ESG could build or break trust in companies. Here are 5 ways to do it right

The environmental, social and governance (ESG) movement is at a make-or-break moment. Investor interest has grown to historically high levels, partly thanks to the expectations of a new generation of investors (millennials and Generation Z).

Yet ESG as a topic remains in flux, with a wide range of perspectives on not only the appropriate definition of ESG, but – more critically – information that will best inform capital allocation. This information includes ESG reporting and disclosures, taxonomies, ESG ratings, and underlying science, data, and modeling capabilities.

There are many actors that make up what we define as the “sustainability information ecosystem”: from investors, board directors, management, employees and civil society members to ratings providers, auditors, regulators and policymakers. Currently, there is little agreement within this group on what ESG includes, how to apply agreed metrics and how best to use available data.

There is wide support for a global standard on sustainability reporting and in making a stronger connection between the “F” of financials and ESG – “FESG”. The overwhelming majority of investors (89%) surveyed for the most recent EY Global Institutional Investor Survey said they would like the reporting of ESG performance, measured against a set of globally consistent standards, to become a mandatory requirement.

Furthermore, differing legal systems, as well as varying social and political contexts, influence the principles that determine standards and regulations governing sustainability information. Not surprisingly, different jurisdictions are moving at different speeds and in different ways to develop and implement ESG reporting rules.

In this article, we highlight five areas of focus that, when addressed across the sustainability information ecosystem, can help in the move toward ESG information reporting that is decision-useful and trusted.

While there are increasing connections between the financial and the sustainability information ecosystems, there are additional voices in the sustainability information ecosystem, including but not limited to largely unregulated ESG ratings and data providers, civil society, including activist investors, and employees.

The sustainability information ecosystem intends to serve two primary investor groups:

1. Those focused on financial risk – that is, those who seek material information related to the financial impact on a company of sustainability-related factors

2. Those focused on social impact – that is, those who seek information about the company’s impact on its external surroundings (including on people, communities, the environment, and society)

To better suit the needs of investors looking for useful ESG data, those within the sustainability information ecosystem must build trust and improve collaboration. New EY research, The emerging sustainability information ecosystem (pdf), has identified five areas of focus to support this objective:

With composite indicators, a company is scored on a wide range of ESG issues, with different weights given to each issue to calculate an overall ESG rating. These issues include everything from climate change to pollution and waste, from product liability to tax transparency.

One challenge is that ESG ratings do not serve investors interested in social impact, as they are weighted on financial materiality. Each of the largest ESG ratings providers uses a financial materiality (i.e., financial risk-based) approach in developing ESG ratings. Furthermore, investors focused on financial risk can find that a lack of transparency over the weighting of ESG topics reduces clarity and decision-usefulness.

The composite approach presents a number of other challenges as well. For example, a lack of consensus on definitions and calculation methodologies can hinder rigorous analysis of an organization’s environmental performance. Meanwhile, social issues – such as human rights, labor standards, and ethno-racial and gender equity – can be harder to quantify against an agreed benchmark, due to social and political differences between jurisdictions.

Investors need to be aware of these distinctions, measurement limitations, and variations.

Sustainability information can serve two purposes: to assess financial risk and to assess social impact. These uses are not mutually exclusive but are easily confused.

To date, the sustainability information ecosystem has evolved to meet the expectations of stakeholders who are primarily interested in assessing financial risk. For example, most ESG reporting regimes, as well as all the major ESG ratings providers, do not gauge a company’s impact on society. They measure its relative exposure to various internal and external financial risks, as well as opportunities.

Yet, recent growth in ESG investing has been driven by investors, including millennials, who prioritize social and moral considerations. A 2020 survey found that nearly three-quarters (71%) of individual investors, globally, want to make a positive social impact as part of their investment objectives, with the response rate for millennials even higher (75%).¹

This begs the question: Is the current sustainability information ecosystem serving both financial and social impact-assessment?

While there are overlaps between the main ESG motivations, there remains a need for more clarity on the distinct use cases of sustainability information. Equally, there is an opportunity for stakeholders within the ecosystem, including standard setters and ESG rating agencies, to consider how they can address the needs of all users of sustainability information.

Independent assurance can help to build trust in sustainability information and the many actors who comprise the sustainability information ecosystem.

Market forces will increase demand for robust, independent external assurance over sustainability information in the coming years. Already, the United States and the European Union are considering mandatory assurance requirements for sustainability disclosure rules.

As the demand for assurance rises, it will be critical that actors in the sustainability information ecosystem recognize and adhere to the risk management concept known as the “three lines of defense”. These lines are widely recognized as critical for building trust and maintaining a rigorous reporting system that provides accurate and unbiased information. They comprise the following:

To achieve real transparency and comparability in sustainability information, jurisdictions need taxonomies founded on complementary principles. Taxonomies are systems that determine which economic activities should be considered sustainable. They can help to clear up confusion over what is considered sustainable and what is not by giving a clear, data-driven reason as to why a particular activity falls within (or outside) that taxonomy’s definition of sustainability.

Some regions and countries are already making considerable progress with developing taxonomies. For example, the EU taxonomy is intended to help the EU scale up sustainable investment and implement the European Green Deal (the European Commission’s plan to make Europe climate-neutral by 2050).

The EU is also working with China on a Common Ground Taxonomy in an effort to find commonalities within taxonomies while reflecting different energy transition pathways, as well as political realities.

Emerging economies will account for a large majority of the world’s greenhouse gas emissions by 2050. Yet they have less resilience to be able to adapt to the impacts of climate change compared with some other markets. Due to their location, they are also likely to be more exposed to severe climate-related events.

The absence of comprehensive sustainability data in emerging economies suggests a need to lower barriers for market participants in these economies to disclose sustainability information. This is not to advocate different standards, which could be counterproductive. However, there should be more upskilling of technical assistance and engagement with emerging economies in the sustainability information ecosystem.

The international standard-setting work being done by the International Sustainability Standards Board may also benefit emerging countries, if they take the opportunity to adopt its standards into their own legal frameworks.

The ESG movement is still in its infancy – and much more work is needed to encourage open collaboration and trust-building. Nevertheless, it is encouraging to see that policymakers, standard-setters and regulators are already taking important steps to define and regulate the information investors seek. At the same time, market participants are collaborating in new ways to develop innovative reporting and data modeling solutions.

As these efforts move forward, it is critical for all stakeholders to engage in both the policy process as well as market-led initiatives and to make their voices heard. The actions we have explored are a contribution to these efforts and underscore why building alliances and forging collaboration is everybody’s business.