Aug 5, 2019 in Business

The Role of Theory in the Decision to Report on Non-Financial Issues: Social and Environmental Concerns

Environmental and social issues have gained a peculiar role in shaping the image of a company and technology behind many business processes in the recent years. These issues present both risks and opportunities for companies in terms of competition, public relations, risk management, strategy, business resilience, and stakeholders’ relations. 

Some of the most important social and environmental issues to be considered are water resources scarcity, energy consumption and sustainability, poverty, human rights, corruption food safety and climate change. Many of these issues are interconnected; for example, food production has to be scaled and cheapened because of poverty problems, and the scale impacts quality of food. Energy production is tightly connected with water, while the extraction of water is done with the use of energy. 

Social and environmental issues, along with the challenging landscape of risks related to supply chain management, customer channels and the growing complexities in business structures emphasize on the importance of attention to stakeholders and investors. Stakeholders divide into seven major categories, and most of them are interested in the financial statement of a company: lenders and investors, employees, customers, suppliers, governments, communities and international organizations. Non-governmental organizations can also be influential for businesses, depending on their sphere of operation. 

Due to long-term stakeholders’ interest in a company’s future, the influence of social and environmental issues gains even a greater impact and the vision of a company’s prospects and current performance. Specifically, stakeholders are looking for valuable information on social and environmental issues and their role in the strategic development and associated risks. Undoubtedly, trustful and transparent relations with stakeholders imply greater business resilience and growing competitiveness. 

The recent emergence of social media and information exchange on the Internet has brought both positive and negative changes into stakeholder relations landscape. On the one hand, the transparency opportunities have grown due to better timing and constant information flow within a company, with stakeholders and between a company and its clients. However, it also constitutes a sufficient source of risk for a company’s reputation and even a threat to its business operations. Companies should work hard on their responses to the social media mentions. 

The regulations in most countries represent risks and potential costs for companies that have problems managing their social and environmental issues. Meanwhile, it is also an opportunity for companies to compete if they have enough power to monitor, forecast and respond to the changing landscape of social and environmental problems. 

The study is relevant due to the growing trend for eco-friendly products and the shift to investors’ preference for environmentally concerned businesses. 

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Types of Environmental Concerns

Most popular non-financial concerns can be divided into several categories: economic risks, environmental risks, geopolitical risks, technological risks, and societal risks. The economic risks embrace

  1. Great price volatility of commodities;
  2. Price volatility of consumer prices;
  3. Energy price fluctuations;
  4. Failures in regulation;
  5. Slowed economic growth;
  6. Fiscal crises;
  7. Fragility of infrastructure;
  8. Liquidity crunch;
  9. Globalization issues;
  10. Collapse in asset prices. 

Environmental risks embrace:

  1. Water pollution and scarcity;
  2. Ocean governance;
  3. Loss of plant and animal breeds;
  4. Global warming;
  5. Threats from earthquakes and volcanoes;
  6. Flooding, cyclones and storms. 

Societal risks are:

  1. Demographic problems;
  2. Food safety;
  3. Chronic non-communicable and infectious diseases;
  4. Migration;
  5. Water scarcity. 

Geopolitical risks include:

  1. Terrorist attacks;
  2. Organized crime;
  3. Illegal trade;
  4. Corruption;
  5. Lack of state power;
  6. Governance failures;
  7. Geopolitical tension;
  8. Weapons of mass destruction. 

Technological risks are:

  1. Online information security
  2. Threats from new technologies;
  3. Breakdown of critical information. 

The key socio-environmental issues, according to Geneva Economic Forum, are human health and safety, poverty, human rights, corruption, population growth, urbanization, demographic issues, social unrest, waste production and management, earthquakes and volcano eruption threats, soil degradation, disappearing forest, plants and animal breeds, water quality and scarcity, global warming, pollution, energy production and consumption. 

Literature Review 

In the long-term, business success primarily depends on finding opportunities and coping to eliminate risks, in order to build competitive advantage and more value for shareholders. Reliable companies adapt well to the changing circumstances, both unforeseen and anticipated. The evaluation of social and environmental issues leads to greater competitive advantage and increased business resilience. Many companies have started to recognize the need to address broader economic influences of their activities, in order to fulfil their goals. According to the survey among global CEOs from the Global Compact companies list, the CEOs have admitted that they were experiencing a new sustainability era with the new demand sources and markets, new sustainable products and practices, new business models and innovations, altered cost structures and changed strategy and business operations. 

The diagram below demonstrates the interconnectedness of external forces, influencing corporate strategy and business risk management, its stability and competitiveness:

interconnectedness of external forces

One of the important word-wide practices for reaching transparency in stakeholder relationships is the publication of reports. That is why, the decision on how to report about the environmental and social issues is one of the best options to improve corporate transparency. Most of these reports are produced according to the well-known social audit model developed by the government in each state. Sometimes, non-governmental organizations also take part in the process (for example, in Brazil). 

