The environmental, social, and governance (ESG) movement is now over 20 years old and regarded as essential for long-term value creation, risk mitigation, and social responsibility. ESG criteria rapidly emerged as a significant factor in business operations, investment decisions, and corporate oversight. Despite its growing importance, the ESG reporting space is riddled with misunderstandings, misapplications, and significant controversy that threaten to derail its promise.
The Trump administration has dramatically shifted sentiment, rhetoric, and applicability for ESG-related policies and programs, and once again removed the US from the Paris Climate Agreement. Many corporations are reevaluating their previous commitments and the strategic importance of ESG reporting.
“At Engage, we’ve had a front-row seat to the good, the bad, and the ugly of ESG reporting,” says Donald Racey, Founder of Engage Global Advisors. “We have seen firsthand the frustrations related to compliance and measurement that companies are experiencing, and we recognize the need for rapid reform.”
What should be a good and noble endeavor, embraced by all, is in dire need of a reset. Where and how has ESG reporting failed to live up to its promise, and what can be done to resolve these issues?
CSR and ESG reporting: A brief history
ESG reporting evolved from the concept of corporate social responsibility (CSR). CSR emerged as businesses began to acknowledge their broader societal responsibilities, extending beyond merely generating profits for shareholders. Companies are increasingly recognizing that their operations have far-reaching impacts on their employees, communities, and the environment.
By the 1990s and early 2000s, globalization, environmental activism, and corporate scandals, such as those involving Enron and WorldCom, accelerated the need for businesses to demonstrate their social and ethical accountability. Many companies adopted CSR policies to show they were responsible corporate citizens, addressing environmental sustainability, employee welfare, and ethical governance.
While CSR was a significant step in aligning business practices with current social expectations, it was often criticized for being voluntary, inconsistent, and difficult to measure. Companies could claim to be socially responsible without being held to concrete standards.
ESG reporting emerged, in part, to address these shortcomings by providing a more structured and quantifiable approach to assessing a company’s impact on environmental, social, and governance issues. It has also evolved as a tool for risk management that looks at a range of factors that impact material business operations.
The growing awareness of climate change also reinforced the need for ESG reporting. As scientific evidence mounted, it became increasingly clear that human activities—mainly industrial pollution—contributed to global warming, biodiversity loss, and environmental degradation. The primary culprit of climate change being greenhouse gas emissions (GHGs) from industrial activities.
The rise of environmental activism and public demand for corporate accountability led many investors and regulators to focus on how companies address environmental risks such as GHGs. This shift has pushed companies to report on their environmental practices more transparently, including GHG emissions, energy efficiency, and their efforts to adopt sustainable business practices outside regulatory compliance.
International agreements such as the Kyoto Protocol (1997) and the Paris Climate Agreement (2015) set global targets for reducing GHGs and mitigating climate change, putting pressure on countries and businesses to reduce their environmental footprint.
Despite its aims, the Paris Climate Agreement has been the subject of considerable controversy from various stakeholders. These disputes stem from the agreement’s effectiveness, equity, economic impact, and enforcement mechanisms. As the demand for ESG reporting has increased, so have the problems and complexities with compliance and execution.
The problem of standardization in ESG reporting
One of the most significant problems with ESG reporting is the lack of standardization in how companies measure and report their ESG performance. Different rating agencies and institutions use various metrics and methodologies, often leading to wide variations in a company’s ESG score. This inconsistency makes it difficult for investors and stakeholders to make informed decisions based on comparable data.
Racey shares, “When we began working with companies on ESG reporting, there were 200+ ESG reporting frameworks from industry associations, non-governmental organizations (NGOs), and non-profits.” According to Ernst & Young, more than 600 ESG frameworks exist worldwide. All want to differentiate themselves, leaving consumers confused and frustrated.
To compound this frustration, organizations that audit company ESG reports and initiatives have played a prominent role by providing scores on a company’s ESG performance based on audits and questionnaires. These scoring organizations derive their authority from no official capacity; instead, they create demand for the scores through their marketing efforts.
The organizations responsible for producing ESG audit scores face serious ethical issues related to transparency and conflicts of interest. As these auditing organizations wield substantial influence, understanding these challenges is critical for stakeholders who depend on the integrity of ESG scores.
Unlike financial metrics such as profit margins or debt ratios, ESG factors are inherently qualitative and complex, involving indicators such as carbon emissions, labor practices, diversity initiatives, and corporate governance practices. This complexity results in varying methodologies organizations use to score the same company.
For example, a company might receive a high ESG score from one organization for its efforts to reduce carbon emissions. In contrast, another organization may score the same company poorly due to concerns over its labor practices. This inconsistency stems from ESG rating organizations using different criteria and weighting systems to evaluate the various indicators.
This lack of consistency makes it difficult for investors and stakeholders to trust the scores or make informed company comparisons. Additionally, the lack of transparency in calculating ESG scores leaves stakeholders uncertain about the data’s reliability, undermining the rating system’s overall credibility. Many ESG rating organizations do not fully disclose the criteria, data sources, or algorithms they use to assess companies, leaving investors and companies alike in the dark about how scores are derived.
