, which includes 85% of the largest companies in the world.8

In their Carrots and Sticks report of 2010, GRI presented a table summing-up the reasons for and against mandatory and voluntary approaches to reporting. See below, in table 1.

Table 1 - Reasons for and against mandatory and voluntary approaches to reporting

Source: GRI Carrots and Sticks report 2010.9

In the debate hard versus soft law, we are confronted with the questions whether we should necessarily exclude one, or if in fact they can be both used and interact as an “hybrid” combination of both (Trubek, Cottrell, and Nance, 2005)10 if both are needed to achieve an optimal result; and in the case of positive answer to the latter question, when and to what extent can one use more or less of one kind of instruments, and if hard law instruments prevail over soft law instruments. In this regard, the European Commission has recommended that the integration of Environmental, Social and Governance (ESG) concerns into business strategy and operations is led by the corporate sector and that public authorities play a supporting role through the implementation of, what the European Commission calls, a “smart mix” of voluntary policy measures and, where necessary, complementary regulation.11 In October 2014, the European Commission adopted a Directive on corporate disclosure of non-financial and diversity information by large European companies (headquartered in the EU or with a large amount of operations conducted in the EU).12 This Directive requires the disclosure of ESG information, as environment, social and employee aspects, human rights, anti- corruption and bribery issues, and diversity policy of board of directors by large public-interest entities, including listed companies, banks, insurance undertakings and other companies that are so designated by member states with more than 500 employees.13 Member States have two years to transpose the new EU legislation into national law (by the 6th of December of 2016) and need to include ESG information in their 2017 management reports onwards (or in a separate report as long as it relates to the same financial year as the management report and it is published together).14 The European Commission adopted a “comply or explain” approach, allowing the reporting organizations to provide an explanation when they decide not to report on certain required issues. The Directive does not provide a disclosure methodology nor endorse any particular reporting guidelines.15 The directive also requires member states to ensure that the statutory auditor or audit firm verifies whether the non-financial statement (included in the management report or in the separate report) has been provided.16 Between the 15th of January and the 15th of April of 2016 the European Commission launched a public consultation on the non-binding guidelines on methodology for reporting non- financial information together the views of stakeholders on this matter.17 Later, on the 26th of June of 2017 he European Commission has adopted non-binding guidelines on the disclosure of non-financial information by companies.18 These guidelines are voluntary and have the objective of helping companies to comply with the reporting requirements set in the Directive. Also in the guidelines, the European Commission maintains its flexible approach to the disclosure of relevant information by the companies and allow for the use of multiple international or national reporting guidelines such as the UN Guiding Principles on Business and Human Rights, ISO 26000, or the German Sustainability Code.19

Several critics have been pointed out to the non-financial reporting Directive, such as, the flexibility for choosing among a vast number of reporting guidelines, very different in scope, the issues covered, and methodology used20 together with a “report or explain” approach could possibly hinder reporting consistency and comparability of the reports;21 the high costs of reporting the negative impacts within the supply chain;22 the lack of specifying the Directive’s audience;23 the ambiguous definition of materiality;24and “substantial variation” of the implementation of the Directive in each of the member states.25

Accountants play an increasingly important role in the assurance of ESG information.26 Although not an obligation in itself, as the European Commission uses “shall” and “may” in the wording of the corresponding Directive’ paragraphs, this legislation has triggered an increase of ESG assurance.27 Research has found that even through a “comply or explain” approach, as chosen by the European Commission, where regulation deliberately allows companies to choose not to make greater disclosure, there was a 30%-50% average increase in ESG disclosure as a result of the regulations being introduced (Ioannou & Serafeim).28 Regulation has also triggered higher third party assurance of reports, without even requiring it, and the use of the GRI reporting guidelines without even endorsing it.29 Incentivized by regulation, companies voluntarily go beyond what they are required to do, improving the credibility and comparability of the information disclosed.30 The EU directive has influenced sustainability reporting globally. The GRI has reported around 180 sustainability reporting initiatives in 45 different countries and regions. This shows commitment to sustainability, and becoming more effective in gaining a competitive edge.31

