The case for standardized, audited ESG reporting
As the U.S. economy ballooned following World War II, so did the professional-managerial class. At the helm of a revived economy, these managers prioritized business growth, unchecked. Except in matters of dividends and stock prices, investors and board directors tended to steer clear of governance matters.
But with an emphasis on growth comes risk. Following a few corporate governance scandals in the 1960s (such as those involving Penn Central Railway, Equity Funding Corporation of America and Allied Crude Vegetable Oil Refining Corp.), the Securities and Exchange Commission in the 1970s prompted the New York Stock Exchange to require each listed corporation to have an audit committee composed of all independent board directors, and they complied. Advocates for stronger, better board governance also pushed for audit committees, nomination committees, compensation committees, and limiting manager-appointed board members.
Fifty-five years ago, Congress passed the Civil Rights Act, but the power to ensure compliance with the act was weak. To enforce Title VII — which prohibits employment discrimination on the basis of race, color, religion, sex or national origin — Congress created the Equal Employment Opportunity Commission. Though the EEOC at first ignored sex discrimination complaints, President Lyndon Johnson in 1968 signed an executive order prohibiting sex discrimination by government contractors and requiring affirmative action plans for hiring women. A slew of court cases in 1969 further solidified precedent-based protection of women and minority rights in the office.
Also in 1969, there was a blowout on a Union Oil rig in the Santa Barbara channel. For nearly two weeks the oil kept coming. It soon blighted, clogged, choked and tarred the Central California coast as far south as Ventura and as far north as the Channel Islands. At the time, it was the worst oil spill in U.S. history and a seminal moment in this country’s environmental movement. In the aftermath, activists marched down Wall Street to create the first Earth Day, and a more bipartisan Washington created the Environmental Protection Agency and passed a series of strong environmental laws.
Each of these seemingly progressive policies followed pain. For every action there was a reaction. It took corporate fraud, years of discrimination and a devastating oil spill to catalyze corporate, social and environmental change. That ESG (environmental, social and governance) investing is now in vogue is a sign that American investors also seek change. They want better information and a better framework to identify the risks and opportunities that ESG analytics represent. Corporate social and governance policies have certainly evolved with social climates, but environmental policies must evolve even faster to help investors stay ahead of the risks of climate change. I say “must” because Washington, D.C., sits beneath a partisan frost so thick that glaciers are melting faster. Though U.S. regulators stepped up in the 1970s to prompt corporate governance practices, there’s little chance they will intercede in business practices now. The greatest regulators now are investors. But to regulate effectively, these investors need accurate, standardized data.
In accordance with Pearson’s Law, that which is measured improves, and that which is measured and reported back improves exponentially. I’d further add: That which is standardized, measured, reported and audited drives lasting change. Published financial reporting standards and the review by third-party auditors are crucial to helping ensure the integrity of our capital markets. Without that same standardized approach to environmental, social and governance reporting, investors can’t accurately assess and compare the triple bottom lines of public institutions.
There’s been progress over the last half-century, particularly as it relates to standardizing environmental reporting — but it was hard fought. The first environmental reporting — initiatives like the Dow Jones Sustainability Index or the Carbon Disclosure Project — relied heavily on voluntary self-reporting by companies and the development of sustainability rating systems by various stakeholders and data providers. Some environmental disclosure initiatives — including the International Integrated Reporting Council and the Global Reporting Initiative — used this volunteered data, but focused on drawing a link between value creation and financial materiality.
Until recently, most reporting around social issues was largely self-initiated and self-reported. Within an organization, marketing or investor relations teams reported data through self-measured and self-compiled impact reports. The introduction of employee reporting tools like Glassdoor and FairyGodBoss allowed for more transparency, and some semblance of checks and balances, but there’s still much to be desired: There’s no standardization in how to measure data, nor how to use qualitative data (such as Glassdoor reviews); there’s limited opportunity to audit these inputs, except through whistleblowers or investigative reporters and analysts; and these reports rarely tie social qualitative data to a company’s financial performance.
Slowly, the investor community began to innovate around these “social” issues. In 2016, Bloomberg announced the launch of a financial services gender-equality index, and it has since expanded the index to cover multiple industries. Though the data isn’t audited or otherwise verified by a third party, it standardizes specific metrics and provides guidance on how to measure them. Not all companies that submit data are included in the index, and those that do aren’t ranked. Companies are instead rewarded for disclosure.
Getting companies to disclose ESG-relevant data has been a recurring theme within the ESG framework. The even bigger challenge has been trying to standardize these disclosures between industries and sectors. Enter the Sustainability Accounting Standards Board. Founded in 2011, SASB aspires to create a unified standard of what nonfinancial factors public companies should report and how they should be reported. Last November, SASB launched a set of 77 codified standards, providing a complete set of global, industry-specific standards that identify financially material sustainability metrics for a typical company in an industry. SASB created a “materiality map” to help investors and companies identify which key performance indicators on sustainability issues have the greatest chance to affect financial performance.
Standardized. Measured. Reported. We’re finally well on our way to treating ESG metrics with the same respect and rigor as financial metrics. But until we garner support from Congress and regulatory bodies, the responsibility of due diligence falls to the investor.
Governance risk is financially material (see: corporate fraud). Social risk is financially material (see: #MeToo movement). Environmental risk is financially material (see: Valdez oil spill). We can’t afford another 50 years for ESG reporting to become standardized and on par with financial reporting and auditing. Hopefully, the pain that catalyzes that eventual shift won’t leave a lasting scar.