Where ESG Reporting Still Falls Short
In a perfect world, investors, board members, and executives would have full confidence in companies’ environmental social and governance (ESG) reporting and see it as an effective way to fight climate change as well as have a sound business strategy with strategic importance.Read More
Where ESG Reporting Still Falls Short
As pressure to disclose environmental and social impacts ramps up, corporate accounting in this area remains murky. Here’s what you need to know to evaluate a company’s ESG issues accurately.
In a perfect world
In a perfect world, investors, board members, and executives would have full confidence in companies’ environmental social and governance (ESG) reporting and see it as an effective way to fight climate change as well as have a sound business strategy with strategic importance.
After all, they determine ESG reporting important and want it to be part of a company’s business strategy, business ethics, and creating a company built on energy efficiency, sustainability issues, human rights, and socially responsible practices.
Unfortunately, that’s not what happens in the real world, despite a businesses’ ESG practices, for several reasons. First, corporate environmental social and governance reporting depends on estimates and judgment calls about greenhouse gas emissions that can be widely off the mark. Second, standard metrics for ESG reporting intended to enable comparisons between companies may not fully grasp the magnitude or the spectrum of the evaluation giving rise to unofficial measures that come with their own problems. Finally, managers and executives routinely encounter strong incentives to deliberately misreport or misunderstand the scope of the issue themselves.
The darker side of presenting ESG information and the ESG reporting accountability issue rests not in the financial performance but the operating decisions that affect those numbers in an effort to achieve short-term results, meaning there is much room for ESG performance improvements and improvements in ESG reporting standards. Finding ways to reduce such behavior in ESG reporting is a challenge for the accounting profession.
Issue 1: The quest for standardization
An accounting reporting framework revolution began in the wake of Enron. Initiatives were underway to create a single set of international accounting standards and reconcile GAAP and IFRS. This continues to require adjustments and calibration, exposing vast differences in the way companies’ value is determined.
To further complicate matters, the way that IFRS regulations are applied varies widely from one country to the next. Each has its own system of regulation and compliance, and in many countries, compliance and enforcement are weak, especially in ESG reporting.
Just as troubling is the fact that many countries have created their own versions of the IFRS system by imposing “carve outs” (removal of offending passages) and “carve ins” (additions) to the official standard promulgated by the International Accounting Standards Board (IASB), an international organization. This further complicates compiling an ESG report.
The global reporting initiative
The reason the GAAP vs IFRS issue is at the core of ESG reporting and climate-related financial disclosures is that the IFRS recently acquired the intellectual property of the CDSP (Climate Disclosure Standards Board).
The Director of the CDP, which had hosted the CDSP for 15 years, said:
“The consolidation of CDSB into the IFRS Foundation represents an exciting step towards realizing CDSB’s vision—mainstreaming sustainability reporting with financial accounting.”
The problem is that there are at least 5 other ESG reporting frameworks out there, including the SBTi, GRI, GHG Protocol, International Sustainability Standards Board, and the Sustainability Accounting Standards Board.
The challenge is to understand which ESG framework and ESG criteria makes sense with your firm’s ESG reporting, sustainable development, and ESG strategy.
Issue 2: Scope 1 Emissions Tracking
Scope 1 Emissions tracking for an ESG report includes a key focus on 3 items that have environmental impacts – hydrocarbons to operate a building, hydrocarbons to operate a fleet of vehicles & fugitive emissions from leaks in HVAC/R equipment, and other fugitive sources.
Two of the three ESG topics are easier to track and or estimate (hydrocarbons), but fugitive emissions from HVAC/R equipment is more difficult since it relies heavily on operational information buried in transactional records dispersed across a vast expanse of properties and sometimes countries that all collect and manage data differently for ESG initiatives.
