There is increasing pressure for businesses and other organizations to be vehicles for social good. Alongside this focus on corporate social responsibility has been the rise of social entrepreneurship and impact investing. Frontiers in Social Innovation brings together leading thinkers from academia and the business world to tackle important questions in the domain of social enterprise and develop practical, actionable solutions.
We present an excerpt from a chapter by Stanford Law Professors Paul Brest and Colleen Honigsberg, “Measuring Corporate Virtue and Vice: Making ESG Metrics Trustworthy.” Organizations ranging from nonprofits to startups to Fortune 500 companies are facing calls to report their social impact. Some think of social impact from a “do no harm approach,” arguing that companies should be cognizant of externalities caused by activities related to the environment, social issues, and governance (ESG). Others believe that companies should be demonstrating positive net social impact they make in the world. Regardless of which approach one takes, impact measurement is of paramount importance.
However, as Brest and Honigsberg compellingly argue, the field of impact measurement is often characterized by hand waving and greenwashing. As an example, many leading ESG metrics are weakly correlated with one another, suggesting poor theorizing and measurement techniques. The authors not only discuss the specific problems in the field of impact metrics but also lay out institutional and strategic solutions. Some of these solutions can be implemented at a company level while others require both domestic and international regulation. Brest and Honingsberg not only cover long-studied areas of social impact (e.g., carbon production) but also emerging domains such as racial and gender equity. This chapter is a must-read for anyone who wants to take impact measurement seriously and not simply treat it as window dressing.—Neil Malhotra
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An increasing number of corporations aspire to meet demands to improve their environmental, social, and governance (ESG) performance. In 2020, one out of every three dollars under professional management in the United States was managed according to “sustainable”—a term broadly synonymous with ESG—investing strategies. The stakeholders interested in ESG measures extend well beyond investors and the companies’ own management. They include employees at the company and in its supply chain, consumers, regulators, and those subject to companies’ environmental and social impacts. These stakeholders may wish to assess a company’s performance for any number of reasons. For example, they may want to improve performance, reward or punish the company, induce a company to internalize its external environmental and social costs, or predict the company’s future financial and ESG performance.
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 financial metrics used to evaluate a company’s balance sheet and its 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. For these reasons, among others, it is not 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 achieving high-quality ESG reporting. In particular, we suggest that a comprehensive framework for ESG reporting must address the following three factors:
- A limited set of metrics, primarily concerned with a company’s key environmental and social impacts. Part 1 of this chapter summarizes the current state of the measurement of companies’ ESG outcomes—particularly the E&S factors, sometimes referred to as “planet” and “people”—and the prospects for improvements. It concludes by describing the requirements of a full-fledged social accounting framework. Part 2 samples the existing reporting requirements for some basic environmental and social issues. Our goal is to explore the possibilities for developing a robust framework and scalable system that captures a company’s major E&S effects.
- A standard-setting body modeled on the Financial Accounting Standards Board (FASB) to develop and particularize those metrics. In Part 3, we suggest that the lessons from financial accounting are instructive in developing an ESG standard-setting body. Financial accounting went through a series of standard-setting bodies before creating the FASB, and FASB is commonly thought to be more successful than its predecessors due to its greater financial, industry and political independence.
- Reporting infrastructures that allow companies to collect, report, and verify the relevant metrics. The reporting framework must produce information that is accurate, objective, and verifiable, but the history of financial reporting has demonstrated the difficulty of generating this type of high-quality data without formal processes and procedures. Thus, in Part 4, we show that companies need robust internal and external reporting frameworks (i.e., internal control systems and third-party auditors) to generate the underlying data and verify the reported information.
ESG reporting is still in a primitive stage, akin to financial reporting in the early-20th century. An article on The Current State of Sustainability Reporting describes these challenges:
- Competing frameworks and standards designed for different audiences.
- Lack of standardization of ESG metrics or performance indicators.
- Measurement uncertainty (many types of sustainability information cannot be accurately measured).
- Different definitions of “materiality,” complicated by evolving criteria related to sustainability.
- Inconsistent reporting methods.
- Disclosures in the form of vague, nonspecific “boilerplate language.”
- Lack of comparability of disclosures.
The history of efforts to improve E&S outcomes by monitoring companies and their suppliers has been full of disappointments. While this has led at least one thoughtful student of the field to look for radically different proxies based on the quality and stability of business relationships, it has also motivated several concerted (but not altogether coordinated) efforts to improve the reporting standards:
ESG metrics as a whole will never have the accuracy, validity, reliability, and commensurability of financial metrics. Yet the considerable efforts to improve ESG metrics described above reflect the increasing interest in them, not only as indicators of companies’ financial performance but of their impact on people and the planet. In the spirit of not letting the perfect be the enemy of the good, it makes sense to rely on the particular metrics that have reached maturation while working to bring the others up to their level, and to treat the integration of the widely disparate E&S metrics as highly aspirational. However, the burden of the last sections of the paper is that without an independent standard-setter to update metrics and strong reporting infrastructure to induce compliance and accuracy, a company’s reports on its metrics cannot be taken at face value. These features are essential components of a robust and useful ESG framework.