ThinkTWENTY20

By Rashida Salahuddin

Rashida Salahuddin is the President & CEO of The Corporate Citizenship Project. She is spearheading this project to address the challenges and ethical issues she has seen first-hand in the field of corporate governance. She believes that corporate America should be transparent and should practise what they preach. For more information, visit https://corporatecitizenshipproject.com/.

Ever since the U.S Securities and Exchange Commission (SEC) proposed rules governing climate-related disclosures from all public companies on March 21, environmental, social and governance (ESG) reporting has become a necessary part of financial company corporate disclosures, especially in today’s environmentally and socially conscious world.  

Whether it’s understanding how a financial company is combatting climate change, how diverse its leadership is or what its corporate policies are, investors, customers and even their own employees want transparency about the ESG impacts, both good and bad, of the company’s activities and their sustainability initiatives.  

To fully understand the standards financial company corporate boards need to meet in navigating their ESG reporting, we first need to understand what’s wrong with the current system.

The State of ESG Reporting Today 

When financial companies disclose ESG reporting in their annual reports, proxy advisory firms, such as Institutional Shareholder Services (ISS), take that information and basically put it on a rating system, where all of the financial company’s ESG efforts are graded on an ABCD+- level. Some proxy advisors, including ISS, also assess companies for overall positive or negative social impacts and assign them a score. For example, just by visiting ISS’s ESG Gateway,¹ you can see that ISS assigns American Express a “C-” ESG rating and the corporation was judged to have a +4.5 positive social impact. Capital One’s ESG Corporate Rating is a “D+” and is judged to have a +1.3 limited positive social impact. Proxy advisors rarely delve deep into the reasoning for companies’ ratings, which poses a challenge for investors attempting to ascertain which companies are the most environmentally or socially conscious.

For boards of directors at financial companies, this challenge is even more significant. Because proxy advisors are opaque about their standards for obtaining high ESG marks, it is very difficult to know which factors are most critical. For example, although American Express and Capital One have relatively similar corporate diversity, pay levels and operations, ISS has assigned them significantly different ESG and social impact scores.   

Because proxy advisors’ standards are so opaque, a cottage industry has formed of ESG consultants who help companies achieve higher ESG rankings. The challenge is that proxy advisors, such as ISS, also offer such services. Many, including the SEC, have taken issue with this business model because of the potential for conflicts of interest.

This resonates with what happened more than 20 years ago with energy-trading company Enron Corp. and its accounting firm Arthur Andersen LLP. Enron kept debt off its balance sheet when reporting annual financial earnings, thus making them a subject of a federal investigation and sparking the conversation for a new set of standards to maintain financial integrity.² Today’s ESG reporting mirrors this situation, as companies may try to do anything they can to earn a better grade and impress their investors. Shareholders and stakeholders want to see credible environmental and social change through a new set of ESG standards, but the current ESG system needs to first be resolved. 

What Needs to Change? 

With the current ESG evaluation system seemingly more focused on ratings than bringing about change, proxy advisors issuing these ratings need to consider reforming their organizations to focus on either ESG ratings or ESG consulting, as both operations create the challenges we are seeing with companies trying to leverage the system for their own beneficial evaluations, instead of actually identifying true change throughout the financial industry. Just as in the Enron story, consulting firms were helping the company boards prop themselves up with false reporting, leaving shareholders to hold a bag of worthless stocks and company valuations at the end of the day. 

Even though the ISS is not the only proponent of ESG ratings, proxy advisors use their own methodologies to rank and score financial companies, in which the reports produced are at times rife with inaccuracies and ultimately sow confusion in the markets. These inaccuracies then consume the bandwidth of financial companies as they scramble to address misstatements that surface in these reports – taking valuable time that could be much better spent on actually improving ESG performance.³

Basically, the people at the shareholder and stakeholder level, who actually do want to see financial companies adhere to a set of ESG standards, are the losers in the current system. Instead of having the transparency of financial companies who are actually responsible in terms of ESG, investors are essentially in this conflict-of-interest system where ESG ratings mean nothing, unless change is in fact taking place.

The New ESG Standards for Financial Companies

When we think of the standards financial company corporate boards need to focus on in their ESG reporting, it becomes obvious that there need to be checkbox standards across each environmental, social and governance branch that the financial company reports, where any investor can publicly verify that reporting themself. Without transparency, the system will continue to hurt companies that are supporting ESG goals while benefiting those willing to “game” the system. A transparent system will. instead. give ESG-conscious investors a leg up in understanding their investments while benefiting companies truly committed to doing the right thing.

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