Consumers, business leaders, employees, investors, and communities all care about a company’s environmental, social, and governance (ESG) practices. The problem is that—unlike with profitability—it’s hard to compare ESG performance between companies or even over time within the same company. With the right data, you can define and improve your company’s position as an ESG leader.
Why ESG Performance Matters
The numbers are simple. According to PwC:
- 83% of consumers want companies to shape ESG best practices
- 91% of business leaders think they have a responsibility to act on ESG issues
- 86% of employees want to work for a company that supports the same issues that they do
These are not just sentiments. PwC data shows that consumers age 17 to 38 are twice as likely as older consumers to consider ESG issues when making purchasing decisions.
Investors are also following ESG trends. From 2017 to 2020, assets under management in ESG funds doubled. Investors are moving to both passive funds that follow ESG indexes as well as activist funds that buy the entire market then use shareholder votes to promote ESG issues.
Even companies that focus strictly on the numbers need to understand how ESG affects their sales and ability to raise capital.
Defining ESG performance is the most important step. Making environmental, social, or governance issues better means different things to different people. There may be differences in values or one cause is better suited to a company than another.
ESG performance can also be hard to quantify. Even if a company takes actions intended to be more green, how exactly can one measure something like reducing pollution? There are various ways ESG considerations are measured.
From an investment standpoint, one of the earliest and most basic ways of defining ESG companies is screening by line of business. The fund might exclude all companies in a list of industries that the manager of the fund has decided don’t align with the ESG values the fund is promoting. This isn’t actionable to most companies, but companies with a small portion of revenues from non-ESG business lines might decide the benefit of being labeled as ESG outweighs the benefit of staying in that smaller line of business.
There are a number of ESG standards boards that operate similarly to the Financial Accounting Standards Board. They define accounting principles and reporting requirements to help create consistency in reporting ESG impact. For example, a company might be required to create a statement of its environmental impact.
These are the leading ESG standards boards:
- Sustainability Accounting Standards Board (SASB)
- Carbon Disclosure Project (now referred to only as CDP)
- Climate Disclosure Standards Board (CDSB)
- Global Reporting Initiative (GRI)
- Task Force on Climate-Related Financial Disclosures (TCFD)
- International Integrated Reporting Council (IIRC)
Global ESG Standards
Accountants who have long been frustrated with learning and applying the differences between GAAP and IFRS understand the problem with having so many different sets of standards. Either the accountant has to spend time converting reports to different standards or end users of the reports have no meaningful way of comparing reports in different standards. ESG standards have the added complexity of focusing on different areas within ESG.
There are almost as many groups trying to create a global ESG standard as there are ESG standards boards. This includes groups of consulting firms, groups of standards boards, various professional organizations, and governmental regulatory agencies. At present, there is no global standard.
There are also certifications that companies can obtain to show their commitment to ESG and that they’re meeting minimum performance standards. One of the leading certifications is the Certified B Corporation.
B Corp Certification is managed by B Lab. B Lab is a private, not-for-profit entity. It claims to be the only organization that reviews an entire company rather than specific products and services. It uses quantitative and qualitative measures to evaluate a business’s impact on its workers, communities, suppliers, and customers. Certified B Corporations also have to legally change their corporate structure and articles to guarantee that non-shareholder stakeholder interests continue to be considered.
Lawmakers are beginning to consider or have already begun requiring ESG disclosure in financial reporting or as separate statements. For example, the European Union expanded its Non-Financial Reporting Directive in 2021. This requires all companies doing business within the European Union that have more than 500 employees to disclose information about ESG factors.
One shortfall of existing ESG measures is that they often lack raw data. A company may only need to make a short text disclosure that it is or isn’t engaging in certain activities or whether it has certain controls or standards in place. Even if something that affects ESG is quantifiable, companies rarely collect the needed data.
There are a number of steps that can be taken to quantify ESG performance.
One of the first steps of measuring ESG performance is to collect data, improve the use of that data, or enhance the reporting of that data.
For example, a transportation company might improve how it tracks mileage and fuel use. Mileage records that were previously only used for maintenance might become part of its financial reports. The company might aim to reduce mileage, show a greater portion of mileage being covered by more environmentally friendly vehicles, or report mileage by fuel type.
With so many different things that fall under ESG, it can be difficult for a company to pick an area of focus. The SASB has set out various topics to track for each sector based on the sector’s largest ESG impacts. For example, agricultural companies focus on the impact on their workers and the environment, while the major concern for airlines is pollution.
Sector benchmarking compares companies within each sector. For example, an airline will generally have a high environmental impact, because there is only so much that can be done to reduce the pollution caused by jets. This means that an airline that is doing everything possible to reduce its environmental impact could have a lower environmental impact score than a company that is in a naturally greener industry but that doesn’t actively do anything to manage its environmental impact. Sector benchmarking allows for a more apples-to-apples comparison that shows which companies are the leaders in each industry.
In standard financial reporting, everything flows to the bottom line. While there are different categories of income and expenses, each contributes to the net profit. ESG measures don’t have a clear flow and often compete with each other. For example, increasing quality of life for workers may include steps that impact the environment.
It’s important to track measures for each stakeholder and category. This might include having separate measures to define how workers are being treated, such as hours worked or wages in relation to the poverty level. Stakeholder factors often seem obvious once they’re defined. The most important step is to identify all the relevant stakeholders to ensure that the impact on each is measured.
With any business objective, budget, time, and other constraints come into play. While measuring individual areas of ESG performance is important, companies also want to track their entire performance. ESG scores are the primary way of accomplishing this.
ESG scores take the raw data, rank it by importance, and give a high-level view of how the company is doing. As with sector measures, different categories of ESG measures have different weights. These vary based on that industry’s impact on the environment and how material the issue is to the company’s operations. The system works very similarly to school grades. Different assignments have varying levels of importance to the course grade. In the overall GPA, some courses are worth more credits and more important areas of study have multiple courses. In the end, the company has one overall ESG score but the data for each component of the score is still available.