Corporate reform — similarly to how Ernest Hemingway described bankruptcy in his novel "The Sun Also Rises," — happens two ways: gradually, and then suddenly.
Environmental, social, and governance (ESG), a movement that seeks to hold corporations accountable for far more than just ordinary financial results, is gathering speed and building momentum.
Of course, it is one thing to back what ESG stands for, and another to implement the needed changes. One of the key things that needs to be done to facilitate the change is to develop an accounting system — a way to put monetary values on transgressions or successes of ESG principles.
"Today, impact investment is measured in trillions. Tomorrow, the whole of capitalism will be measured by impact-driven measures," says Ronald Cohen, chair of the leadership council of Harvard's Impact-Weighted Accounts Initiative and co-founder of London-based private equity firm, Apax Partners.
Harvard Business School academics, of which Cohen is one, are leading the way with work on how to express in monetary terms environmental and societal impacts, such as water purity, biodiversity, workplace safety, greater pay equality, and employment diversity, to name just a few.
A company's financials would be weighted on its impacts on all the above factors, and more. The first step is going to be to value impacts, Cohen said.
One of the key things that need to be done is to develop an accounting system — a way to put monetary values on transgressions or successes of ESG principles.
But not everyone is focused on the weighted impact approach of Cohen. The commercial real estate ESG consultant Aquicore points out that the huge $36 billion global commercial real estate industry formed an organization called Global Benchmark for Real Assets (GRESB). The non-profit collects, validates, scores, and benchmarks ESG data to provide business, intelligence, and engagement tools. The benchmarks are based on data from more than 1,500 real estate investment trusts (REITs), the primary method of organizing enterprises in commercial real estate.
“More than 120 institutional and financial investors use GRESB to make decisions that lead to a more sustainable and resilient world,” GRESB says.
The ESG Focused CFO
ESG measurement standards, if implemented, will revolutionize the role of the CFO. The CFO of the future is going to have a job that is far more complex than it is today as they seek to weigh the company’s ESG compliance.
“The first step is going to be to value impacts and prepare an income statement that shows revenues, costs, and impacts. In my view, this will be mandated by regulators in the next three to five years”, Cohen says.
Throw in the huge leap in awareness of issues such as climate change, the recent wildfires, George Floyd's death, and the rise of the MeToo movement, and what really has occurred is a perfect storm that has driven powerful and widespread calls for ESG implementation.
The first step is going to be to value impacts and prepare an income statement that shows revenues, costs, and impacts. In my view, this will be mandated by regulators in the next three to five years. — Ronald Cohen
Today, companies such as Intel, Unilever, and L'Oreal are voluntarily disclosing their impact-related data and improving their impact performance as a result. In fact, there are hundreds of corporations like Unilever and L’Oreal who have started to issue reports on their adherence to the values that drive ESG.
But Cohen says it’s not enough: “We need mandatory accounting of social and environmental impacts so that impact performance is measured and compared in a similar way to financial profit.”
That means governments are going to have to step in and legislate or regulate for ESG adoption to become commonplace. So far, signs are encouraging as European and U.S. regulators have begun to work on regulatory frameworks. However, nothing has been mandated by law or by regulation in either locale yet.
Accounting for Company ESG Impacts
Another thing that is critical to the “weighted impact” ESG accounting, being developed by the Harvard Business School’s ESG Weighted Impact Accounting Development Committee, is that the weighted average ESG accounting system they are working on may have a good chance of being widely adopted. Or even mandated by regulatory authorities to be the standard by which ESG adherence is measured.
Other organizations that are reportedly considering working on developing ESG impact accounting frameworks are the Sustainability Accounting Standards Board (SASB), the Task Force on Climate-Related Financial Disclosures, and the Big Four accounting firms.
With this type of adoption of impact-weighted ESG accounting, if it is widely accepted or even mandated, investors will be able to look at ESG-weighted impact income statements and compare those statements to other companies in an apples-to-apples way, making the values espoused by the ESG movement deeply imbedded in the corporate mindset and value and reporting systems.
But it cannot be overemphasized how difficult it is going to be to effectuate such a radical change in corporate action and in the corporate mindset. The purpose of ESG impact-weighted accounting is to assign a dollar value to the harm a corporation may make on the environment, for example. And as it does harm, to charge them in dollar terms until the corporation changes its ways.
Investors will be able to look at ESG-weighted impact income statements and compare those statements to other companies in an apples-to-apples way.
And while it is true that regulators such as the Securities and Exchange Commission (SEC) have been working on ESG-inspired regulation since the start of the year, it is mostly contemplating mandating data be published on the E in the ESG equation. And even if the SEC does implement these regulations, its mandate is only for public companies. The SEC has zero jurisdiction over private enterprises.
We are a long way toward widespread adherence and mandating ESG impact weighted accounting. One thing is for sure though, we are at the forefront of a new form of corporate reform and the fight around it promises to be one of the most important and interesting in corporate history.