The theory behind environmental and social reporting defines the variables that play a role in forming regulation, optimal indicators and standards of environmental and social impacts of business activity. For example, the study by Bufoni, Ferreira and Carvalho, who investigated the socio-environmental reports of over 200 big Brazilian companies, have shown that there is a close relationship of social and environmental visibility with customer loyalty, future mergers and acquisitions, productivity gains and new markets. Research findings also have an impact on the market regulations, certifications, economic tools and competition restrictions.  

Considering the issues in environmental and social spheres in terms of business impact, has become very important to business success, as business process optimization is no longer enough. It is also essential to reconsider conduct, values and activities that inspire the quality of life in terms of ethics, environmental and social problems. Actually, the implementation of innovative economic models and social responsibility and sustainability frameworks have led to extended pressure upon firms, not only to start short-term and one-time programs, but also to substantiate them. 

There are two major theories that are frequently used to support corporate social responsibility research: the stakeholder theory and the resource-based theory. 

The first one addresses the need for ethics and morals in organizational management. The theory also argues that not only traditional stakeholders (owners of a company) are important for business but there are multiple groups of stakeholders influential for a company including suppliers, partners, trade unions, employees, financiers, customers, governmental and non-governmental bodies, trade associations and political parties. Some researchers even add competitors to stakeholders because of their importance and the ability to affect a firm. Stakeholders are referred to as anyone with the ability to impact the environmental and social performance of a firm and the results of related activity. The external groups including community services, environmentalists, consumers and minorities add pressure on companies as they require businesses to share the information about all aspects of business, especially in the developed countries. This pressure is transmitted through both institutionalised direct approach and public indirect approach. The theories have helped to improve the top managers’ attitude towards transparency in information completeness as it leads to reduced cost of capital for a company as well as the extended opportunities to enter international markets and better planning. 

The second one states that firms are sources of assets that have the potential to produce any economic value imaginable. According to this theory, each company has a unique set of capacities, resources, and competences to apply them which also makes a company’s environmental performance unique. 

The traditional ways companies react to social and environmental issues include reaction to damage, passive behaviour, proactive attitude to issues, and risk-preventive behaviour. Regardless of what general strategy is taken, researchers still debate about how to extract value from the investment into socio-environmental issues and how to reach maximum efficiency in such activities. Boiral provides a variety of options for social-environmental actions and associated investment decisions. Companies who have interest in potential investment into new technologies for better environmental performance can make the final decision based on several factors including reduced pollution and associated taxation, pollution control or the implementation of environmental management systems. There is also a range of variables that are out of top managers’ control including industry (auto regulation, barriers to enter and culture), entity levels (circumstances, financial and tactical), organizational (consumers, regulation, stakeholders and economy). 

The decision to report on environmental and social performance in accounting is related to environmental performance and its relationship with the investment activity, to ethical employee training and professional development, corporate policy and external social investments. The measurement of environmental performance is done through several indicators: the amount of provided information, the rate of toxic emissions, the number of fines, certification efforts and losses, and the brand power gained through eco-friendly activities. 

The research by Bufoni and, Ferreira and Carvalho demonstrates that there is a positive relationship between environmental investments and a company’s revenues. There is also a positive relationship between environmental and external investments which proves the potential connection between the investment decisions in social and environmental spheres. The research also included an interesting result: companies with a significant share of employees over 45 were unlikely to invest into environmental issues. The society’s program of increasing environmental awareness among young people has been effective and changes the behaviour of companies while more environmental and social proactivity is expected in several years when younger generation reaches the top management positions. 

It is also important that the framework of social and economic issues embraces its inputs and outputs. The inputs include the measurement of resources amount and scarcity indicator (water, energy, land and inventories). The outputs include the efficiency of the process (yield or mass balance calculation) and the influence of outputs which can be tonnes of produced carbon and other gases, level of product recyclability, pollution and waste. 

The direct accounting measures lie within the reporting entity only while the indirect measures will also mention the previous step and next step supply chains that were involved into taking the product into the market. For instance, a bank can report on its own environmental performance with all its offices and branches but a full report would mean that a bank should include complete information about the environmental impacts of its most important clients who loaned money for business purposes. It is rare to see a company reporting on its indirect influence because of the difficulties in measuring the environmental impact outside a reporting company. Researchers still argue whether such information should be included into the banking reports. 

Environmental Reporting Guidelines 

In most world states, the reporting on social and environmental issues is completely voluntary and should comply with the usual standards. However, big companies find it hard to avoid environmental and social reporting because of the high political visibility of big brands and their concerns about a brand’s reputation, especially in highly developed economies. 

