The importance of non-financial information has grown dramatically for both companies and investors over the last two decades. Today, a large majority of investors and corporations would not argue anymore with the assumption that environmental, social and governance (ESG) measures are important for both long-term value and holistic risk assessment. Even more so, corporate leaders and large investors increasingly call for the firm to reclaim its public purpose, assuming a wider responsibility towards environment and society. Driving the last nail in Friedman’s shareholder primacy's coffin, this view is supported and advocated by the writings of several leading economists, such as Colin Mayer ('Prosperity'), Paul Collier ('The Future of Capitalism') and Mariana Mazzucato ('The Value of Everything').
While all of this is positive, the velocity of this development has also created challenges. Especially the fast growth in demand and consequently offers of large sets of comparable information about companies', non-financial performance is linked to serious concerns regarding this data's quality and reliability. This is particularly concerning, because ESG is powerful: the US SIF Foundation estimated in 2018 that one in four professionally managed US dollars today considered ESG. This ratio is likely even higher in Europe.
While a whole industry of data vendors has emerged to assess, analyse and rank companies' performances on various indicators of ESG, it is still not easy – if not impossible – to recognise a company's true commitment to address social and environmental issues solely based on ESG scores. In fact, there seems to be an increasing divergence between company’s efforts of disclosing and integrating social and environmental issues, and the way they are being externally assessed for it.
In traditional financial analysis, corporate disclosure and filings are the most important resources used to assess a company's financial health, while credit ratings and indices merely substitute these insights. Financial statements issued by listed companies are globally regulated and follow the standards issued by either the US-based Financial Accounting Standards Board (FASB) or the International Accounting Standards Board (IASB). Due to these standards, analysts and investors can easily interpret, compare and track the financial performance of companies. In other words: in financial disclosure, companies and investors speak (at least for the most part) the same language.
In the case of ESG analysis, the link between assessment and disclosure is more distorted. In fact, analysts will find it difficult to get a clear and comparable sense of a company's social and environmental performance only by looking at a company's sustainability reports. To fill this gap, a rapidly growing industry of ESG data vendors has emerged, providing ever larger universes of comparable environmental, social and governance-related information. What many don't realise, however, is that also all ESG data vendors rely on corporate disclosure. Where public disclosure is incomplete, a survey to each company – in other words, private company disclosure – is used to fill the gaps. A data-collection method which often leads to complaints of survey fatigue from companies, who are asked to fill up to 50 different information requests on non-financials every year. News and NGO reports of incidents are only used to supplement this information.
Today, a handful of large data vendors control the ESG data market, most notably MSCI ESG Research, Refinitiv (former Thomson Reuters), Sustainalytics, Vigeo-EIRIS and ISS-Oekom. In addition, several tech start-ups have emerged to leverage web scraping, machine learning and artificial intelligence for the collection of ESG-related information. To understand the gap between company disclosure and ESG, it is important to comprehend that the assessments of these data vendors are based on a process of social construction. As we describe in one of our recent working papers1, each ESG data vendor goes through an explicit process of selection (or sense-making, as the academic would say) in which they decide on the inclusion and exclusion of specific issues to measure E, S and G, on the methodology of how to collect, aggregate and weigh these indicators, and on the underlying definition of materiality. Through these selective steps, data vendors form a specific profile on an increasingly saturated market and define their specialised (and evergrowing) service and product offerings. Now, it is important to understand that there is nothing inherently wrong with this process of social construction – if anything, it is natural and necessary to sustain a growing and competitive market for ESG. It does, however, highlight that there is an explicit step of sense-making and interpretation between corporate disclosure and the creation of ESG, highlighting the potential distortion of message between one and the other. In other words, there is no 'right' assessment of ESG.
Early efforts of environmental and social corporate disclosure were often (rightly) criticised as greenwashing, but corporate sustainability disclosure has come a long way. Whereas earlier forms of corporate reporting on ESG were often reactive, only addressing current scandals or looming reputational risks, the last 15 years have shown a remarkable increase in proactive sustainability reporting: according to the Governance & Accountability Institute, 85% of all S&P 500 companies published a sustainability report in 2017.
