According to this recent study from consulting firm McKinsey, investors want to see a different kind of sustainability reporting. The authors observe that, in light of mounting evidence “that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind.” Although there has been an increase in sustainability reporting, McKinsey’s survey revealed that investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. The rub is that, ironically, it’s the SEC that isn’t on board with that idea—at least, not yet.

In response to a question from McKinsey about sustainability standards, 14% of investors said there should just be fewer standards, but an overwhelming 75% of investors said there should be only one standard. Executives had a similar perspective: 28% said there should be fewer standards, and 58% said there should be only one standard. In addition, the vast majority of investors agreed or strongly agreed that more standardization would help with effective capital allocation (85%) and with more effective risk management (83%). A similar majority of executives agreed or strongly agreed that more standardization would help their companies benchmark against their peers (80%) and enhance their companies’ ability to create value or mitigate risk (68%). What’s more, 82% of investors said companies should be legally required to issue sustainability reports and, surprisingly, 66% of executives agreed.

In 2018, a rulemaking petition advocating that the SEC mandate environmental, social and governance disclosure under a standardized comprehensive framework was submitted by two academics and multiple institutional investors, representing over $5 trillion in assets. Not only is ESG disclosure material and relevant to understanding long-term risks, the petition contends, but the variety of approaches currently employed highlight the need for a more coherent standard that will provide clarity, completeness and comparability. (See this PubCo post.)

The SEC has not taken any action on the petition. Right now, many of the key players at the SEC appear to be opposed to imposition of a mandatory ESG framework. While SEC Chair Jay Clayton “acknowledges the growing drumbeat for ESG reporting standards,” in this article from Directors & Boards, he indicated that the nature of social and environmental components of ESG varies widely from industry to industry and country to country. As a result, the disclosure approach for “E” and “S” matters “cannot be the same, as issuers and investors approach each of them differently.”

With that in mind, when it comes to mounting calls for rulemaking that standardizes ESG disclosure, Clayton was less than enthusiastic: “My view is that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies. Such a step would be inconsistent with our mandate, would be a departure from our long-standing commitment to a materiality-based disclosure regime, and could effectively substitute the SEC’s judgment for the company’s judgment on operational matters.” Instead of imposing marketwide ESG regulation, Clayton favored the application of “the ‘materiality’ based approach to disclosure regulation. This has been the commission’s perspective for 84 years and it has served our investors and markets very well. Keeping that perspective in mind is critical to our mission.” He believed investors were much better served by understanding how each company looked at its business, its assets and risks. (See this PubCo post.)

Corp Fin Director William Hinman views the issue of ESG disclosure as “complicated,” largely because of the tension between the desire of some for specific sustainability disclosure requirements—along with the debate about which set of reporting standards should apply—and the concern of others that specific sustainability disclosure requirements will elicit information that is not really material to a reasonable investor. (See, for example, this PubCo post and this PubCo post.) These issues have not yet settled out in the marketplace, and the SEC is continuing to monitor the evolution of market-driven solutions, comparing information in SEC filings with information provided voluntarily outside of SEC filings. In particular, he said, the SEC is wary of imposing specific bright-line disclosure requirements that can increase the costs of being a public company without delivering relevant and material information to investors and others, thus potentially decreasing the attractiveness of public-company status. (See this PubCo post.)

SEC Commissioner Hester Peirce has taken an even stronger position, having previously opined that the acronym “ESG” stands for “enabling shareholder graft.” (See this PubCo post.) She has also criticized institutional investors for advocating ESG disclosure regulation. In Peirce’s view, the “ESG tent seems to house a shifting set of trendy issues of the day, many of which are not material to investors, even if they are the subject of popular discourse.” While there are a number malefactors at work here—Peirce names developers of ESG scorecards, proxy advisors, investment advisers, shareholder proponents, non-investor activists and governmental organizations—the primary instigators, she argues, are “non-shareholder activists—the so-called stakeholders—who identify the controversial issues du jour. Other people quickly heed their call to action.” Also substantially at fault are the “self-identified ESG experts that produce ESG ratings. ESG scorers come in many varieties, but it is a lucrative business for the successful ones. The business is a good one because the nature of ESG is so amorphous and the demand for metrics is so strong. ESG is broad enough to mean just about anything to anyone. The ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences. Not surprisingly then, there are many different scorecards and standards out there, each of which embodies the maker’s judgments about any issues it chooses to classify as ESG.” (See this PubCo post.)

According to McKinsey, there is quite a proliferation of frameworks and standards that have been developed by numerous organizations: the Global Reporting Initiative (GRI), the Greenhouse Gas Protocol (from the World Business Council for Sustainable Development and the World Resources Institute), the UN Global Compact, the Carbon Disclosure Project (now CDP), the International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board (SASB) (see this PubCo post) and the Embankment Project for Inclusive Capitalism. The volume of frameworks leaves companies to make a choice. McKinsey reports that, in making that choice, many companies consult “members of stakeholder groups—consumers, local communities, employees, governments, and investors, among others—about which externalities, or impacts, matter most….” Together, all of the choices and inputs has led to a lot of diversity in the disclosure, which is both “a defining feature of sustainability reporting as we know it—and a source of difficulty.”

