The writer is professor of business and public policy at Oxford’s Blavatnik School of Government
For investors seeking more focus on environmental, social, and governance issues, 2020 might have felt like a good year as numerous CEOs embraced ‘ESG-speak’. But much of this, I suspect, was to dress up the disappointment of Covid-19-induced losses. And their posturing only seemed real because accountants and standard setters got in on the act.
Before investors take any ESG claims seriously, though, the accounting has to become a lot more serious. That means incorporating the features of high-quality accounting rules — and here are three that I believe could make a difference.
First, prudence. In accounting parlance, that means having a higher threshold for recognising positive claims than for negative ones. As companies laud themselves for wins on the environment or on meeting social responsibilities, the ESG accounting rules should impute scepticism.
To date, however, I have not encountered a single set of ESG standards that requires prudence. UK-based fashion retailer Boohoo waxed eloquent in its 2019 report about its “zero-tolerance approach to modern slavery”, and scored highly on several ESG indices — only to be exposed for using suppliers that paid workers less than the UK’s minimum wage.
Second, dual reporting. If a firm is reporting on its greenhouse gas emissions in a given period — what accountants call a “flow” — then this figure should be contextualised against the corresponding “stock” in accounting terms: ie, cumulative greenhouse emissions over prior periods and, if relevant, any pollution credits for future emissions. After all, It is an accepted principle that a company’s financial reporting should encompass both the flows and stocks of the item being reported on.
Reporting on flows gives users a picture of current-period performance, while reporting on stocks allows users to examine how sustainable that performance has been over time. But, again, I am not aware of any ESG standards that mandate both flow and stock reporting in the unit being reported.
Third, “matching”. This is how accountants set current investments against future benefits. For example, £1bn building cost of a new factory is not simply recorded as an expense on the income statement but held on the balance sheet and gradually recognised in the income statement as depreciation during the asset’s life. ESG accounting needs benefits matching, too.
This matters because it encourages investments in the future. If managers had to take large current losses on capital expenditures, they might think twice about them — especially if the benefits were very long-term, and only enjoyed after their tenure. Accounting rules that set out the matching of ESG investments and their benefits would moderate this problem.
At the same time, if we want corporate managers to make costly pro-social investments in the environment or in community welfare, we need matching rules to assess their impacts in the future. Recently, Nestlé announced that it was investing €3bn over five years to cut greenhouse emissions as part of its 2050 “net zero” commitment. But how do we know this is enough and will make any meaningful difference to the environment? ESG accounting standards should require Nestlé to state more precisely what ESG value it expects its investment to generate and over what period. The investment could then be “matched” to any realised benefits over that period.
These three principles — prudence, dual reporting and matching — are all fairly basic in financial reporting, but virtually unheard of in ESG accounting standards, As the accounting authorities and the auditing firms push for more environmental and social reporting, this situation has to change.