Despite this increase, legitimate concerns about the relevance and selectivity of corporate sustainability disclosure remain, giving rise to a wide range of reporting frameworks addressing these issues. Most commonly known are the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), and the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD). In addition to these, the emergence of materiality as an applicable concept in corporate sustainability (especially advocated by the Sustainability Accounting Standards Board, SASB) has become a key for the relevance of this disclosure.
However, one problem of corporate sustainability reporting remains: the reader will often not know whether a company has actually changed its behaviour towards social and environmental issues, or whether sustainability management is dispersed across unrelated projects in the organisation. To address this, the Integrated Reporting Framework highlights the necessity of 'integrated thinking' at the core of each organisation. Unfortunately, the extent to which a company measures and discloses social and environmental issues is not necessarily correlated with the degree to which these measures are integrated into business operations. In fact, pressures of reporting and managing non-financials can create counterproductive incentives: collecting data for the disclosure of a wide variety of different measures (as is the case for ESG) is a quite different endeavour than creating a meaningful methodology to measure technically relevant metrics which can then be incorporated into corporate decision-making.
Non-financial assessment is costly, and not all companies manage to do both reporting and integration well. They face challenges in the balance between comprehensive disclosure and custom-made solutions for real business problems. Addressing increased external demands to disclose a vast variety of non-financial and non-material information to ESG data vendors and investors can take up resources that a company may need to find solutions to really champion the integration of these measures into decision-making.
Balancing between external demands for information and internal need of integration is hard, because each side has the need for vastly different data. Whereas investors seek highly standardised, time-consistent and comparable data, companies rely on ground-level specificity and to some extent trial and error in integration. Arguably, a company’s first concern should therefore not be disclosure, but rather the integration of non-financial measures in its operations and processes to achieve less harmful operations. Yet, it is often easier to feed the demand for ESG information than to really integrate social and environmental considerations into business practice. A true commitment to integrated goals requires radical rethinking on topics such as performance and success, and consequently a reconceptualisation of incentive structures at all levels. And while some companies champion these challenges through innovative forms of impact valuation and sustainability accounting, others are too busy catering the ESG trend to focus on the actual problems that underly this information.
To tackle this problem, priorities need to be reshaped. If companies were required to disclose on a specific material set of issues with a fixed, standardised methodology, many of these problems could be resolved. Firstly, data – both from ESG sources and from company sources – would be comparable, as their collection would be based on the same principle. Second, data would be more credible, as standards in methodology make them auditable. Third, data would be more selective and take the burden of companies to disclose on issues that may be non-material to their business, while incentivising a more thorough examination of material issues.
This all sounds relatively straightforward – so why are there no standards? It seems to be a problem of competence and complexity. Firstly, no institution perceives itself to be the 'right one' to formulate standards of this kind. While many regulatory bodies have already released recommendations for the disclosure of ESG-relevant information (such as the European Commission’s High-level Expert Group and IOSCO), none has pushed for more. Second, there is still the looming question of how to standardise. While standardisation only makes sense at the disclosure level (and not at the ESG level, as some may argue), there is still a variety of complex decisions to be made about the 'right' definition of materiality and the ‘correct’ measurement of issues that are very difficult to capture.
In a debate at the Oxford Union in December of last year, two teams of four delegates each debated the question of whether FASB and IASB would be the right institutions to set standards for corporate sustainability reporting. While both sides brought forward excellent arguments, all representatives from the institutions themselves were in contra. Two thirds of the audience, on the other hand, were in favour. This shows that a public call for the necessity of such standards exists, which at this point, however, is still unable to overcome institutional resistance.
The views expressed in this article are those of the author and may differ from the published views of Commerzbank Corporate Clients Research Department, the communication has been prepared separately of such department. No representations, guarantees or warranties are made by Commerzbank with regard to the accuracy, completeness or suitability of the data.