Where It Is Now and How It Got Here

Germany’s top money manager DWS was rocked by scandal in early June as police and agents from that county’s securities regulator BaFin swarmed into the company’s Frankfurt head office to investigate allegations of greenwashing.

Greenwashing is the practice of claiming to follow environmental, social, and governance (ESG) principles when those claims are exaggerated or downright false. The case of DWS is possibly a glaring example of prospectus fraud considering the allegation up to half the $900 billion DWS has under management.

Here in the United States, the bank BNY Mellon has been fined. The latest target is none other than the venerable Goldman Sachs, which the Wall Street Journal says is being investigated by the Securities and Exchange Commission with regards to exaggerated ESG claims in its fund management business.

Why Now?

All this should come as no surprise. Lately, investment managers and C-level executives have been falling all over themselves, shouting ESG from the rafters. There are now more than 3,000 investment groups with $103 trillion under management claiming to be “integrated” in some manner with the ESG, according to the Financial Times.

But calls for corporate reform are as old as the corporation itself. Why now, all of a sudden, the almost frenzied effort by all and sundry to at the very least give lip service to ESG? Stakeholder capitalism, for example, a movement out of which ESG has grown, appeared in the 1970s but never really got much play in the mainstream press.

At that time, Nobel laureate economist Milton Friedman was at the peak of his influence with respect to the then prevailing thinking about the nature of the corporation. For Friedman, profit was king, and society was best served by corporations maintaining a laser-like focus on maximizing profit and shareholder value. The idea of ​​“tricle-down” social benefits developed later on.

Around 2020, though, Freidman’s notions came under attack like never before. The new thinking was turbocharged amid a perfect of developments that overnight seemed to galvanize the body politic: climate change as first stormfires swept through California and elsewhere, the death of George Floyd, as well as the Me Too movement in the wake of Harvey Weinstein’s downfall.

All of these came to prominence and, like an express elevator, powered ESG to the very top of corporate agendas.

ESG Reporting Challenges

The problem now is implementation. The complexity of ESG is, frankly, mind-numbing. The difficulties around standardized reporting are equally so. But the DWS brouhaha shows how critical it is for ESG reporting to become standardized and for corporate reporting officers — the chief one who is, of course, the CFO — to settle upon standardized ways to measure ESG compliance.

Zurich-based investment banker Leeor Groen has been a worldwide advocate for ESG for years. Now that acceptance of ESG has become pretty much universal, he says that more than ever the CFO’s role within the corporation will be transformed.

“CFOs have become responsible for reporting on far more than just financials,” he said, also pointing out that large corporations have been hiring people whose sole job is to promote diversity.

Regulators in Washington DC have been focused mostly on the E (environmental) in ESG, emphasizing climate change. In mid-March, the Securities and Exchange Commission put a plan that would require companies forward to disclose information about their greenhouse gas emissions and other climate change-related risks to their businesses.

Under the proposal, what used to be footnotes to financial statements would now have to be audited by an accounting firm, a consultant, an engineer, or some other expert independent entity.

The SEC’s proposed rules so far have exempted smaller companies and would apply only to publicly held companies with tradeable shares worth more than $250 million.

Managing the Additional Workload

Certainly, the Big Four accounting firms are getting prepared. Back in 2020 they got together with the World Economic Forum — the organizer of the Davos global leadership conference — and agreed on a set of standard ESG metrics so that corporate statements could be compared on an apples-to-apples basis.

And the Big Four have been putting their money where their mouths are: KPMG said in October that it planned to spend $1.5 billion over the next three years developing ESG expertise within its ranks, including extensive training for all its 227,000 employees.

Ernst & Young plans on spending $10 billion over the next three years on ESG audit quality, sustainability, and technology. PricewaterhouseCoopers has unveiled a five-year, $12 billion plan to train employees and hire an additional 100,000 new people.

For now, though, there really is no accepted standardization around ESG reporting even though hundreds of corporations have issued reports on their efforts to be good ESG citizens. Recent research by Bain suggests that “most finance leaders don’t feel prepared for this work, although they may welcome the structure of data and reporting standards.”

Just over half of finance chiefs said that they are not equipped to measure ESG outcomes or effectively report metrics on ESG performance. Nearly two-thirds said that they either have no plan or are just beginning to form a plan to manage the additional workload.

Out of the fog of complexity that is ESG reporting in its infancy, there are some standards that have gained prominence, according to investment banker Groen.

Organizations such as the Sustainability Accounting Standards Board (SASB), the Task Force on Climate-related Financial Disclosures (TCFD), and the Big Four all have credibility, according to Groen.

But an ESG analysis by professors at MIT/University of Zurich — an analysis they aptly called “Aggregate Confusion” — shows just how difficult it’s going to be to get apples-to-apples comparison capability in ESG’s quagmire of subjectivity.

The paper examined the ESG ratings used by consultants in the field, including KLD, Sustainalytics, Moody’s, S&P Global, Refinitiv, and MSCI. The results show very little correlation between the ratings, ranging from 0.38 to 0.71.

For comparison’s sake, the correlation between credit rating agencies when they are ranking standard financial statements for credit quality purposes is very high (0.92).

So, going forward, as we make progress in ESG reporting, there is likely to be some controversy and mistakes made along the way, especially given the subjectivity inherent in the task.

Meanwhile, the frenzy surrounding ESG has reached such a point that Bloomberg has begun to wonder if we are in the midst of an ESG bubble, once article carrying the headline: “Does This Collateralized Debt Obligation Come in Green?”

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