As an example, you own a building that you’re doing ESG disclosures on and external stakeholders want to know about. It has dozens of 49 LB rooftop AC units. None of these units require any compliance reporting. Your team assures you that you comply with all regulations and have no compliance refrigerant consumption to report. However, when reporting Scope 1 fugitive emissions, your team does not know how many pounds of refrigerant you used, because they don’t track refrigerant usage from AC Units with less than 50 LB charges, because the EPA and state law does not require it. They assure you that it is a small emissions factor, and you believe them, only to realize that a peer company in your cohort group reported that their fugitive emissions accounted for 50% of all their Scope 1 Emissions and you reported zero. An auditor wants to know why the discrepancy? And how did you come up with zero?
Under current GHG reporting protocols and ESG objectives, if there is no concrete transactional record to measure actual consumption, a business may assume (incorrectly) that they are now expected to report the emissions from that source for ESG information.
There are 3 reporting formats for fugitive emissions for ESG information
1. Estimates – This is where you estimate emissions based on some math that your team or advisor determines. Traditionally, estimates under-report emissions by a factor of between 3-15x
2. The Factor – Developed by Trakref. We are using profile information from our knowledge base of ESG data and other ESG factors to model a company’s emissions based on a series of items related to other associated entities and based on a profile aligned to our taxonomy structure. It has proven to be about 80-90% accurate
3. Performance – These are actual emissions values based on transactions recorded during maintenance and verified by comparing to CMMS and invoice systems. This is the Gold Standard and the only auditable process.
Requiring reporting and work done by the IFRS and SASB will help with ESG information, but the change will not eliminate problems. After all, estimating emissions requires managers to exercise judgment, introducing yet another opportunity to make good-faith errors or to deliberately tilt estimates in such a way that the resulting emissions are closer to meeting targets or profiling a misleading narrative about the company’s performance. Therefore, as these new standards are adopted and implemented, investors will need to examine closely the assumptions and methods used to estimate emissions and report impact.
Issue 3: Unofficial Tracking Measures
Today, Sarbanes-Oxley requires companies on U.S. exchanges to reconcile GAAP measures of earnings to non-GAAP measures, and IFRS has a similar requirement. In addition, the SEC requires that management be able to support the reasoning behind including an alternative measure in its financial disclosures. For example, a company might justify the use of a non-GAAP measure by noting that it is required by one of its borrowing covenants.
Now carry this concept forward to reporting Scope 1 Emissions and environmental impact, and you realize that there is a significant gap between the possibilities and the results. For instance, many companies estimate emissions from refrigerants at between 1-3%, however actual numbers are closer to 15-25%, based on the macro emission rates.
The best results for emission reporting are recording and reporting emissions from all equipment, based on material transactions.
Climate-related financial disclosures
If we continue to use financial reporting as a guide to capturing results in emissions, even commonly used measures such as EBITDA can be noncomparable from business to business—or in the same company from one year to the next—because of differences in what’s included or excluded in the calculation. Investors and analysts need to exercise great caution in interpreting unofficial earnings measures and look closely at corporate explanations that might depend on the use (or abuse) of managerial judgment.
Issue 4: Fair effort reporting
Tracking and reporting refrigerant material emissions is like creating financial statements in that every company has control over the data, but often lacks the processes to verify the transactions. Scope 1 Emissions would be easily verifiable in financial statements if a company task force used the same principles to verify their emissions as they do to manage invoices and payables.
The concept of fair effort reporting injects significant subjectivity into any reporting process, creating new challenges for both preparers and users of ESG statements and Scope 1 reporting, The U.S. Financial Accounting Standards Board, the SEC, the IASB, and the Public Company Accounting Oversight Board—a nonprofit corporation created by Sarbanes-Oxley to oversee the audits of public companies. The goal was to guide auditors on how to verify fair value, but the result has been more confusion, not less. The measurement process has proved difficult, often highly subjective, and controversial.
Issue 5: Greenwashing
When, analysts, investors, directors, and other stakeholders talk about accounting games in annual reports, they usually focus on how costs are accrued in a company’s reports.
