Beware the rush

As standard-setting bodies seek to create integrated reporting systems, is there a risk of undermining the aims of the ESG movement? 

I will start by making clear that I truly support ESG – environmental, social and governance – causes. I see the damaging impact of global warming around the world. I believe in the need for reducing our collective carbon footprint. I believe that businesses should be responsible social actors. But reporting on ESG is not like reporting on a company’s financial position. I have deep reservations about the rush to create a so-called integrated reporting system for ESG. 

Today, businesses are knee-deep in an alphabet soup of self-appointed standard-setting agencies that are all working to establish such systems. These agencies make utopian claims: that they can create a summary metric that will be simple to understand, verifiable, and decision-relevant, simultaneously serving the needs of a variety of stakeholders. I am highly skeptical about those aims, the feasibility of these groups’ work and the frantic speed at which they are proceeding. I believe that such a system – hastily built on the back of half-baked ideas for which the research is divided – could detrimentally affect the efficiency of capital allocation. There are four fundamental issues that leaders should consider carefully.

1 Who are the stakeholders?

Creating any information system requires identification of its users and a good understanding of their objective functions. When it comes to ESG causes, neither the users, nor their objective functions are well defined. We are simultaneously talking about concerns such as shareholder value, lenders’ security, racial diversity, gender diversity, biodiversity, corporate governance, wealth disparity, air, water and soil pollution, workers welfare, local needs and tax compliances. 

A summary metric can be created only if the objective functions of different stakeholders point in the same direction. Increasing revenues while decreasing costs, for example, leads to higher profits, which benefits both lenders and equity shareholders. But in the ESG context, the objective functions of different stakeholders not only differ, but often conflict with each other. If a company could create shareholder wealth by simply doubling its employee wages, while somehow producing drinking-quality water, then it would have already done it. But the reality is that companies are often playing a zero-sum game when managing different stakeholder objectives. So how can the same summary metric satisfy all stakeholders?

2 Different organizations need different information systems

A good information system takes into account not only the needs of its audience, but also the characteristics of the organization producing that information, such as industry, production function, business model, and life cycle. But the emerging models for integrated reporting pay no heed to company context. It makes no sense to demand the same carbon footprint reporting from a steel maker as from a software maker.

3 Accountants’ expertise in ESG matters

The personnel at the agencies working on ESG reporting come mostly from an accounting or related background. Accountants are, at best, trained in basic economics and some business concepts. They have little understanding of the technicalities of production process, supply chain systems and human issues – which are the ground on which ESG initiatives stand or fall. Do these accountants know ESG matters better than specialized agencies like (to take two examples from the US) the Occupational Safety and Health Administration, focused on worker welfare, or the Environmental Protection Agency, which has specialism in emissions standards? Such agencies employ an army of PhDs with specialized knowledge. 

The problem this creates is that accountants tend to take the easy path. To create systems based on what can be easily-measured and verified, they tend to shy away from difficult-to-measure but meatier concepts. For example, accountants have thrown up their hands when it comes to intangibles – such as human capital – because they cannot measure or verify them. Auditors perpetuate these limitations, because they only focus on reducing their litigation costs, rather than on producing something that is decision-relevant to the society. 

The errors introduced by accountants’ ignorance of these meatier matters can be judged by observing two summary metrics – earnings and book values – for modern, knowledge-based corporations. Both have lost relevance for equity investors’ decision-making. Loss-making firms are valued at billions of dollars. Almost every financial valuer now undoes accrual accounting to revert to cash flows. Book values are so far removed from market valuations that they are best ignored: contrast Apple’s $3 trillion valuation with its book value of $50 billion.

4 Justification for the underperformance of fund managers

On average, adjusted for costs and risks, most fund managers now underperform the markets. Some might now claim to be maximizing some esoteric ESG metric and not chasing shareholder value. I believe that ESG-based systems would give a new excuse to fund managers to justify underperformance. The cost could be the mis-allocation of capital: good, productive, businesses could miss out on the investment that they might otherwise receive. The end result would be to leave us all worse off.

What can executives do? 

In summary, I believe that we need a more patient and thoughtful discussion before proceeding further down the road of ESG reporting. But of course, executives are already under significant pressure to travel that road. What can they do? First, be thoughtful before committing to a reporting system; avoid pandering to the demands of just one standard-setter, or a small set of stakeholders. Spend time understanding your full set of stakeholders and their information requirements in the round: establish what information they want, in what form, and how frequently. Some may want a mere statement of commitment once a year, some may demand quantified performance metrics once a month, while still others may demand prompt reporting of any change, and nothing else – so consider preparing alternative reports that individually meet those stakeholders’ requirements. But be careful in labeling anything an integrated report or a summary metric – because there aren’t any.

With ever-increasing resources flooding into ESG projects, we need to be careful that laudable goals are not undermined by misguided efforts to achieve the impossible when it comes to reporting. 

Anup Srivastava is Canada Research Chair in accounting, decision-making and capital markets, and full professor at Haskayne School of Business, University of Calgary.