The proliferation of ESG scorecards, and the confusion they can create for investors, is also discussed in this WSJ article. While investors flock to companies that align with their values on ESG, according to the article, identifying those companies has become complicated—the many tools and raters available “may be obscuring, instead of illuminating, the path to righteous investing….The flurry of firms attempting to grade companies on ESG factors, and the dizzying array of techniques and methodologies used to arrive at those scores, has led to mixed signals in the marketplace.”

The results offered by ratings providers and companies can sometimes be erratic: “ESG-scoring firms often rely heavily on information that companies voluntarily disclose in annual sustainability reports, which can be inconsistent across sectors or even within a single company year to year. Scoring firms try to find uniformity across industries by supplementing company reports with information gleaned from analysts’ own surveys, interviews or online sources. From there analysts apply varying weight to factors they think are most relevant to a given industry. Each firm has its own formula, its own process. The result: a lot of different results.” According to one commentator, some of the assessments are deficient because they don’t take into account factors in the “workplace environment that can be difficult to ascertain from the outside.” To illustrate the problem, one commentator raised by analogy the confusion that would result if there were major disagreements among credit rating agencies about a corporate bond. And, the article reports, there are at least 200 providers of ESG ratings. This issue is compounded by the wide diversity of methods that companies use to measure their own ESG performance.

That’s not to say that 30 years of sustainability data is useless—stakeholders have used it compare sustainability performance year over year at individual companies and to detect patterns, trends and even rankings in aggregated data. Academics and other analysts have used the data to examine the link between sustainability performance and financial performance, showing correlation if not causation. Now, with sustainability having become mainstream, asset managers and other institutional investors are paying more attention to sustainable-investment strategies and integration of sustainability factors into investment analyses.

The growth of sustainability as a factor in investing has fueled the demand for sustainability disclosures that meet the following three criteria identified by McKinsey: financial materiality, consistency and reliability.

With regard to financial materiality, McKinsey says that investors clearly want more disclosure about sustainability that is material to financial performance. And this desire represents a shift: an executive at “a large global pension fund remarked, ‘The early days of sustainable investing were values based: How can our investing live up to our values? Now, it is value-based: How does sustainability add value to our investments?’” (See this PubCo post and this PubCo post.) Financial materiality seems to be something of a no-brainer. Even Commissioner Peirce has acknowledged that, to “the extent that some ESG issues may have a material financial impact, there is little controversy that those issues should be disclosed, not because of ESG, she contends, but because they are financially material.”

Investors and executives identified the inconsistency, incomparability and lack of alignment of standards as the most significant challenge of sustainability reporting. That applies not just to companies that produce their own reports, but also to third-party services. According to McKinsey, these “services use different methods to estimate missing information, so there are discrepancies among data sets. Some services normalize sustainability information, replacing actual performance data (such as measurements of greenhouse-gas emissions) with performance scores calculated by methods the services don’t reveal. Research shows a low level of correlation among the data providers’ ratings of performance on the same sustainability factor….Similarly, proprietary indexes and rankings of sustainable companies, which some asset managers use to construct index-fund portfolios, can also diverge greatly. It is not unusual for a company to be rated a top sustainability performer by one index and a poor performer by another.”

And then there are serious questions about the reliability of some of the data and the systems in place to collect it. For some factors, such as greenhouse-gas emissions, the systems are well established, but gauging other factors, such as corporate culture, are more subjective. Moreover, nothing is audited. The survey showed that 97% of investors—and 88% of executives—thought there should be some type of audit, and 67% of investors (36% of executives) thought the audit should be as rigorous as a financial audit.

McKinsey concluded that the most salient priority for sustainability reporting was “ironing out the differences among reporting frameworks and standards.” Investors believe that more uniformity in reporting standards would “help companies disclose more consistent, financially material data, thereby enabling investors to save time on research and analysis and to arrive at better investment decisions. Some efficiency gains would accrue as third-party data providers begin aggregating sustainability information as consistent as the information they get from corporate financial statements.” Sixty-three percent of investors “said they believe that greater standardization will attract more capital to sustainable-investment strategies. However, about one-fifth of the surveyed investors said that uniform reporting standards would level the playing field, diminishing their opportunities to develop proprietary research insights or investment products.” Executives identified as problematic the excessive amount of effort and expense devoted to answering numerous requests for the same sustainability data, tabulated in different ways to conform to different standards. Harmonized standards, McKinsey concluded, could reduce that burden, and even make an audit more feasible.

At a meeting of the SEC’s Investor Advisory Committee in December 2018, a company representative noted that, in the past year, the company had 55 ESG-related survey requests, which required the expenditure of substantial time and money. She contended that there was some confusion about what ESG comprehended: it should be about “value,” she argued, not “values.” However, she thought private ordering of ESG disclosure worked well and did not favor the imposition of SEC requirements.

In contrast, the representative from CalPERS contended that private ordering was inefficient and the resulting data risked becoming just “noise.” The time was ripe to move to the regulatory arena. For example, how should investors address the fact that most companies do not voluntarily report? With all the companies CalPERS has to monitor, the current process was too ad hoc.

Another meeting participant contended that the voluntary nature of current standards is a problem because it allows companies to engage in cherry-picking and “greenwashing,” that is, filtering to portray an environmentally responsible public image. From a practical perspective, however, a former SEC General Counsel observed that rulemaking on sustainability would be difficult because, unlike MD&A, which is based on financial statements prepared under GAAP, there was no comparable starting point for ESG disclosure. (See this PubCo post.)