Companies are increasingly combining mandatory compliance (e.g following the European Commission mandatory requirements in the EU) with voluntary commitments, as e.g. third party assurance, using reporting guidelines as the GRI, the IIRC and the Sustainability Accounting Standards Board (SASB, in the US market), being signatories, among others, of the UN Global Compact, the UN-supported Principles for Responsible Investment and the CDP (formerly, the Carbon Disclosure Project).32 This shows that the EU Directive was a fundamental step but seem yet insufficient, as it appears to fall short of what is needed to correct and improve companies ESG performance.33 Voluntary instruments still have an incremental role to play. It is increasingly perceived that organizations experience the best benefits of reporting, as improved performance, competitiveness and internal costs savings, when mandatory reporting requirements are complemented with voluntary reporting frameworks (See, Figure 1 below, GRI, 2010).34 When organizations engage with voluntary frameworks beyond legally obliged, signals their strong interest in sustainability reporting and it has an inductive effect on their peers and on asset management (when organizations are large clients). Even if the reporting is not yet perfectly structured and embedded within the organization it has a multiplying effect on other reporters to follow their peers’ practices.

Moreover, the voluntary space given to the reporting organization allows them to innovate (also recognized by the European Commission),35 to find solutions to the most pressing ESG risks and see opportunities where others see challenges (see Figure 6 below, GRI, 2010). However, one may say that when codification requires the same as voluntary reporting instruments do, then reporters would not have anything to fear. Currently voluntary frameworks go beyond what is required by law, frontrunners are using voluntary reports and setting the pace. This is a good thing. The legislator does not set the pace, it follows the pace set by practice, maximizing the usefulness of mandatory sustainability reporting. Practice has to show that sustainability information is essential, equally to financial information, to evaluate the overall performance and impact of a business on people and planet. The same happens for sustainability assurance standards.36 New reporters have to accommodate to the state of the art of reporting requirements.

Figure 6 – The interplay between the voluntary and regulatory spheres (as named by the GRI, 2010)37 Figure 6 below, shows how the mandatory vs. voluntary reporting has evolved until 2016.

Source: GRI, 201038

Figure 6, above, shows that in 2010 the regulatory sphere (which includes mandatory sustainability reporting) was lower than the voluntary sphere. We see in 2016 (in figure 7 below) that 65% of the reporting instruments in place are mandatory (mostly Government regulation and European Commission’s Directive requirements) compared to 35% of voluntary instruments. The GRI’s 2016 report also registered the fast continuing growth of voluntary reporting instruments when compared to the growth of mandatory instruments.39 See below in figure 7.

Figure 7 – mandatory vs voluntary instruments, 2016 vs 201340

Source: GRI, 201641

Already in 2010, GRI reported the complementarity of mandatory and voluntary sustainability reporting as a growing trend. At that time GRI had explained that when there is a complementary relationship between mandatory and voluntary approaches, on the one hand, Governments need to determine the appropriate minimum level of mandatory requirements, and on the other hand, the reporting entities have to decide how willing are they to go beyond their mandatory compliance to gain a competitive advantage.

Corporate reporting is meant to provide information about a company’s business to all its stakeholders but also to seek engagement with its stakeholders, which can be referred as the information and the transformation function of corporate reporting.42 The second function identified by Professor Robert Eccles and Professor George Serafeim is the transformation function comprising the stakeholder engagement carried out by a company, where it receives feedback from the stakeholders. Regulation influences the two functions, it is important for an effective information function, being comparable to accounting standards regulation but less relevant for the transformation function or even inhibiting it. A voluntary approach might be more beneficial for stakeholder engagement, where a mandatory approach is more effective in achieving the information function. These two functions can both be applicable to sustainability reporting and financial reporting.43

It is important to retain that to get a holistic view (Keith Ambachtsheer, 2016) of a company’s business and strategy we need both financial and sustainability information.44 Besides, the current reporting practices suggest that a combined mandatory and voluntary approach work the best to bring the most material information to the knowledge of stakeholders.45