Observers Say ESG Disclosure Principles Need Refreshing

Influential management consultant Peter Drucker famously said that if you can’t measure something, you can’t manage it. In other words, you can never tell how something is performing if you lack a way to quantify its performance. That’s all well and good, but what if the real problem is that your system of measurement is bad?

According to an article published this month in the Harvard Business Review, companies and investors that focus on environmental, social and governance matters are suffering from just such a problem. In sum, the piece contends that today’s best practices for recording companies’ ESG performance have become outdated. “Our research shows that ESG ratings — and thus the investments associated with these ratings — are suffering from a ‘measurement trap’ that occurs when a metric used as part of the ESG rating is systematically biased toward certain industries or certain types of companies,” wrote the article’s trio of authors.

The academics who penned the HBR article – Lauren Cohen of Harvard Business School, Umit G. Gurun of University of Texas at Dallas and DePaul University’s Quoc Nguyen – began studying what they termed the “ESG-Innovation Disconnect” years ago. In the latest update on their inquiries, the group dives into what they perceive as “structural biases in ESG ratings.” The article highlights three measurement traps that they say degrade the quality of the measurements they’re taking.

First, there’s the error of zeroing in on metrics that can be easily measured. For example, the authors note that when companies report their easily obtainable Scope 1 carbon emissions, they’re not giving financial-statement users a full picture of how their businesses affect the environment. As a result, they’re obscuring their environmental impact if they don’t disclose indirect emissions through the companies’ value chains.

Meanwhile, the authors say our general approach to creating categorical frameworks also tends to oversimplify what is getting rated. Lastly, complex ESG data doesn’t fit nicely into individual measures.

So how are we to overcome these obstacles to creating useful ESG metrics? The authors offer two suggestions of their own.

The first is to “unbundle” ESG. That means treating environmental, social and governance issues as separate and distinct from one another. The academics contend this would enable companies and investors alike to pay even closer attention to the factors that matter most to them.

Additionally, the authors encourage companies to choose where they focus their energy when it comes to ESG efforts. This approach eliminates the possibility of companies trying to make their ESG initiatives into broad, ineffectual campaigns. It also prevents companies from turning ESG programs into perfunctory exercises by diverting resources away from more effective ESG efforts.

Bear in mind that in the wake of the Supreme Court’s decision earlier this year to overturn Chevron deference, ESG reporting appears likely to, at some point, fall out of the purview of the Securities and Exchange Commission. With companies themselves taking a more active role, don’t be surprised to see some of them get creative with what they choose to disclose and how they choose to disclose it.