Katharina Cavano l Palladium - Aug 27 2021
Is it Possible to Measure Morality? Improving ESG Reporting and Methodology

Credit: Roy Perez

Corporations are now being asked by stakeholders, both internally and externally, to take on added purpose beyond profits. There’s an expectation that companies will become environmentally and socially accountable by reporting on a broader set of metrics than just those on the balance sheets.

Today, 58 percent of S&P 500 Index companies issue ESG (environment, societal, and governance) reports, guided by standards set by multiple standard setting organisations.

But those diverse standards often serve to confuse matters, a problem compounded by the fact that each component of ESG is inherently different, making a common framework against which the three can be measured almost impossible.

In July, Palladium thought leader and creator of The Balanced Scorecard, Dr. Robert S. Kaplan, published How to Fix ESG Reporting. The latest working paper from the accounting academic and Harvard Business School professor, aims to provide improvements in reporting for ESG matters for corporations globally.

“There are a lot of different groups introducing different ways to evaluate and measure ESG out there,” says Eduardo Tugendhat, Palladium Director of Thought Leadership. “Companies are tying themselves up in knots trying to utilise these standards and often they’re not particularly effective because they focus more on outputs than outcomes, making it difficult to either assess impact or compare.”

According to the working paper, the breadth of ESG reporting allows corporations to gloss-over implicit moral trade-offs when their actions improve one of the reported ESG metrics, but worsen performance for an unreported metric. Take for example, a car company that only manufactures and sells electric vehicles, great for the environment and carbon emissions, but purchases minerals from impoverished artisanal miners with practices that are environmentally and socially harmful.

“Companies work within systems, and they have to properly account for what they’re doing within those systems.”

For both Tugendhat and Kaplan, this proves to be the crux of the issue, and without means of measuring these issues throughout a business’ unique ecosystem, you can’t solve the issues themselves. Reporting is further complicated when it comes down to considering who in a business’ system gets credit for their mitigation efforts, and how actors within the supply chain are incentivised to also meet ESG standards.

“That car company must incentivise the mining company by giving them some of the downstream benefits of the industry and vice versa, the car company must take on and share some of the responsibilities and liabilities,” Tugendhat explains. “Companies work within systems, and they have to properly account for what they’re doing within those systems.”

Systems-Level Reporting

So, in a complicated world where corporations work within extensive global systems, how can ESG reporting truly capture and measure a multitude of diverse issues? How to Fix ESG Reporting suggests that it must be based on the distinctive measurement issues in each of its dimensions in order to be as relevant and reliable as financial reporting. In this context, metrics for E and S are easier to capture because they’re based on a clear objective, while reporting on G, tends to get a bit muddled.

“One of the important things to remember is that E and S can be really clearly focussed on outcomes, but good governance (G) is a process, not an outcome,” notes Tugendhat. Given the global focus on climate change, impact on greenhouse gases (GHG) is the most obvious outcome under E, but these can be defined based on materiality in a particular system. For example, water and biodiversity can take on particular significance.

Defining meaningful outcome-oriented metrics for S have proven more difficult. For example, counting the number of people trained says nothing materially about whether this results in jobs and prosperous livelihoods.

He adds that companies must get to a place of measuring E and S in a way that makes sense to them and their stakeholders before addressing the G, which becomes the process for managing and achieving those strategies and goals. That’s where Kaplan’s recommended cost-accounting methodology and principles comes into play, giving organisations a way to measure the values related to the different metrics and how these are properly allocated to the different actors in the system.

Rather than attempt to capture everything with ad hoc ESG metrics, the working paper recommends that corporations begin with wide-spread adoption of specific metrics of environmental and societal performance and incorporate the governance component into reporting on the whole. Kaplan notes though, that there should be a focus on learning how to report and audit just a few highly relevant and controllable metrics before expanding disclosures to a broader set of metrics.

Read the working paper, How to Fix ESG Reporting, and contact info@thepalladiumgroup.com for more information.