Thai Institute of Directors

More than values: The value-based sustainability reporting that investors want

Courtesy of McKinsey & Company
By Sara Bernow, Jonathan Godsall, Bryce Klempner, and Charlotte Merten

As evidence mounts that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other nonfinancial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind. When companies report on ESG-related activities, they have largely continued to address the diverse interests of their many stakeholders—a long-standing practice that involves compiling extensive sustainability reports and filling out stacks of questionnaires. Despite all that effort, a recent McKinsey survey uncovered something that should concern corporate executives and board members: investors say they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.

What’s unusual and challenging about sustainability-focused investment analysis is that companies’ sustainability disclosures needn’t conform to shared standards in the way their financial disclosures must. Years of effort by standard-setting groups have produced nearly a dozen major reporting frameworks and standards, which businesses have discretion to apply as they see fit. Investors must therefore reconcile corporate sustainability disclosures as best they can before trying to draw comparisons among companies.

Corporate executives and investors alike recognize that sustainability reporting could improve in some respects. One advance that executives and investors strongly support, according to our survey, is reducing the number of standards for sustainability reporting. Many executive respondents said they believe this would aid their efforts to manage sustainability impacts and respond to sustainability-related trends, such as climate change and water scarcity. And many investors said they expect greater standardization of sustainability reports to help them allocate capital and engage companies more effectively. While these findings might not surprise readers involved with sustainable investing or sustainability reporting, it was striking to learn that investors also support legal mandates requiring companies to issue sustainability reports (Exhibit 1). In this article, we offer executives, directors, and investors a look at how sustainability reporting has evolved, what further changes investors say they want, and how investors can bring about those changes.

Reporting today: Externality focused and inconsistent, yet informative

The current practice of sustainability reporting developed in the 1990s as civil-society groups, governments, and other constituencies called on companies to account for their impact on nature and on the communities where they operate. A milestone was passed in 2000, when the Global Reporting Initiative (GRI) published its first sustainability-reporting guidelines. The following year, the World Business Council for Sustainable Development and the World Resources Institute released the Greenhouse Gas Protocol. The same period also saw the creation of voluntary initiatives, such as the UN Global Compact and the Carbon Disclosure Project (now CDP), encouraging corporations to disclose information on sustainability. Since the financial crisis, additional frameworks and standards have emerged to help companies and their investors develop a greater understanding of the risks and benefits of ESG and nonfinancial factors. For example, the International Integrated Reporting Council (IIRC) advocates integration of financial and nonfinancial reports, the Sustainability Accounting Standards Board (SASB) identifies material sustainability factors across industries, and the Embankment Project for Inclusive Capitalism assembles investors and companies to define a pragmatic set of metrics to measure and demonstrate long-term value to financial markets.

Given the proliferation of reporting frameworks and standards, companies have had to decide for themselves which ones to apply. These frameworks and standards allow businesses considerable freedom to choose their sustainability disclosures. Many companies select their disclosures by consulting members of stakeholder groups—consumers, local communities, employees, governments, and investors, among others—about which externalities, or impacts, matter most to them and then tallying the stakeholders’ interests in some way. More recently, stakeholders have asked for increased disclosure about how companies address opportunities and risks related to sustainability trends, such as climate change and water scarcity, which can meaningfully affect a company’s assets, operations, and reputation.

The scope and depth of these disclosures differ considerably as a result of the subjective choices companies make about their approaches to sustainability reporting: which frameworks and standards to follow, which stakeholders to address, and which information to make public. According to the executives and investors we surveyed, the diversity of these disclosures is a defining feature of sustainability reporting as we know it—and a source of difficulty, as we explain in the following section of this article.

Nevertheless, 30-odd years of sustainability reporting have produced a trove of useful data. Stakeholders can use this information to track the relative sustainability performance of companies from year to year. By aggregating data from many companies, stakeholders can not only discern patterns and trends in companies’ responses to sustainability issues but compare and rank businesses as well.

Analysts in academia, government, and the private sector have also used these sustainability disclosures to examine the link between sustainability performance and financial performance. A substantial body of research shows that companies that manage sustainability issues well achieve superior financial results.2 (Researchers have shown only that these two phenomena are correlated, not that effective sustainability management leads to better financial outcomes.)

Investors and asset owners appear to be taking note of corporate sustainability disclosures and adapting their investment strategies accordingly. The Global Sustainable Investment Alliance has found that the quantity of global assets managed according to sustainable-investment strategies more than doubled from 2012 to 2018, rising from $13.3 trillion to $30.7 trillion.3 BlackRock reports that assets in sustainable mutual funds and exchange-traded funds in Europe and the United States increased by more than 67 percent from 2013 to 2019 and now amount to $760 billion.4 And research by Morgan Stanley indicates that a majority of large asset owners are integrating sustainability factors into their investment processes. Many of those asset owners started to do so only during the four years before the survey.5

What investors want: Financial materiality, consistency, and reliability

With so much capital at stake, investors have begun to question prevailing sustainability-reporting practices. The shortcomings investors now highlight have existed for some time but were mostly acceptable to early sustainable investors and the diverse civil-society stakeholders that used to be the primary readers of sustainability reports. But now that more asset owners and asset managers are making investment and engagement decisions with sustainability in mind, a louder call has gone out for sustainability disclosures that meet the following three criteria.

Financial materiality

Investors acknowledge that their expectations for sustainability disclosures have shifted. As the head of responsible investing at a large global pension fund remarked, “The early days of sustainable investing were values based: How can our investing live up to our values? Now, it is value-based: How does sustainability add value to our investments?”

From our interviews and survey results, it is apparent that investors want companies to provide more sustainability disclosures that are material to financial performance. According to a senior sustainable-investing officer at one top 20 asset manager, “Corporations do not provide systematic data on one-third of the sustainability factors [that we consider] material.” This could change as more companies issue reports in line with the sector-specific standards that SASB created in consultation with industry experts and investors.

Government authorities and civil-society organizations also appear to be coming around to investors’ views about the material connection between a company’s handling of sustainability factors and its financial performance. The European Union’s 2014 directive on nonfinancial reporting and the Financial Stability Board’s creation of the Task Force on Climate-related Financial Disclosures in 2015 are two signals that financial regulators realize sustainability-related activities can materially affect the financial standing of companies and should be reported accordingly.

Consistency

With so many reporting frameworks and guidelines to choose from, and so many potential stakeholder interests to address, companies rarely make sustainability disclosures that can be compared as neatly as their financial disclosures can. This circumstance makes the job of investors more difficult, as they indicated in response to our survey (Exhibit 2). As the head of sustainable investing at a major asset manager explained, “We have positions in over 4,500 companies. Unless [sustainability information] is comparable, hard data, it is of little use to us.”

Reliability

As the head of responsible investing for one of the world’s five largest pension funds put it, “Many companies do not have the systems in place to collect quality data for [sustainability] reporting.” For certain tangible sustainability factors, such as greenhouse-gas emissions, performance-measurement systems are generally well established. For other factors, such as corporate culture, human capital, and diversity and inclusion, clear ways to gauge performance are more elusive.

Investors also harbor doubts about corporate sustainability disclosures because few of them undergo third-party audits. Nearly all the investors we surveyed—97 percent—said that sustainability disclosures should be audited in some way, and 67 percent said that sustainability audits should be as rigorous as financial audits (Exhibit 3).