The proposed ESG reporting standards presented by the EU last week are overwhelming. I advocate to limit reporting requirements to two metrics: profit and emission reductions.
Last week, EFRAG published the first version of the European Sustainability Reporting Standards. The set of standards describes in detail the topics that companies report on and also obliges them to develop targets that define the company’s ambition.
The ESG metrics are presented in 15 appendices spanning many hundreds of pages. About fifty metrics focus on every company in general and dozens of other metrics are industry-specific. The metrics are intended to ensure that firms on balance create social value to society.
Research by George Miller from 1956 established that a human being can hold five to seven metrics simultaneously. In their April 2004 Nature publication, Edward Vogel and Maro Machizawa confirm this finding. The five versus fifty plus yardstick comparison presents us with a problem. Can company leaders and investors be expected to oversee fifty-plus -de facto hundreds of- metrics on their development and outcomes?
Recent research on ESG metrics by Jurian Berg and colleagues shows that rating agencies differ widely on how the metrics add up to determine whether a company is performing favorably or unfavorably on ESG. Rajna Gibson Brandon and colleagues find that such confusion gives “green funds” reasons to make investments that would fail to meet the “green test”.
As results on ESG metrics suggests it is unlikely for anyone to appreciate the full set of measures let alone that society agrees on what measures are relevant. Of course, employees can be appointed within the companies, each of whom controls part of the metrics from the system. However, the question is how these are related to each other? An example.
Companies must report on non-recycled waste. Suppose we make an employee responsible for waste reduction. The employee goes to work and manages to reduce waste by 50 percent. However, the reduction does mean that from now on raw materials will have to come from the other side of the world, while they are now sourced from a nearby company. The reduction in waste then leads to an increase in scope 3 emissions because the goods have to be transported over thousands of kilometers instead of a few. In addition, it must then be determined whether there is a risk that the goods were produced by underpaid employees or by slaves.
Every metric in the EFRAG system is connected to all other metrics which makes the system unfathomable and society would therefore be better off to have one metric that captures all contributions and withdrawals from society by the organization. This metric exists in theory: Economic Profit. In practice, we come across this metric under the name of residual income and this metric differs from Economic profit because not all contributions or withdrawals from society are reflected in the metric in time or in full. For example, we do not see the social costs of pollution reflected in the price of kerosene. The profit that Shell reports to make on kerosene is incomplete and Shell’s scope 1 reporting should provide clarity in this. The question now is whether we are indeed better off with the reporting system that EFRAG wants to introduce?
Given the fact that individual metrics are intertwined we seem to be getting out of hand with the reports proposed by EFRAG. We will soon be receiving extended ESG reports, but due to the combination of (1) the limited processing capacity of employees described by Miller and (2) the fact that all metrics are interrelated, it is highly questionable whether we can really make progress with the proposed level of detail. No one will be able to comprehend the full system metrics.
In that context, EFRAG had better come up with overarching criteria with which the firms can assure that it is on the right track of emission reduction. For example, one can imagine that a company is asked to indicate how the investments of 2022 at what time in percentage points compared to 2021 have resulted in a CO2 reduction. Companies could also be obliged to submit the same report on other pollutants. Such a system would lead not only to fewer metrics but also to more encompassing metrics that directly take issue with emissions for which reductions are essential.
Finally, the question is whether Social and Governance have only taken into account the urgency of greenhouse gases in the system, should that perhaps be a priority and should we use S (license to operate according to the buyer and supplier) and G (for finance). The S and G already exist on a voluntary basis and it would be good to keep them. It really is enough if we use two measures, profit and emissions!
Jan Bouwens
Professor of accounting
University of Amsterdam
Research fellow at the University of Cambridge
