Fall 2023 Workshop

• We’ve seen this movie before. Professor Eddie Riedl kicked off the event with an overview of the relevant history. He reminded us that prior to the 1920s, even financial statements were not required disclosures. This information was only mandated following the establishment of the Securities and Exchange Commission (SEC) in response to the historic stock market crash of 1929. Previously, firms varied considerably in the nature and quality of financial information provided; subsequently, the process and general nature of reported financial information became much more uniform.Over recent decades, we have witnessed other examples of additional reporting, which has become mandatory, often despite initial resistance. In the 1990s, in response to the Savings & Loan crisis, fair value reporting became mainstream as required disclosures and reporting. In the early 2000s, as capital markets became global, International Financial Reporting Standards (IFRS) were implemented, bringing financial reporting from multiple domestic reporting standards towards a more uniformly applied set of global reporting standards.Across all of these instances, debates arose regarding the merits of transitioning to a new reporting regime. Each reflected progressive leader firms initially providing this information voluntarily, industry groups slowly coalescing around common metrics, and ultimately, regulators enshrining a standardized reporting framework. That is, in time, all these major reporting shifts have now become mainstream and widely accepted as best practice. Most in the room anticipated a similar story to emerge for several ESG metrics.

• We won’t get it right immediately, and there is value in moving towards some standardization. The panelists recognized that the conversations today around Scope 1 and 2 carbon emissions were unimaginable 20 years ago, suggesting significant progress in this area. Yet, it seems likely that initial efforts to report ESG data will reflect errors. Previous challenges in financial data led to the emergence of an industry to interpret financial information (including the Chartered Financial Analyst (CFA) professional). While the panelists do not expect initial disclosures to be perfect, they do expect such metrics to evolve. Further, there appears a collective appetite for companies to disclose such measures, reflecting demands from various stakeholders. Nonetheless, time is needed for effective and informative metrics to develop. Any impediments should not stop us from starting now.
  
  There was also considerable discussion regarding the value of having standardized ESG metrics in the future, even though they are complicated and expensive to report today.
   
• Reporting isn’t free and the playing field should be leveled. The panelists acknowledged that there are costs to additional reporting. However, the consensus was that these costs will decline over time as we shift from the current unregulated ESG environment towards more standardization of regulation. There was agreement that firms providing useful ESG information should not be disadvantaged compared to those who choose not to report, suggesting another motivation for moving towards some standardization. Moreover, topical areas that do not necessarily reflect short-term financial implications, for example, environmental or social metrics, should also be included in regulations as they also reflect relevant information (albeit, for longer-term horizons).
   
• The best managed companies are already looking at this information, just not in a standardized format. Our panelists noted that ESG is evolving from its historical positioning as a separate topic towards being intertwined with and core to the company strategy; if you’re not currently looking at these issues, it’s likely you’re not running your business well. Integrated reporting (reflecting ESG + finance) appears to be the way forward. For example, companies should already know if their facilities are subject to the risk of wildfires and should be disclosing this information. Enhanced regulation will make this easier, despite the costs.  

How do today’s ESG risk disclosures compare to a voluntary standard (SASB)?  Are the practices of the largest firms within an industry more influential than voluntary standards? 

Professors Estelle Sun and Eddie Riedl have been measuring ESG risk disclosures in current SEC 10-K filings. Their work compares current filings with guidance from SASB, a quasi-regulator that has proposed voluntary standards using 26 different categories of ESG topics. SASB indicates which sustainability topics are material within each industry and therefore should likely be described in a company’s risk disclosures. 

The researchers looked at the risk factors section of SEC 10-K filings, where companies are required to disclose material risks. They then compared this content with what SASB recommends regarding ESG disclosures within that industry, assessing how consistent or inconsistent companies are with the SASB recommendations. They also compared the consistency and inconsistency of these ESG risk disclosures with industry leading firms.   

What they found is that companies disclosed less than 50% of what SASB recommends regarding material ESG topics within this risk factors section. Furthermore, they determined that firms on average disclose 40% of reporting topics deemed immaterial by SASB. Noting a weak correlation with SASB recommendations, they then compared these ESG risk disclosures within an industry against the largest players in the same industry and found that about 70% of ESG topics disclosed by the largest firms were also disclosed by other firms. Finally, they documented that the strongest predictor of current ESG risk disclosures for so-called “left-tail” outcome (ESG-related penalties and incidents) primarily relate to what the largest companies within an industry are disclosing, rather than what SASB recommends.  

Dr. Riedl moderated our panel discussion and asked questions of our panelists. The following has been heavily edited and condensed from the actual conversation. 

What are the most important areas to focus on within ESG?  

Our panelists stressed the importance of conducting a wide stakeholder analysis – investors, customers, shareholders, regulators, employees, and communities – to identify the most critical ESG topics for companies to disclose. They noted that the most important ESG topics will vary across industries, and even from company to company. Understanding materiality and doing a materiality assessment of key ESG topic areas for a company is crucial. Individual companies should continue to report beyond what is regulated for areas of critical importance to their operation. 

What’s the best way to address ESG issues – is it firm-level, industry-level, or a top-level regulatory solution that will work best?  

Our group responded that multi-level answers will be needed, but that we should start at the firm level, as they best understand the unique corporate strategy and thus ESG risk that the firm is exposed to. ESG is not a separate topic but should be intertwined with company strategy. Starting at the firm level and seeing how a firm compares to others in the industry, ahead of regulations, is important. Firms that are doing the right thing should not be put at a disadvantage and, in fact, the most imaginative companies are leading the way. Our panel agreed that things that aren’t necessarily short-term financial, for example, environmental or social metrics, need to be included in regulations so that companies can’t claim that they didn’t know about those issues. It’s important for companies to prepare for new reporting requirements and investors to ask companies about their preparation.

