ESG issues affect firms of all sizes, but small and Medium-sized Enterprises (SMEs) have been missing from the discourse until recently. SMEs account for 99% of businesses in the EU and about 97% in Germany´s manufacturing sector. In 2021, the EU Commission proposed to extend the Corporate Sustainability Reporting Directive (CSRD), which previously focused on large, listed companies, to listed SMEs.
But, given the financial toll COVID-19 has had on businesses, what does ESG reporting mean for SMEs?
ESG information is material for investment and financial performance. Disclosure may improve competition and financial performance (Porter and Kramer, 2011; Wan and Wasiuzzaman, 2021; Porter, Serafeim and Kramer, 2019). It can enable firms to reinvent themselves and their product offerings in line with the needs of society.
ESG performance and disclosure guide investment decisions—ESG disclosure can mitigate investment risks, e.g., stranded assets. According to the EY Global Institutional Investor survey, 91% of investors consider ESG performance/disclosure in their investment decisions. But how reliable is the ESG risk information? Does greater disclosure mean greater engagement with ESG issues? And are firms prioritising survival (subduing external pressures on their bottom line) over impact? Investors are demanding credible information and about 82% believe an independent review of the impact of green investments could boost confidence in disclosures.
ESG disclosure can reduce information asymmetry and signal compliance with societal norms regarding sustainable business conduct (Reber, Gold, and Gold, 2021; Serafeim, 2020). Voluntary disclosures can enhance social legitimacy, which may reduce idiosyncratic risks and impact the profitability and survival of a firm. However, firms may use their ESG disclosure to manage their image without an impact. E.g. Deegan & Rankin found that companies only disclosed information favourable to their image despite environmental misconduct (1996).
Porter, Serafeim and Kramer (2019) believe ESG reports should go beyond image management, i.e., steering investments towards firms that contribute profitably to social progress.
Evidence shows that ESG disclosure positively affects firm value, e.g., Ioannis and Serafeim (2011). Eliwa, Aboud, and Saleh (2019) also found lenders reward ESG performance/disclosure with a lower cost of debt capital. Lenders rely on ESG information to assess default and reputational risks—the lower the risk, the lower the cost of debt. Investors could eliminate SMEs that do not disclose ESG information from their asset allocation plans, depriving them of the crucial finances necessary for their survival.
Policy responses may depend on a company’s size and capital endowment. The demand for ESG information is growing, and SMEs may find it difficult to adapt reporting procedures and tools employed in large firms (Steinhöfel et al., 2019) due to limited resources and operational flexibility (Ren et al., 2020).
ESG reporting is complex and expensive (hire expertise). It may be cumbersome for SMEs to choose the methodology and the factors to analyse.
The EU Commission has proposed simpler reporting standards than those applied to large companies. This would address the conflicting stakeholder demand for ESG information.
Similarly, Kornelia Fabisik, Assistant Professor of finance at Frankfurt School, noted:
“We also need to understand the importance of not overburdening SMEs with reporting, while allowing, e.g., banks to assess their ESG quality. One possible way would be to have something in the spirit of “mini-GmbH” vs “GmbH” in terms of reporting. Instead of a full-fledged sustainability report, there should be a “mini-sustainability” report produced in a simple, yet standardised way without the need for each firm to employ an ESG officer.”
But how receptive are SMEs to ESG reporting? The SME Panel Consultation found that 53% of SMEs in the EU agree to a voluntary reporting standard, 15% (mandatory), while 30% found no need for a reporting standard.
ESG reporting for SMEs is no longer a question of “if” but “when”. So, how do we ensure SMEs deliver impact and what role can financial intermediaries play? The Covid crisis is perhaps a window of opportunity for change. But change never appeals to the “kings and priests” of the time. The actions of large corporations alone may not spur us into a sustainable future, but a paradigm shift within SMEs could be the spark that ignites the flame.