According to this recent study from consulting firm McKinsey, investors want to see a different kind of sustainability reporting. The authors observe that, in light of mounting evidence “that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind.”  Although there has been an increase in sustainability reporting,  McKinsey’s survey revealed that investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.”  Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible.  According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting.  The rub is that, ironically, it’s the SEC that isn’t on board with that idea—at least, not yet. 

In response to a question from McKinsey about sustainability standards, 14% of investors said there should just be fewer standards, but an overwhelming 75% of investors said there should be only one standard. Executives had a similar perspective:  28% said there should be fewer standards, and 58% said there should be only one standard. In addition, the vast majority of investors agreed or strongly agreed that more standardization would help with effective capital allocation (85%) and with more effective risk management (83%). A similar majority of executives agreed or strongly agreed that more standardization would help their companies benchmark against their peers (80%) and enhance their companies’ ability to create value or mitigate risk (68%). What’s more, 82% of investors said companies should be legally required to issue sustainability reports and, surprisingly, 66% of executives agreed.

According to McKinsey, there is quite a proliferation of frameworks and standards that have been developed by numerous organizations: the Global Reporting Initiative (GRI), the Greenhouse Gas Protocol (from the World Business Council for Sustainable Development and the World Resources Institute), the UN Global Compact, the Carbon Disclosure Project (now CDP), the International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board (SASB) (see this PubCo post)  and the Embankment Project for Inclusive Capitalism. The volume of frameworks leaves companies to make a choice. McKinsey reports that, in making that choice, many companies consult “members of stakeholder groups—consumers, local communities, employees, governments, and investors, among others—about which externalities, or impacts, matter most….” Together, all of the choices and inputs has led to a lot of diversity in the disclosure, which is both “a defining feature of sustainability reporting as we know it—and a source of difficulty.”

That’s not to say that 30 years of sustainability data is useless—stakeholders have used it compare sustainability performance year over year at individual companies and to detect patterns, trends and even rankings in aggregated data. Academics and other analysts have used the data to examine the link between sustainability performance and financial performance, showing correlation if not causation. Now, with sustainability having become mainstream, asset managers and other institutional investors are paying more attention to sustainable-investment strategies and integration of sustainability factors into investment analyses.

The growth of sustainability as a factor in investing has fueled the demand for sustainability disclosures that meet the following three criteria identified by McKinsey: financial materiality, consistency and reliability.

With regard to financial materiality, McKinsey says that investors clearly want more disclosure about sustainability that is material to financial performance. And this desire represents a shift: an executive at “a large global pension fund remarked, ‘The early days of sustainable investing were values based: How can our investing live up to our values? Now, it is value-based: How does sustainability add value to our investments?’” (See this PubCo post and this PubCo post.)  Financial materiality seems to be something of a no-brainer. Even Commissioner Peirce has acknowledged that, to “the extent that some ESG issues may have a material financial impact, there is little controversy that those issues should be disclosed, not because of ESG, she contends, but because they are financially material.”

Investors and executives identified the inconsistency, incomparability and lack of alignment of standards as the most significant challenge of sustainability reporting.  That applies not just to companies that produce their own reports, but also to third-party services. According to McKinsey, these “services use different methods to estimate missing information, so there are discrepancies among data sets. Some services normalize sustainability information, replacing actual performance data (such as measurements of greenhouse-gas emissions) with performance scores calculated by methods the services don’t reveal. Research shows a low level of correlation among the data providers’ ratings of performance on the same sustainability factor….Similarly, proprietary indexes and rankings of sustainable companies, which some asset managers use to construct index-fund portfolios, can also diverge greatly. It is not unusual for a company to be rated a top sustainability performer by one index and a poor performer by another.”

And then there are serious questions about the reliability of some of the data and the systems in place to collect it.  For some factors, such as greenhouse-gas emissions, the systems are well established, but gauging other factors, such as corporate culture, are more subjective.  Moreover, nothing is audited.  The survey showed that 97% of investors—and 88% of executives—thought there should be some type of audit, and 67% of investors (36% of executives) thought the audit should be as rigorous as a financial audit.

McKinsey concluded that the most salient priority for sustainability reporting was “ironing out the differences among reporting frameworks and standards.” Investors believe that more uniformity in reporting standards would “help companies disclose more consistent, financially material data, thereby enabling investors to save time on research and analysis and to arrive at better investment decisions. Some efficiency gains would accrue as third-party data providers begin aggregating sustainability information as consistent as the information they get from corporate financial statements.”  Sixty-three percent of investors “said they believe that greater standardization will attract more capital to sustainable-investment strategies. However, about one-fifth of the surveyed investors said that uniform reporting standards would level the playing field, diminishing their opportunities to develop proprietary research insights or investment products.”  Executives identified as problematic the excessive amount of effort and expense devoted to answering numerous  requests for the same sustainability data, tabulated in different ways to conform to different standards.  Harmonized standards, McKinsey concluded, could reduce that burden, and even make an audit more feasible.


Posted by Cydney Posner