The Impracticality of Standardizing ESG Reporting (ESG: Myths and Realities)
In recent years, rising frustration among investment managers and retail investors over the plethora of competing ESG reporting standards and rating agencies has led to calls for standardizing the mandatory disclosures of ESG information. While in theory having a universal ESG reporting framework—similar to what we have for financial reporting—would bring consistency to ESG reporting, in practice, serious implementation and enforcement challenges would arise from mandating a uniform set of ESG reporting standards that apply to all public companies. This essay discusses the challenges and argues that implementing and enforcing a standardized global ESG framework is impractical and would be extremely costly due to the distinctive features of ESG reporting, which differentiate it from financial reporting.
A significant challenge when mandating uniform ESG disclosure regulations and applying them to all public companies is related to implementation difficulties. In particular, identifying ESG materiality (i.e., defining what specific ESG issues are topics for reporting) will inevitably be arbitrary and unsatisfactory to many “stakeholders.” ESG encompasses a broad set of issues including waste and water management, supply chain management, hiring and compensation, and climate change. Stakeholders’ interests in ESG differ. Hence, so do their views of what is of material interest for corporate disclosure.
Adding to the identification challenge is the fact that the materiality of specific ESG information will depend upon company-specific attributes including geographic location, industry, and business model. Furthermore, given the likely divergence of viewpoints on the importance of specific ESG issues, standardizing ESG disclosure across public companies will inevitably involve value judgments thereby making the process political and costly.
Supplying accurate and understandable information is another challenge facing efforts to standardize ESG-related disclosures. Given the scope of ESG issues that are of potential interest to varied stakeholders, it is likely that any disclosure standards implemented will be broad. Broad standards would leave more room for managerial interpretation of what specific ESG information should be reported and could therefore result in ESG misreporting. On the other hand, were specific standards to be applied generally, it would be likely that the standards would not fit the circumstances of any particular firm and, hence, would be of limited value to any set of stakeholders.
Supplying accurate and actionable ESG information in a standardized format is further challenged by the reality that much of the information that might be relevant to specific stakeholders is not quantifiable. Even when ESG behaviour and outcomes are readily measurable, assigning monetary values to them is often not possible. How can we, for instance, objectively assign a monetary value to the racial or gender composition of board membership? Without being able to aggregate the ESG-related activities and performances of disparate companies into a uniform metric, it will be impossible as a practical matter to rank companies by any standardized index.
Finally, effectively enforcing mandated common ESG reporting standards across all public companies would be challenging because ESG metrics are highly subjective, frequently rely on internal information, and lack external reference points such as industry benchmarks. Verifying ESG information for internationally diversified companies with large and dispersed supply chains would be extremely costly, if not impossible, because companies might not have ready access to the ESG information they are expected to report, particularly as the requisite information resides outside their legal jurisdictions.