The very same things happen in ESG reporting of refrigerant emissions. Examples of overprovisioning in your ESG reporting journey include overestimating your emissions rate so future emission rates look better than today’s or under-reporting emissions rates in order to stay on target toward a goal.
Managers goose the numbers by manipulating operations, not reports.
Rethinking corporate ESG data reporting
A study published in the Journal of Accounting and Economics asked executives to imagine a scenario in which their company was on track to miss its earnings target for the quarter. Within the constraints of GAAP, what choices might they make to reach the target?
The study revealed that managers tend to manipulate results not by how they report performance but by how they time their operating decisions. For example, nearly 80% of the respondents said that if they were falling short of earnings targets, they would cut discretionary spending (such as R&D, advertising, maintenance, hiring, and employee training). More than 55% said they would delay the start of a new project even if it entailed a small sacrifice in value.
Similarly, in reporting fugitive emissions and ESG performance, managers have shown creativity in controlling the narrative to other stakeholders.
What makes these difficult to accept is that gaming practices for ESG performance are widespread in corporate governance and are not in violations of any framework sustainability reports covenants. Corporate executives can do as they please in the comforting knowledge that auditors can’t challenge them. What’s more, such destructive behavior is exceedingly difficult to detect under current disclosure rules.
New Analytical Tools Can Help
Investors and board members understand that manipulating ESG performance to report lower emissions in the short term introduces the very real risk of compromising a company’s long-term success. It is up to investors and directors to demand more disclosure on those operating decisions.
Rather than creating extra paperwork and lengthier data resources, what companies need is to refine data collection and deploy governance which is a smarter approach to controlling emissions and empowering teams to rely on software to analyze the data and guide them to verify and disqualify results.
The Bathtub Curve
The bathtub curve is a type of model demonstrating the likely failure rates of technologies and products. Over a certain product lifetime, the bathtub curve shows how many units might fail during any given phase of a three-part timeline. The HVAC/R asset lifecycle can be measured using the bathtub curve, and it should be noted that the curve also symbolizes an asset’s likelihood of leaking.
HCVAC/R maintenance can be costly and challenging to manage despite its effect on climate change, with work often going to the lowest bidder. However, the true measure of success with maintenance is reliable equipment operation with the lowest possible failure rate.
Maintenance maturity also plays a role in your company’s ability to accurately report Scope 1 Emissions. To report Scope 1 Emissions, you will need to know several key pieces of information.
1. Installed base of equipment at the beginning of the year (consider this beginning inventory)
2. Material details on all systems
3. Activity tracking and management (governance)
4. Installed base of equipment at the end of the year (consider this ending inventory)
The business models of a mature maintenance team will have 3 resources including, a CMMS system, an EAM (Enterprise Asset Management) system, and a CTS (Compliance Tracking Solution) like Trakref. In Trakref, we combine all the needed formatting to use the data from the CMMS and EAM to compile records and reports as needed by compliance and sustainability teams.
The material ledger
Manipulation of ESG results and ESG issues are most prevalent in the early years of a CEO’s tenure and decrease over time, a recent study shows. A possible explanation is that the early years are the period of greatest uncertainty about a CEO’s ability.
For ESG reporting to fulfill their important social and economic function to fight climate change, they must reveal the underlying economic and environmental truth of a business. To the extent that they deviate from that truth, capital will be misallocated and jobs will be destroyed.
Of course, we will never reach a world where what companies disclose in ESG reporting is perfectly and reliably true, but an understanding of their shortcomings and the availability of new tools to detect manipulation can help us continue to strive for that ideal.
Discuss These Issues With Us
If you want to learn more about current issues with ESG reporting, be sure to join us at our open mic next week on May 26 at 12pm.
And if you want to share more information about these issues with colleagues or have a handy guide for yourself, download our handout on where ESG reporting falls short.
Gavin is the Lead Writer at Trakref.