Accounting
Robert Eccles

How Accounting Can Help Build a Sustainable Economy

Burgess COMMENTARY

Peter Burgess

How Accounting Can Help Build a Sustainable Economy

Environmental, social, and corporate governance (ESG) issues are often referred to by investors as “nonfinancial information.” As Robert G. Eccles, a professor of management practice at Harvard Business School points out, that’s not because these issues don’t have financial consequences. Rather, it’s because there are no standards for how to measure and report on ESG issues, unlike a company’s financials. Eccles, a mathematician by training and one of the foremost experts in corporate reporting, has for the past five years been working to create sustainability accounting standards for the investment community (he is also the chairman of ESG asset management firm Arabesque Partners). It’s been slow going. As world leaders gathered in Paris for the 2015 United Nations Climate Change Conference, I spoke with Eccles about the effort to provide nonfinancial information with the same level of accounting rigor as traditional reports—and what that would mean for the global effort to build a sustainable economy.

HBR: ESG investing of all flavors seems to be gathering momentum. Are you encouraged by this trend?

Eccles: Yes — but with a caveat. Long-term asset owners, such as pension funds, are increasingly putting pressure on their asset managers to look beyond the traditional financial information in developing their investment strategies. As a result, there is a lot of “greenwashing” by asset managers who are rushing to tweak their models to claim they are doing this — too often funds retrofit existing products and call it a “green investment.” I met with some senior folk at a major bank and they were laughing cynically about this asset manager who came into see them and said “We pulled Exxon from our portfolio and replaced it with Google and now we are a green fund.” All the flim flam and hocus pocus will shake out eventually once a company’s ESG reporting becomes standardized.

HBR: You were the first chairman of the Sustainability Accounting Standards Boards in 2011, which was founded for the purpose of enabling investors to compare apples to apples when it comes to ESG disclosure. How has that effort progressed?

Most sustainability reporting that companies do is not aimed at investors but rather different stakeholders such as NGOs. So investors don’t find them that useful. There are data vendors that scour through open-source material to try to paint a picture of a company’s ESG record. But this is a proxy for information reported by the company itself and doesn’t have the rigor of audited financial information based on a set of accounting standards.

SASB aims to fill this gap. Regulation S-K, which sets the specific disclosure requirements for a company’s Form 10-K and other Security Exchange Commission (SEC) filings, requires that companies report material information, both financial and nonfinancial. SASB provides guidance for determining material ESG information for companies in every industry. For example, carbon emissions of an insurance company itself is not material, but for a coal-fired utility company it certainly is. With the input of a variety of stakeholders, SASB is finishing up this standards-setting process for 79 industries grouped into 10 sectors. Provisional standards for all 79 industries will be completed by the end of the first quarter of 2016. The standards are appropriate for global use; 40% of the downloads from the SASB website are from overseas visitors.

In addition to SASB, there are other sustainability accounting initiatives including the Climate Disclosure Standards Board, Global Reporting Initiative, the International integrated Reporting Council and others, all of which are doing important work extending corporate reporting beyond financial accounting.

HBR: What needs to happen for standards to be widely adopted?

There are basically two ways: regulation or market forces. I think we need to start with the latter and this is the next implementation phase for SASB. U.S. companies should use the SASB standards because they are good guidance for the 10-K filings. This also enables the company to explain to its investors how it is managing the risks and opportunities of the material ESG issues that affect their ability to create value. At the same time, investors should ask companies to report on these standards. This will enable them to build more sophisticated models that incorporate both financial and nonfinancial information in their investment strategies. Ultimately regulation will be needed in order to create the system-level benefits that standards make possible.

HBR: What role will auditors play in enforcing standards?

I think this is a fundamentally important question. Today you have four big accounting firms that audit around 99% of the world’s market cap. It’s not a perfect system—you still have financial scandals—but it works pretty well. Accounting standards are in place, the SEC is the enforcement mechanism, and the Big Four are monitored by the Public Company Accounting Oversight Board.

But if you look at nonfinancial reporting, there is no such apparatus. Audits are often performed by little boutique sustainability consulting firms that are paid a mere pittance for their work. Even the Big Four are paid much less to audit nonfinancial information compared to financial information. A big company can spend $10-100 million for a financial audit, and then a few hundred thousand dollars at best for an assurance opinion on their sustainability report. What we ultimately need is audits on integrated reports that contain both financial and nonfinancial information.

The auditors say it’s too soon because they need the standards to perform such an audit. But once companies start using SASB’s standards in their 10-K filings, then auditors will be able to treat ESG information with the same scrutiny as financial information. It won’t be a perfect system, but my feeling is that it will be good enough to prevent most abuses.

HBR: Is there historical precedent for what SASB and others are trying to accomplish?

When the U.S. Securities and Exchange Commission was first created in the 1930s, many questioned whether its mandate of creating a common set of accounting standards was even possible. At the time, every accounting firm — and there were many of them — had their own accounting and auditing standards and listed companies often didn’t report revenues because they thought it was giving sensitive information to competitors. We’ve come a long way — and it required a massive effort.

Just as we wouldn’t have the capital markets we have today without financial accounting standards, we won’t have the capital markets and society we want for tomorrow without sustainability accounting standards. Yes, it will be hard work, and yes it can be done. And for the sake of all of us it needs to happen sooner rather than later.