Conflating ESG Disclosures . . . Out of Need, Not Choice

What happens when investors need high-quality information on critical business metrics but can’t find it? Or when what they can find is a mountain of immaterial, nonstandardized information primarily intended for non-investor stakeholders?

Market inefficiencies develop, alpha opportunities are missed, there is inadequate portfolio risk transparency, and capital is inefficiently allocated, among other outcomes.

Investors rely on the ready availability of high-caliber information to make investment decisions — 10-Ks, earnings calls, investor presentations, and so forth. The compilation and dissemination of this information is guided by financial accounting standards and established disclosure frameworks vital to the underlying issuer-shareholder relationship.

There is currently a significant lack of relevant issuer-investor information in the area of financially material sustainability factors, or environment, social, and governance (ESG) issues.

Unsatisfied Demand

According to a recent CFA Institute survey, 73% of respondents reported taking ESG issues into account when analyzing or making investment decisions, while 61% stated that public companies should be required to report on a cohesive set of sustainability indicators.

The need for better, if not necessarily more, disclosure was confirmed in this PricewaterhouseCoopers survey. Here, investors reported serious discontent with corporate sustainability disclosures — 68% were dissatisfied with key performance indicators on material sustainability issues, while 82% expressed dissatisfaction with how risks and opportunities are identified and quantified in financial terms. All of this suggests that the current state of disclosure on material sustainability factors is far from adequate.

But how can this be when sustainability reporting has skyrocketed in recent years? In 2015, 81% of S&P 500 companies published sustainability reports, up from a mere 20% in 2011. In addition to publicly issued reports, companies often receive and respond to hundreds of ESG surveys from investors and ratings or index providers each year. Indeed, a recent Institute of Management Accountants (IMA) webinar survey found that 7.5% of participating members reported receiving over 250 ESG surveys per year.

ESG Disclosures for Who?

Corporations disclose sustainability information to a variety of stakeholders, including community organizations, employees, and customers. For the most part, these communications are outside the established issuer-investor communication channels and rightly so, given that the needs of most of these stakeholders are distinct from those of professional investors. Thus much of this sustainability information is not useful for investment analysis.

A team of Harvard Business School professors found that 80% of sustainability data points are immaterial when using the Sustainability Accounting Standard Board (SASB)’s industry-specific materiality lens. The study also established evidence for finding alpha opportunities by distinguishing between material and immaterial sustainability factors (also discussed here). As a group, companies that can successfully differentiate the material from the immaterial enjoyed over 6% relative-to-market performance.

Sustainability reporting intended for non-investor stakeholders regularly lacks true and fair representation of actual performance. One study of corporate A or A+ GRI sustainability reports found that 90% of the significant negative social or environmental events that occurred were not reported. The authors concluded that such alternate communication channels “camouflage real sustainable-development problems, presenting an idealized version of company situations.”

SASB research discovered that 10-K disclosures overwhelmingly lack usefulness for investors. Companies provide 10-K disclosures on 75% of sustainability issues likely to be material at the industry level, yet the vast majority of these disclosures were broad, qualitative, and often boilerplate. Only 13% of these financially critical issues contain metrics, but these are typically nonstandardized and largely useless to an investor.

Conflating ESG Disclosures

All this indicates that:

• The majority of investors integrate ESG into analyses.
• General stakeholder ESG disclosures that are financially immaterial are plentiful.
• Financally material ESG disclosures intended for investors are of overwhelmingly poor quality, but those that are material lead to alpha opportunities.

The result: Investors are conflating general stakeholder communications with material investment information.

Arguably, this arises out of investor need for better information. But this outcome runs the risk of further promulgating market inefficiencies unless immaterial ESG disclosures improve or investors narrow and strengthen their focus to material factors only. Absent investing out of social principles, the evidence demonstrates that it is better to ignore immaterial sustainability information altogether. Further, those investors using third-party sustainability ratings should determine whether this distinction exists within the ratings’ methodology.

The market doesn’t conflate material with immaterial types of information when it comes to more traditional data, financial or otherwise. For example, investors don’t care about the depreciation expense of REITs even though it’s an available disclosure, nor do they look to P/E ratios of development stage biotechs, or the churn rates of nonsubscription-based business models. Overall, investors don’t use immaterial information in traditional investment analysis and decisions, yet this is exactly what the markets are doing with ESG disclosures.

 Narrowing (and Strengthening) the Focus

“The Dog and the Shadow,” from Aesop’s Fables, said it best: “Beware lest you lose the substance by grasping at the shadow.” The same goes for integrating ESG factors into investing.

Frustration with the lack of high-quality sustainability disclosures is elevated, yet the evidence is clear that driving meaningful ESG integration forward through a focus on the substance — material information — will better inform investment analysis and decision making.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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