ESG: A market challenge with a market solution

The House Financial Services Committee recently discussed proposed legislation that would require companies to report environmental, social and governance information.

ESG disclosure has become mandatory in Europe and the U.K., partly because — when done effectively — it can help investors better understand the risks and opportunities embedded in their investments. One of the arguments put forward by opponents of the legislation is a familiar one: the high cost corporations bear in supplying this information versus the benefits they gain. However, this line of thinking overlooks the costs of not reporting and discounts the potential financial upside of enhanced ESG performance. For example, research suggests that companies’ access to and cost of capital will suffer if they don’t supply investors this information, particularly in a global environment where their competitors are increasingly likely to be doing so. Furthermore, it is well-established in empirical analyses that with appropriate strategic focus, good corporate stewardship leads to greater risk-adjusted returns on investments, and in academic financial literature that such a focus also drives improved return on sales, sales growth, return on assets and return on equity.

Armed with this understanding, investors are increasingly incorporating ESG considerations into their investment decisions in order to allocate capital to the most efficient users of that capital. In fact, more than 2,300 organizations representing more than $86 trillion in assets have become signatories to the Principles for Responsible Investment, which supports the integration of ESG factors into investment and ownership approaches. But for a market to be allocationally efficient, it must first be informationally efficient. Investors need ESG information that is both relevant and reliable if they are to make informed decisions concerning whether or not to invest in a company or whether to overweight or underweight an investment compared to a benchmark.

In the absence of financially material, decision-useful sustainability information from companies, investors turn to other sources of information. To fill the void and satisfy investor demand for information, a new industry has developed to try to estimate how “sustainable” a company is relative to its peers. These third-party data providers cull through publicly available information from various sources and create rankings or ratings of companies with respect to their performance on a range of sustainability issues. Investors use this information in investment decisions; however, the data do not always reflect what companies are truly doing concerning corporate stewardship and often lack clear financial implications. Moreover, the data are often inconsistent and not comparable across firms. This is why it is important for corporations to tell their own story and provide financially material sustainability information directly to investors in a way that is consistent, comparable and reliable.

Of course, companies are increasingly reporting sustainability information. Indeed, 86 percent of S&P 500 companies produced a standalone sustainability report in 2018. However, this information often lacks clear links to a company’s financial condition, operating performance or market valuation, which is what drives investor decision-making. A 2018 Bank of America Merrill Lynch report indicated that 100 percent of corporations polled felt confident in the quality of ESG information reported, while only 29 percent of investors polled were confident in the quality of ESG information they were receiving. Moreover, 60 percent of corporations, but only 8 percent of investors, polled thought that existing ESG disclosures allow for comparison across companies and peers. In other words, investors need consistent, financially material data they can use to compare companies and determine where to invest their capital. Investors want to know the companies in which they are investing are sustainable — meaning they will be around for the long term. Investors want to know that corporations are good stewards of corporate assets, which increasingly consist of intangible assets that today account for approximately 85 percent of corporate market value. Just 30 years ago, that number was slightly over 30 percent, which demonstrates why it is critical that companies more effectively measure, manage and report their non-financial risks.

Indeed, mismanagement of what would traditionally have been considered “non-financial” risks and opportunities can have clear, direct and significant financial impacts for both companies and their investors. In other words, “non-financial” risks can become financial risks, which can quickly become, as we have seen before, fatal for a company. This is why, at least in part, we’ve recently seen a large consumer goods company make a staggering $15 billion write-down as consumer preferences shift toward healthier, more natural alternatives to packaged foods. It is, in part, why a social media giant’s increasingly shaky stock price took one of the largest single-day hits in history (about $120 billion in market cap) as the company’s data privacy foibles piled up. It explains, in part, why, in the wake of a prominent commercial bank’s governance failures, the company’s stock price stumbled during a year when its industry rivals gained between 33 to 46 percent on a wave of optimism buoyed by the promise of tax cuts and regulatory reform. And it is why, in part, one of the largest utilities in the U.S. lost roughly two-thirds of its market value, saw its credit downgraded to junk status, and filed for bankruptcy after equipment failures resulted in a series of wildfires. Each one of these is an example of losses relating to so-called “non-financial” risks which investors have a right to know — risk exposures for which the Sustainability Accounting Standards Board (SASB) provides tangible metrics along its five key risk dimensions: Business Model & Innovation, Social Capital, Human Capital, Leadership & Governance, and the Environment.

Although a wide variety of sustainability reporting frameworks have emerged, SASB is the only organization in the ESG space that is focused solely on the needs of global capital markets. With those needs in mind, SASB provides a complete analytical framework and robust ESG standards and metrics across a wide spectrum of industries and a full suite of material risk dimensions — all designed to facilitate more effective communication between companies and investors, creditors and even insurance underwriters who are exposed to issuers’ contingent liability tail-risk.

By focusing on the subset of sustainability issues most closely linked to business outcomes in each industry, SASB standards can help sharpen the focus of a company’s ESG efforts and streamline its reporting. (Indeed, there are 77 industry-specific SASB standards, which, on average, contain just six disclosure topics and 14 performance metrics.) Companies using SASB standards can benefit from greater transparency, more effective risk management, improved long-term performance and a stronger, more valuable brand. Meanwhile, for investors, SASB standards provide the framework and metrics needed to identify inefficiently priced, residual ESG risks embedded in their portfolios, analyze related performance across peer corporations, and allocate financial capital to its highest and best use. Although corporate sustainability initiatives are nothing new, SASB’s approach is unique. In short, it provides practical tools that capital market participants can deploy where the rubber meets the road.

U.S. equity markets, at $30.5 trillion, represent 44 percent of global market capitalization. Whether or not federal policy makers want to write legislation or create new regulations related to ESG disclosure, investors in the U.S. and beyond are demanding — and will continue to demand — sustainability information. SASB represents a market-driven solution that requires no new regulation and observes traditional concepts of financial materiality. SASB’s work is based on extensive feedback from companies, investors and subject matter experts to ensure the industry-specific standards are focused on financially material issues and that the benefits of reporting exceed its costs.

Since the launch of SASB standards in November, a rapidly growing number of companies — including many of the world’s largest — have begun to use the standards in core communications with investors. As more companies increasingly recognize the value of relevant, reliable, investor-grade ESG data, markets will need accountants’ expertise in measurement, controls, assurance and reporting. Ultimately, high-quality, investor-focused ESG reporting can help corporations develop their awareness and understanding of financially material sustainability risks and opportunities and establish effective risk responses that create long-term value for themselves and their shareholders while facilitating sustainable and inclusive economic growth for society at large.