Which is better? Lean on industry to come up with a solution? Or do you want regulation?  

Our panelists agreed on the merits of standardization and a regulatory framework, so long as there remains room for customization of disclosures based on individual corporate materiality analyses. Standardization would create a level playing field and make it easier to point to metrics when speaking with investors, would allow for easier comparisons across companies within an industry, and would improve communication and interaction with investors. The speakers recognized that good companies are looking at these areas anyway, and that investors need to know what the firms are doing. For example, companies should already know if their facilities are exposed to the risk of wildfires and should be reporting this information. The group also expressed a desire for ESG and financial reporting to be viewed not as separate, but as highly complementary in the nature of information that they convey.  

What are you hearing from companies about the costs?  

The costs of reporting additional information are real, because companies need to buy data and build the reporting infrastructure. But generally, this cost was viewed as negligible compared to the potential impact to actually change negative externalities. Over time, the costs will likely decrease and become normalized, as has happened with other required disclosures. It was noted that quarterly reporting of earnings already makes it hard to think and act long-term. Most countries have a semi-annual reporting requirement, rather than the quarterly reporting requirement of the United States. Thus, an open question is how frequent ESG-related disclosures should be provided and updated.  

Let’s talk about frequency of reporting. Should we be thinking about a once-a-year framework? Is there a benefit to doing it more frequently?  

We don’t need quarterly reporting of quantitative ESG data. Rather, investors look for ESG momentum and whether companies are making progress and going in the right direction. If ESG issues are part of the corporate strategy, then company leaders will consistently be paying attention to them. But there’s a lot of pressure to maintain quarterly earnings expectations, as these not only affect external shareholders, but also things like employee morale and a company’s ability to raise capital. Ultimately, companies shouldn’t wait for investors to ask the question; they should be proactive in their reporting, particularly on metrics that impact the sustainability of their business.   

What do you see as the key impediments to getting us to a much more comprehensive ESG reporting framework?  

The impediments shouldn’t stop us. Companies want to disclose, and they’ll need time for metrics to develop. But we won’t get it perfect right away. To get past the issue of boilerplate disclosures, we need well-trained managers who read the research and apply it. It’s easier if there are regulations on data points, which create guardrails for companies who are being proactive and have a pulling effect for companies who aren’t already doing this reporting. Standardization is important and can help with polarity – the short term vs. the long term. Our political environment also has an impact because companies are also hearing from investors telling them NOT to disclose ESG. We see companies doing things and being hesitant to disclose it because of the political environment.   

What are 2-3 insights about how we can create a path forward on this issue?  

Standardized reporting must be the starting point; that will drive the systemic change we need. But that set of standards must allow flexibility. Collaboration among investors across industry would be helpful, because in the end, we all want to be sustainable and improve the world. It’s important for companies who make claims to show the data to back those claims. This reporting can’t be seen as a small area to appease some investors, but rather systemic change is needed.   

Concluding Remarks from Dr. Riedl  

Reporting is now recognized as an important corporate responsibility and we’re moving to a more structured reporting environment. There will be false starts along the way. Creating regulations is important, but standards aren’t enough – it is also critical to understand how those standards are implemented. The United States lags behind Europe in this way. Climate change and carbon emissions aren’t important for just one set of firms, they’re important for all manufacturers across the globe and we need credible information across industries. Part of the way to ensure credible information is that the institutions overseeing that reporting also are credible. This includes the potential role for the auditor, whose job is to safeguard the information and provide a check and balance to the system. We need to be thinking about an integrated reporting framework where ESG measures are central to the company’s mission and strategy. As these metrics are incorporated into the financial statements, they’ll come under the purview of some attestation and oversight beyond just the regulator. Attestation will provide a useful validation of data that will need time to evolve.   

• Reporting standardization frameworks are necessary and helpful to allow for comparisons within industries; it’s especially helpful if the frameworks are specific to industry peer groups. But there needs to be leeway for some estimation, because it’s hard to provide raw data for everything, especially if the company is large.
   
• It’s important to define what we mean by standardization – bright line standards are very prescriptive, while principles-based are more general. It’s important to get the balance right.
   
• Standardized regulations are necessary to ensure company recognition, uniformity of data, and clarity on what is material and as the market matures and technologies advance, standardization will become easier.
   
• Reporting Scope 3 greenhouse gas emissions is essential, but measuring emissions from a company’s supply chain is a challenge. GHG emissions are divided into Scope 1: a company’s direct GHG emissions; Scope 2: the GHG emissions from the energy supplied to a company; and Scope 3: the GHG emissions from up and down a company’s supply chain.
    
• Data quality is a huge issue and companies need to invest in better data systems to ensure that the data they report is valid. Institutions help give more validity to the data and standardization brings more collaboration within companies, elevating internal controls and providing checks and balances.
   
• There’s a lot of diversity in how different companies are managing the huge volume of ESG data and that analysis requires a huge amount of effort and cost. As more ESG information is provided, the challenge is how to weight that information and indicate which is more important; more is not always better, but more data is the intermediate step and then we will start to gravitate to a lower number of metrics.
   
• Investors and companies prefer hard numbers and currently there’s an emphasis on quantifiable disclosures.
   
• There is a range of how companies are handling ESG disclosures – from investors simply asking companies to check a box versus wanting to know if companies are actually doing something meaningful with regard to reducing their environmental impact.
   
• From the investors’ standpoint, clients want to see the raw data and it’s important to understand ratings across agencies; standardization is important because it provides information on what is most material. From a corporate perspective, it’s important to report on what is deemed material, and to get recognition for reporting.