This post is part of ImpactAlpha’s “Frontiers in Social Innovation” series with Stanford GSB Center for Social Innovation. The posts in the series are adapted excerpts from the book, “Frontiers in Social Innovation,” edited by Neil Malhotra of the Stanford Graduate School of Business.
The Security and Exchange Commission’s proposal to require publicly traded corporations to disclose their greenhouse gas emissions will be fought over in Congress and the courts. Whatever the outcome, however, demand for the disclosure of corporations’ environmental, social, and governance (ESG) performance will only grow.
In 2020, one out of every 3 dollars under professional management in the United States was managed according to “sustainable” – a term broadly synonymous with ESG – investing strategies. Not only investors, but consumers, employees, regulators, and other stakeholders may wish to assess a company’s ESG ratings to predict or improve its performance, to reward or punish the company, or induce it to internalize its external environmental and social costs.
It is a cliché, because it is generally true, that you can’t manage what you can’t measure. There is a broad consensus about the metrics used to evaluate a company’s financial performance and overall value, and these metrics are largely commensurable across a range of industries and geographies.
By contrast, ESG factors are dissimilar, the techniques for measuring them are varied and complex, and many are not readily comparable. Under these circumstances, it is hardly surprising that the assessments of the various ESG ratings services are poorly correlated with each other and that the question of whether good ESG ratings predict better returns for investors is perennially controverted.
Despite the huge differences between ESG and financial reporting, we believe that practices developed in financial reporting can contribute to high-quality ESG reporting.
In particular, we suggest that a comprehensive framework for ESG reporting requires: (1) a robust framework and scalable system that captures a company’s major ESG metrics and permits comparisons among different companies; (2) a standard-setting body to develop and particularize those metrics; and (3) reporting infrastructures that allow companies to accurately collect, report, and verify the relevant metrics.
The SEC’s proposed climate-related disclosure requirements indicate both the possibilities and limitations for developing such a framework. Drawing on the well-established Greenhouse Gas (GHG) Protocol, the SEC would require the disclosure of three categories of GHG emissions: Scope 1 (emissions by the company itself); Scope 2 (emissions from the production of energy purchased by the company); and Scope 3 (emissions from both upstream and downstream activities in a company’s supply chain).
Scope 1 and 2 emissions are readily calculable and comparable across companies and industries. By contrast, the calculation of Scope 3 emissions is fraught with difficulties, including the reliability of the data a company can collect from various participants in its supply chain, the costs of collection, and the avoidance of double-counting in order to fairly attribute emissions to a particular actor. Yet Scope 3 emissions are often many times greater than Scopes 1 and 2. For example, Carlsberg estimates that its Scope 3 emissions, from purchasing barley to transporting beer to customers, account for more than 10 times the direct emissions from its breweries.
Whatever the complexities of measuring Scope 3 emissions, the standards are evolving to become clearer over time. And many core ESG social standards, such as those involving workplace safety and the prohibition of child and forced labor, are well defined by the Global Reporting Initiative (GRI). Yet others, like prohibitions against discrimination, elude easy definition, especially for companies with a global footprint.
For all the good work of the GHG Protocol and GRI, the history of financial accounting suggests the need for an independent standard-setting body that has a formal government imprimatur. Contemporary financial accounting began in the aftermath of the stock market crash of 1929, with the newly created SEC having the authority to set financial accounting standards for public companies.
The two predecessors to the Financial Accounting Standards Board (FASB) relied on part-time academics and practitioners, including representatives of the major accounting firms. As a result, their standards lacked uniformity and were buffeted by pressures from the industries subject to their standards. Although not without controversy, FASB has been more successful than its predecessors because of its greater financial, industry, and political independence.
If financial reporting is politically controversial and subject to immense lobbying, imagine the potential controversies related to ESG reporting. At a minimum, any ESG standard-setter must be a financially independent institution with significant research capacity and full-time, well-compensated board members who represent a broad swath of stakeholders.
But the focus on standards alone is incomplete. An ESG reporting framework must also produce information that is accurate, objective, and verifiable. And this requires concurrent improvements in internal and external ESG reporting infrastructures. Companies must have robust internal control systems and third-party auditors to generate the underlying data and verify the reported information.
Such formal processes and procedures have been essential to providing reliable financial data. The challenges of ESG reporting are considerably greater given the wide variety and complexity of social and environmental data, and the need to verify the behavior of companies in a supply chain.
ESG metrics as a whole are unlikely to have the accuracy, validity, reliability, and commensurability of financial metrics. But in the spirit of not letting the perfect be the enemy of the good, it makes sense to rely on the metrics that have reached maturation while working to bring others up to their level, to establish an independent and capable standard-setting organization, and to develop internal and external ESG reporting infrastructures.
Paul Brest is former dean and professor emeritus (active) at Stanford Law School, a lecturer at the Stanford Graduate School of Business, and co-director of the Effective Philanthropy Learning Initiative at the Stanford Center on Philanthropy and Civil Society.
Colleen Honigsberg is an associate professor at Stanford Law School, where her work focuses on accounting and governance issues.