In July this year, the Environment Agency published a report analysing current levels of environmental disclosures in the annual reports and accounts of companies in the FTSE All Share. The findings, conducted by Trucost, were startling. The study found that current environmental disclosures lack depth, rigour and quantification, and few could be described as comprehensive or adequate for shareholders to properly assess environmental risks or opportunities facing companies.
‘So what?’ you might ask. Well, in just five months, the introduction of the operating and financial review (OFR) will require directors of all listed UK companies to provide shareholders with a balanced and comprehensive analysis of the main trends and factors underlying development and performance of their business – both today and in the future.
In order to comply with the regulation, companies will need to disclose relevant data on employees, environmental matters, social and community issues ‘to the extent necessary’ to enable the shareholders to assess the strategies adopted by the company and the potential for those strategies to succeed.
And yet, if the poor quality of environmental reporting highlighted by the Trucost study is anything to go by, few listed companies would be in compliance with the requirements of the OFR on the basis of their current annual reports and accounts.
The rationale behind the OFR is straight forward enough. It is generally acknowledged that including guidance on appropriate non-financial key performance indicators (KPIs) is more likely to result in information that is consistent and comprehensive, allowing shareholders to make comparisons both over time and between companies. The standard itself, however, is likely to be principles based.
The legislation marks a concerted effort by the government to boost shareholder confidence in business following a series of scandals that have rocked corporate Britain.
The implications are not to be sniffed at. It is the first ever mandatory reporting requirement of non-financial elements under UK company law, and will affect around 1,290 companies.
Auditors, meanwhile, will be required to review and report on the OFR. They must express an opinion on whether the directors have prepared the OFR after ‘due and careful enquiry’ and ensure that it is consistent with their knowledge of the accounts. It is also up to auditors to state whether any matters have come to their attention, in their role as auditor, that in their opinion are inconsistent with the information presented in the OFR.
One problem likely to occur is that current details as to how the OFR will affect companies in real terms are still sketchy. The Accounting Standards Board will set the standard for reporting in an OFR. But even though an exposure draft is due by the end of this year, the finalised standard will not be published until January 2005, which is just two months before the beginning of the reporting period to which the OFR regulations will apply.
As a result, companies will have to start collecting data for inclusion without definitive guidance. How can companies overcome this difficulty without wasting management time collecting irrelevant data, while following a process they can demonstrate to auditors amounts to due and careful enquiry?
Perhaps not surprisingly, resistance has already surfaced. The CBI commented that due and careful enquiry is ‘one of the highest legal standards’ and warned that the OFR will ‘expose companies to unnecessary and excessive reporting burdens, not to mention damaging litigation’.
Contrary to the CBI’s claims, the DTI is keen to stress that the aim of the OFR is to provide shareholders with relevant and meaningful information without placing too great a burden on business.
One way of achieving this is to ensure that only relevant data is collected and that the information is useful to the management themselves. The data required should be extracted from the information companies rely on for day-to-day management.
If companies struggle to provide this information for the benefit of shareholders then those shareholders are entitled to infer that companies are failing to recognise and effectively manage the underlying environmental issues. Put another way, increased reporting requirements should be viewed by companies as an opportunity to demonstrate management quality.
The fact that a company already produces supplementary reports will not exempt it from the obligation to produce an OFR, even if corporate social responsibility and environmental reports contain information that would be considered relevant to, and possibly be duplicated in, the OFR.
Understanding how a company is performing and how it compares with its competitors, in terms of environmental efficiency, is just one potential aspect of the OFR. Nonetheless it is a key issue for business and shareholders alike. The OFR will have major implications for environmental disclosures, and for the first time in company law, there will be a requirement for directors to make forward-looking statements.
Increasing environmental regulation, environmental taxation, and emissions trading schemes are forcing companies to recognise hidden costs to the environment. As a result, companies that manage their environmental impacts well will be more financially successful than companies that do not.
Although directors will have the discretion to decide whether or not to include environmental matters within the OFR, the process employed to make this decision will be subject to auditor review and must demonstrate ‘due and careful enquiry’.
The reporting burden on companies may not be as bad as some think. Research conducted among FTSE All Share companies found that 86% only need report on four environmental KPIs, although these will vary from company to company. And 97% of companies would have to report on less than 10 KPIs. A total of 26 KPIs would cover the significant environmental impacts of every company in the All Share index and the maximum number any individual company need report on is 17.
Bearing in mind the short timescales, it is important that directors of UK-listed companies and their investors understand the wide-ranging implications of the OFR regulation, and what they need to do to prepare.
The real test will come when the Environment Agency repeats its analysis of environmental disclosure in the FTSE All Share in 2006, at which point we can truly assess whether the OFR has prompted greater corporate transparency on these matters.
Simon Thomas is chief executive of environmental research company
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