Companies don’t know if they’re doing well or poorly on the ESG agenda

It is not possible to manage what is not measured. This management concept has taken on new meaning amid the proliferation of ESG (environmental, social and governance) commitments.

With investors directing more capital towards sustainable businesses, many companies are rushing to announce their goals and implement best practices. The challenge, however, is to be able to measure performance on this agenda.

Unlike financial issues, sustainability cannot be evaluated through objective indicators, such as revenue, profit margin and cash flow.

A survey by consultancy Accenture of companies that reported more than $1 billion in revenue showed that the difficulty in measuring, reporting and managing sustainable performance is pervasive, which can even undermine the achievement of ESG targets.

According to the report, only 26% of companies have clear and reliable information to monitor their sustainability objectives.

The survey also indicates that while the majority (78%) of executives are seeking to understand ESG risks in their business, only 47% have defined key metrics and data sources for their reports.

Celso Lemme, professor of finance and sustainability at UFRJ (Federal University of Rio de Janeiro), says that monitoring is challenging, but great advances have been made over the last few years.

One of the reasons mentioned by him is the dissemination of reporting systems —the so-called “frameworks”— such as the GRI (Global Reporting Initiative), the TCFD (Task Force on Climate-Related Financial Disclosures) and the CDP (Carbon Disclosure Project).

“This alphabet soup is not always simple to use, but it is very useful to provide an information structure”, says the professor, who integrates the CDP and GRI councils.

The initiatives provide models for companies to disclose their “non-financial” information, such as carbon emissions, waste management and labor relations.

However, the plurality of indicators did not necessarily help to provide more transparency. On the contrary, the excess of approaches caused a polyphony for investors and for the companies themselves.

So many metrics have led the market to a quest for standardization. In 2020, the Big Four audit firms (Deloitte, PwC, KPMG and EY), called the Big Four, came together to create a common ESG reporting framework.

The measure, led by the International Business Council, an arm of the World Economic Forum, seeks to encourage large companies to adopt the standards.

A similar initiative was announced during COP26, the UN climate conference. The IFRS Foundation, responsible for international corporate accounting standards, inaugurated the ISSB (International Sustainability Standards Board), with the objective of defining sustainable disclosure standards for companies. The idea is to help investors and allow information to be comparable.

Ricardo Assumpção, executive director of the consultancy Grape ESG, says that the profusion of models adopted has created confusion in the market. “There is now a lot of pressure from investors to clean up this mess,” he says.

According to him, the way sustainability is currently measured is flawed, which can be seen in the discrepancy between the assessments of rating agencies (classification).

“If a company does well in one index, there is no guarantee that it will be evaluated well in another”, he says.

As it is a complex topic and less subject to objective indicators, the sustainable performance of a company is hostage to methodological decisions.

One ESG index may give more weight to environmental issues, while another values ​​governance aspects. The consequence of this is that the valuation of the same company undergoes sudden variations from one index to another.

A study by the MIT (Massachusetts Institute of Technology) business school evaluated the discrepancy between the world’s largest ESG rating agencies and concluded that the way to monitor the issue is confusing and unbalanced.

The researchers found that the correlation between scores given by organizations such as MSCI, Sustainalytics and Refinitiv averaged 0.61 — indicating a low alignment between them. The scale ranges from zero (no correlation) to one (maximum correlation). Moody’s and S&P’s credit ratings, for example, are correlated at 0.92.

For Assumpção, initiatives such as the ISSB are positive, as they facilitate the work of companies and investors.

“This is essential for us to be able to compare sustainability. Today, sustainability is unparalleled all over the world — and even more so in Brazil”, he says.

Celso Lemme, from UFRJ, also believes that convergence efforts are meritorious, but he makes one caveat: standardizing too much can take away the essence of ESG.

“If there is no standard, companies are lost, but if the standard is absolute, it becomes a straitjacket. The metric cannot be the target, it is the arrow.”

Sustainability reports reflect little on what the company does

The professor says that companies are measuring their sustainability performance better and more frequently, but only highlighting what they think is going well.

He compares the reports to professional resumes. “Usually people don’t lie, saying they’re doing something that’s not true, but they put more emphasis on what they do best,” he says.

According to Lemme, it is essential to consider materiality, that is, the issues that are impacted by the company’s activity. “Water economics, for example, should not have the same weight in the ESG analysis of a bank and a beverage company.”

Exaggerations in sustainability disclosures were addressed in an article by the Harvard Business Review. The publication argues that although reports have multiplied over the past 20 years, carbon emissions and environmental damage have continued to increase, as have social inequalities.

“Report is not a proxy [procuração] for progress. Measurement is often non-standard, incomplete, inaccurate and misleading,” the article says. “Worse still, a focus on reporting can actually be an obstacle to progress. […]diverting attention from the real need for changes in mindset, regulation and corporate behavior”, he adds.

ESG metrics indicate process, not impact

Another challenge for a company to be able to assess its sustainable performance is the absence of indicators. Not all socio-environmental issues are translated into accurate metrics.

A company’s contribution to the greenhouse effect, for example, can be measured by the amount of carbon it emits. The impacts on biodiversity, for example, are not so easy to monitor.

In other cases, process indicators are confused with impact indicators, as in the case of diversity goals. Companies can measure the number of people of color and women on teams, but they do not necessarily capture the desired result: corporate decisions that reflect multiple perspectives.

Marcos Rodrigues, partner at BR Rating, the first Brazilian ESG risk rating agency, agrees that it is not easy for a company to know its sustainable stage. However, he says there are ways to approach this understanding.

Independent reviews are one of them. Instead of answering a generic questionnaire, the company undergoes an in-depth assessment carried out by a third party, with the help of interviews and documents.

“With another company evaluating, the company will not disclose what it wants. Greenwashing [propaganda enganosa verde] occurs, most of the time, with the use of incorrect or false information. Having an independent review ensures more transparency,” he says.