It’s becoming an all too familiar refrain: Investors need better data on companies’ environmental, social and governance (ESG) performance. And that refrain is typically followed by the litany of problems that exist with the current sources of ESG data.  

A recent Wall Street Journal article  — “Providing Timely ESG Information Is Becoming More Crucial for CFOs” — makes the case for “frequent data updates from companies to inform real-time investment decisions.” While this is an absolute necessity, “good” ESG data is nonexistent in the market.

As a 30+ year veteran of the sustainability space, my take is that this data crisis has been building for decades and will come to a head in 2021. In a market that had developed normally, there would be several competing solutions before we had reached this point, but there are several intrinsic barriers that have prevented the assimilation of better ESG data, and which are important to recognize now so we don’t compound the problem going forward.

Sustainability is not just an investment

It’s important to start at the beginning. Sustainability is a global movement aimed at maintaining and improving life on this planet. Only recently have some of these issues crossed over into the realm of mainstream investors. Twenty-five years ago, I worked on my first report — Intel’s 1995 ‘environmental report.’ Since then, voluntary reporting of ESG information has become a fixture of large companies, with more than 90 percent of the S&P 500 now issuing sustainability reports. However, this ubiquitous annual ritual is far more oriented toward the marketing department than investor relations. Typically, companies collect the relevant data only once per year, often on spreadsheets, to update their corporate responsibility story. This information is not adequate for investment-grade decisions, nor is it all that helpful for developing corporate strategy.   

Immaturity of accounting

Unlike financial disclosures, the accounting rules for many ESG topics are immature. I recall my days at Apple when our team was seeking international standards to measure and manage supply chain labor issues, but finding little. This is still the case for many ESG concerns, with one notable exception: carbon. The Greenhouse Gas Protocol provides well established and internationally accepted methods for measuring GHG emissions. But, in case you thought this was easy, the GHG Protocol runs in excess of 750 pages, and there is still a lot of confusion with indirect (Scope 3) emissions. 

Inconsistent standards and lack of assurance

There have been many calls for the convergence of reporting standards as a threshold step toward better ESG data. Progress is being made toward merging the existing standards at the same time that the International Financial Reporting Standards Foundation (IFRS) is developing its own ESG standards, starting with climate. If this were not confusing enough, the assurance standards for ESG disclosures are also still developing. Thankfully, there is a solid standard from the American Institute of CPAs and an emerging international standard from the International Auditing and Assurance Standards Board.  With all of these moving parts, it’s not surprising that less than 30 percent of ESG disclosures are assured.  

Lack of regulation – for now

While most ESG disclosures are still voluntary, regulations are on the rise. The Europeans (as usual) are leading the way with the nonfinancial reporting directive (NFRD), which originally came into force in 2014. The EU is now revising the NFRD because of concerns regarding the consistency and quality of the reporting. It’s likely there will be new legislative and regulatory moves in the U.S. as well. In 2019, I testified on the ESG reporting bills going through the House Finance Committee at that time. More recently, the Securities and Exchange Commission (SEC) has signaled its interest in this area by appointing Satyam Khanna as senior policy advisor for climate and ESG, a newly created role. And the incoming chair of the SEC, Allison Herren Lee, stated: “I have focused on climate and sustainability, and those issues will continue to be a priority for me.” The forecast is a 100 percent chance of more ESG regulation, with climate being on top of the list. 

Lack of comparability

Lacking consistent standards and assurance backed by regulations, it’s not a surprise that ESG disclosures are hard to compare. Many have complained about the lack of comparability in ESG analytics. But there is more to the story than just poor standards and assurance. Unlike financial reporting — which is about one thing: money — ESG is a very broad collection of topics that are often impossible to compare. For example, it’s magical thinking to assume that good carbon performance can offset poor diversity results — the two issues are just not fungible nor comparable. Yet, that is just what many ESG analysts do: compare the incomparable to produce the incomprehensible.  

Enter the World Economic Forum: Through its International Business Council, the WEF has proposed a set of 22 core metrics drawn from existing standards that it recommends all companies, regardless of sector, should report. Whether you agree with all 22 metrics or not, if all companies report on the same ESG issues, investors could more easily compare the results. (Notably, WEF also recommended “expanded metrics” to help companies communicate more thoroughly). Adopting this method will improve quality and consistency, but again, good analytics must compare companies only on comparable metrics.  

Lack of technology

These barriers have stunted the development of robust technology for gathering, managing, auditing, forecasting and reporting sustainability information. However, with mounting pressure from investors, the mandates from regulators, and converging standards, better solutions are rapidly emerging on the market. Given the urgency of the climate crisis and the relative maturity of its accounting standards, enterprise reporting solutions will be built for this issue first. But other issues, such as diversity, will soon follow.  

The bottom line: A tipping point is near on ESG data

“What gets measured gets done” is the old axe ascribed to management guru Peter Drucker — and it’s never been more apt than with ESG data. The barriers outlined above have hindered companies from managing ESG issues, as well as investors in making portfolio decisions aligned with ESG performance. 

But 2021 signals a tipping point where the barriers to better ESG data will be overcome. With regulators on both sides of the Atlantic and in China driving reporting mandates, unprecedented levels of money flowing into ESG assets, and pressure from mainstream investors, this market will rapidly mature.  And not a moment too soon.

Image credit: Sam Valadi/Flickr


Originally post at TriplePundit.com