Due to the voluntary nature of the environmental reporting, companies are free in choosing the most convenient approach to it but in reality, there are some popular frameworks. One of them is called Global Reporting Initiative. It describes how a company needs to report on various aspects of the environmental and social performance. It gained popularity among the US companies in the end of the 1990s. The initiative itself is the non-profit organization that works to promote environmental and social sustainability as well as economic advantage. Eventually, this framework has also become popular throughout the world, starting from European countries, and was adopted to compete the financial statements of many companies, either in an open manner (naming the framework exactly) or following the guidelines of GPI selectively without following all of them. 

The decision on the socio-environmental reporting is made in the period of producing annual reports and as needed, in exquisite reports, on company information channels such as websites, blogs, ads, videos and other promo media. Until the popularization of environmental concerns, there were a few mentions of the issues, but in the recent years, most businesses started producing an individual report dedicated only to environmental and social performance. There is no fixed standard for such reports, and the production is usually expensive. Sometimes companies use it as a part of their marketing and public relations strategy, others name it a ‘sustainability report’, while others connect their social performance to environmental information (for example, informing about new jobs generated, charity activities, training, etc.). The wording of the headline varies from company to company, and brands use it to drive additional attention to the report document. Phrases such as ‘corporate responsibility report’ and ‘citizenship report’ are some of the available alternatives. 

The motivation for environmental reporting is derived from psychological theories and the need to market the brand values in a socially responsible way. The stakeholder theory stresses out how different interested parties (both external and internal) can benefit from the environmental and social reporting. Even future generations can learn lessons from the reported information. Additionally, shareholders get a more complete picture of where a company is going and what public image it builds. The additional information is the ground for trust and reduced the gap between the board of directors and a company’s shareholders. 

Social and environmental reporting successfully removes the problem of questioned ethics and competence. For example, the most active environmental reporters are big environmental impact companies such as petrochemical or fuel-generating businesses. Sometimes these reports are used occasionally as a response to specific events, concerns or challenges informing shareholders and the public about how these problems have been addressed. If a company is a participant of a high impact environmental accident, it decides to include more environmental information to reassure stakeholders that the problem has been dealt with and the lessons are learnt. At times, the threat from the incidents is so big that a company runs under the risk of losing its license, and it is important to legitimate the perception of a company’s activities in the eyes of the public. That is why behaviourist theory and the cognitive theory also play their role as companies attempt to influence the psychological perception of themselves. 

There are some monetary advantages too. The popular opinion is that the socio-environmental reporting inspires business optimization and higher business process efficiency in organizations of all types. This is related to the need to install the technical equipment for the measurement of environmental indicators and process information on business operations. These measurements and the results of their analysis can potentially open the blind spots, increase efficiency and decrease costs along with less production waste. This is when the rationalization theory by Max Weber comes into place. 

Additionally, the costs associated with the environmental risks can be decreased. The concerns of shareholders can be resolved by covering an extended range of potential risks that a company faces, including the social and environmental issues.

The Limits of Theoretical Justification for Socio-Environmental Reporting

In spite of the recent emphasis on reporting non-financial issues, there are several issues with the way theory works for environmental performance efficiency: 

  • Limits in time and resources. Investors are limited in time and resources while studying the environmental information, so they can miss out on the disclosed data. Moreover, the abundance of information in the financial statement makes its harder to understand each individual part of it. Environmental information is not directly linked to decision-making process, and it may be challenging for stakeholders to use it efficiently and support the investment process. 
  • High costs. The acquisition and installation of the environmental equipment is expensive, and the ROI is challenging to calculate.  
  • Lack of data reliability and clarity. Due to the voluntary nature of environmental and social reporting, there are no fixed regulations. There is also no auditing system that governs the reporting process. That is why credibility of information can be questionable. 
  • Lack of comparable data. The traditional financial data is always benchmarked and compared to other companies’ indicators, and because of the lack of fixed guidelines and governance, qualitative comparison is not possible. 
  • Mostly positive nature. Most companies include the type of socio-environmental information that they perceive as beneficial for the brand image, so the environmental reports often carry a one-sided positive-only character. 
  • Investors frequently see the non-financial reports as irrelevant, incomparable, unreliable and too abstract compared to other financial information. 

Some of the potential implications for environmental and social reporting include introduction of a multi-stakeholder process that taken the investors’ interests into account and explain how non-financial information can relate to the efficiency of the decision-making process. However, the problems of investors’ sceptical attitude, the only-positive nature of the information, lack of comparison and reliability because of no regulations, and lack of connection to corporate performance are all sufficient barriers on the way to efficient environmental and social reporting. 

Сonclusion

Therefore, the decisions made about social and environmental reporting are mostly based on the stakeholder theory, the resource-based theory, the rationalization theory and the psychological theories such as behaviorism and cognitivist views. The main goal of non-financial reporting is improving the relations with the investors and changing the image of the company in the eyes of the public. However, formal barriers, such as lack of formal regulation, no fixed framework, the voluntary nature of the reporting limit the efficiency of social and environmental reporting. The evaluation of environmental and social performance will become more effective in case these problems are resolved by introducing a formal regulative framework with reliable, measurable and comparable information.  

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