Without transparency in methodology, stakeholders cannot properly evaluate whether the ratings accurately reflect a company’s ESG performance. For instance, ESG ratings often rely on a mix of publicly available data and self-reported information from companies. However, the extent to which these sources are used, the process for verifying data accuracy, and the weighting of specific ESG factors remain unclear. This lack of transparency raises questions about the rigor and objectivity of ESG audits.
Additionally, many companies may disclose only selective information, skewing the ratings. Since ESG rating organizations are often reluctant to reveal their complete methodologies or decision-making processes, it becomes challenging for external parties to assess the validity of the ratings. As a result, stakeholders must rely on unclear assessments, which could lead to misguided decisions.
Conflicts of interest in ESG rating agencies
Conflicts of interest are a significant problem in the ESG auditing industry. ESG-scoring organizations operate as profit-driven entities, which raises concerns about their impartiality, mainly when their clients are also the companies they are evaluating. This is similar to the issue that credit rating agencies faced during the 2008 financial crisis, where the agencies were paid by the companies issuing the debt they were rating, leading to accusations of inflated ratings.
In the context of ESG reporting, companies pay these organizations to conduct ESG audits on vendor companies within their supply chain. This arrangement can create a conflict of interest, as rating agencies may feel pressure to provide more favorable scores to secure or retain business from the companies they evaluate. While ESG audit organizations may claim that they maintain independence in their assessments, the potential for biased scores due to financial incentives cannot be ignored.
Furthermore, many ESG audit organizations offer consulting services to the same companies they rate. These organizations may advise companies on improving their ESG performance and then rate them on those criteria. This dual role as both advisor and evaluator creates an inherent conflict of interest, as the audit organization may be incentivized to rate companies more favorably to highlight the effectiveness of their consulting services.
If you are a company receiving an ESG audit at the request of a large customer, this often feels like a shakedown for money.
Companies feel forced to submit to an audit for which they must pay because a large customer requests it. Once they have paid for and received their initial score—which is typically extremely low—the auditing organization or their consulting partner immediately contacts them to market their consulting services to improve that poor score. The company receiving the audit then feels obligated or forced to purchase consulting services to get back into the good graces of its customer or customers.
The problem is that the company being audited is not being judged on the effectiveness of its sustainability actions or policies. Poor scores are often a result of how a policy is formatted. Does the policy have a logo? Is it a stand-alone document or part of an employee handbook? Whether a policy is valid, enforceable, or based on best practices is of no concern to the audit organizations. It all becomes form over function.
The audit organizations create a set of standards of which the company being assessed is often completely unaware. The only winner is the auditing organization or its network of consultants that can charge fees to advise on how best to address these audit findings.
In short, they charge you to dig a hole, push you in, and then sell you a rope to get out.
Companies often feel at the mercy of these organizations because scores are made publicly available on their platforms and frequently used as selection criteria for the requesting company regarding whether to do business with the company being audited.
Small to mid-sized companies are the most vulnerable, as rectifying ESG scores can cost thousands. For many companies, the risk of disclosing ESG information could be worse than refusing to comply with the original audit request.
Vendor and customer relationships cultivated and fostered over many years are now being put in jeopardy, not because of poor performance in performing the duties they were contracted to do, but rather a set of ESG audit criteria that has no bearing on actual performance.
Lack of regulatory oversight and accountability
Unlike traditional financial ratings, which are subject to regulatory scrutiny, such as the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, ESG scores are mainly unregulated. This lack of oversight means few checks and balances ensuring ESG-scoring providers operate fairly and transparently. As the demand for ESG reporting grows, this regulatory gap becomes increasingly problematic.
Without regulatory standards governing the production and disclosure of ESG scores, scoring providers and their consulting partners can engage in predatory practices without fear of external scrutiny. Additionally, the company being audited has little recourse to dispute a score.
The combination of non-transparent reporting methodologies, conflicts of interest, and lack of regulatory oversight creates fertile ground for greenwashing, where the practice of companies exaggerate or misrepresent their ESG impact.
The lack of trust in ESG reporting practices leads to declining confidence and adoption of the entire ESG movement. When stakeholders believe ESG reporting is unreliable or biased, they may avoid ESG-focused strategies altogether, depriving companies that genuinely prioritize sustainability of much-needed capital and recognition for their good work.
The ESG scoring industry needs greater transparency and standardization to address these issues. Establishing clearer methodologies, improving disclosure requirements, and ensuring that scoring providers are free from conflicts of interest is essential to making ESG reporting more reliable, consistent, and accountable. Only by addressing these flaws can ESG reporting fulfill its potential as a credible and powerful force for positive change in ESG business practices.
Are you uncertain about how to address this within your organization? The impacts on company culture, recruitment, and customer loyalty could be profound. Contact us today to learn more.