Someday soon, environmental, social and governance data won't be separate from the other information companies report. Here's how we might get from here to there.
Despite growing focus on the value of environmental, social and governance (ESG) data in our marketplace, we are only at the beginning of the beginning of how this traditionally “non-financial” data will matter. At the end of this process, it will cease to exist as something separate from financial reporting, and we will look back on the journey and wonder at the flat-earth nature of where we were.
Here is how I see the timeline unfolding:
The beginning of the beginning
This is where we are now. Roughly half of all large and mid-cap companies report some of what is material about their ESG performance. Some of this data is verified by an external auditor. Some fraction is also delivered in a format so companies can be compared with each other. Ingesting this dizzying array of ESG sources is an equally dizzying array of ESG data providers, or “raters”, that somehow bake up full-sector reports on ESG performance.
The output is varying versions of the truth, both at the raw data level and at the rating level. The “facts” can vary widely, depending on whether a company’s reported number is taken at face value or is adjusted according to a proprietary estimating methodology – or estimated wholesale (as sometimes happens if a company is not reporting at all). After arriving at a set of facts, an ESG rater then generally proceeds to normalize the facts so that all companies can be compared on an “apples to apples” basis. The end result is varying ESG ratings for the same company from different raters. Like the facts themselves, the ratings portray different versions of reality on ESG performance.
The end of the beginning
Where we are headed next will be about reconciling divergent realities in terms of both the facts and the ratings. Technology will steadily improve our ability to monitor and measure performance. Once facts become more knowable , ratings on performance will begin to align. Additionally, coverage of mid- and smaller cap entities will increase as the cost barriers to data access are reduced. We will begin to have some possibility for meaningfully comparing large numbers of companies in a sector to each other.
More interestingly, new models for rating will begin to mature. As sustainability and its growing collection of technical innovations become more and more cost-effective, ESG ratings will shift from risk avoidance to capturing opportunity. Consumers of data will want to know where a business model is beginning to capture a new, lower-cost, more sustainable innovation, and therefore delivering better performance to its owner. Direction of travel will be key for diverse investment use-cases, from alpha-capture to carbon-divestment. High ESG ratings will connote improved growth and cost management performance in a firm. ESG will have begun the process of losing its distinction from traditional financial reporting.
The beginning of the end
At this point, ESG ratings begin to become quite useful for non-investment use-cases. What was once a system which that allowed an observer to compare companies to each other has morphed into a system that allows a policymaker or a consumer to assess actual performance of a firm versus scientific or policy goals. In other words, Exxon achieving an A rating (which it does in many ESG ratings tools now), will not connote that it performs well compared to its oil major comrades, but rather that it performs well against scientific guidance on climate designed to allow for long term health and value creation across our global economy.
The end of ESG
At the end, not only has ESG become a part of financial reporting, but financial reporting has ceased to be about financial performance. Instead, how and what a company reports will be about how it contributes to the sustainable economic development of its stakeholders, including shareholders and the planet. Data quality will be a non-issue with cost barriers to transparency reduced to near zero and information processing speeds at quantum rates.
In this world, performance will expand both beyond the firm and to within the firm. As they do now, small groups of enormously powerful individuals will make decisions which affect the lives of countless millions of observers. Those millions of observers will now be observing. Accountability for individual leaders, and their “individual ratings”, will become as important as firm-level performance. Similarly, the network of stakeholders outside a firm will have accountability. Key investors, policymakers, clients, community leaders and even trusted colleagues and influencers will be knowable, not just in their performance record, but also their tendency to drive performance in entities they touch. At the end of ESG, ESG will become a part of a larger whole, where progress on sustainable development will be transparent and owned by all who have the ability to impact it, likely accelerating a new era of thorny transparency-related problem-sets to replace ESG.
A version of this article originally appeared in The Economist Intelligence Unit.
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