Ever since the U.S Securities and Exchange Commission (SEC) proposed rules governing climate-related disclosures from all public companies on March 21, environmental, social and governance (ESG) reporting has become a necessary part for financial company corporate boards to address, especially in today’s environmentally and socially conscious world.
Whether it’s understanding how the financial company is combatting climate change, how diverse the financial company’s leadership is, or what the financial company’s corporate policies are, investors, customers, and even their own employees want transparency into the ESG impacts, both good and bad, of the financial company’s activities and their sustainability initiatives.
However, to fully understand the standards financial company corporate boards need to play in navigating their ESG reporting, we first need to understand what’s wrong with the current system.
The State Of ESG Reporting Today
When financial companies disclose ESG reporting in their annual reports, proxy advisory firms, such as Institutional Shareholder Services (ISS), take that information and basically put it on a rating system, where all of the financial company ESG efforts are graded on an ABCD+- level. Some proxy advisors, including ISS, also assess companies for overall positive or negative social impact and assign them a score. For example, just by visiting ISS’s ESG Gateway, you can see that ISS assigns American Express a “C-” ESG rating and was judged to have a +4.5 positive social impact. Capital One’s ESG Corporate Rating is a “D+” and is judged to have a +1.3 limited positive social impact. Proxy advisors rarely delve deep into the reasoning for companies’ ratings which poses a challenge for investors attempting to ascertain which companies are the most environmentally or socially conscious. For Board of Directors at financial companies, this challenge is even more significant. Because proxy advisors are opaque about their standards for obtaining high ESG marks, it is very difficult to know which factors are most critical. Case in point, American Express and Capital One have relatively similar corporate diversity, pay levels, and operations however they have significantly different ESG and social impact scores from ISS.
Because proxy advisors’ standards are so opaque, a cottage industry has formed of ESG consultants who help companies achieve higher ESG rankings. The challenge is, proxy advisors like ISS also offer such services. Many, including the SEC, have taken issue with this business model because of the potential for conflicts of interest.
This resonates similarly with what happened more than 20 years ago between energy-trading company Enron Corp. and accounting firm Arthur Andersen LLP, as Enron kept debt off its balance sheet when reporting annual financial earnings, thus making them a subject of a federal investigation, and sparking the conversation for a new set of standards to maintain financial integrity. Today’s ESG reporting mirrors this situation, as companies may try to do anything they can to earn a better grade and impress their investors. Shareholders and stakeholders want to see credible environmental and social change through a new set of ESG standards, but the current ESG system needs to first be resolved.
What Needs To Change?
With the current ESG evaluation system seemingly more focused on ratings than bringing about change, proxy advisors issuing these ratings need to consider reforming their organizations to focus on either ESG ratings or ESG consulting, as both operations create the challenges, we are seeing with companies trying to leverage the system for their own beneficial evaluations, instead of actually identifying true change throughout the financial industry. Just like the Enron story, consulting firms were helping the company boards prop themselves with false reporting, leaving shareholders to hold the bag of worthless stocks and company valuations at the end of the day.