The Future of ESG Is … Accounting? – Harvard Business Review

While sustainability has become a central concern of many managers, investors, and consumers, a major sticking point remains for the ESG movement: There are still no universally adopted standards for how companies can measure and report on their sustainability performance. Instead, we have a large number of NGOs working independently to develop standards for sustainability reporting, which is creating complexity and confusion for companies and investors. But this might be about to change, thanks to a quiet revolution in the accounting community.

That revolution is being led by the IFRS Foundation, the body that oversees the work of the International Accounting Standards Board (IASB) in setting financial reporting requirements for most companies in the world, across more than 140 jurisdictions. (In the U.S., these requirements are set by the Financial Accounting Standards Board, or FASB). This past September, the IFRS Foundation proposed the creation of a parallel Sustainability Standards Board (SSB).

The IFRs Foundation is well-placed to make this proposal. That’s because of its expertise in the standard-setting process, its legitimacy in the corporate and investor community, and its support from regulators all over the world. If its proposal is adopted, investors and other stakeholders will suddenly have a much clearer view of any company’s sustainability performance—just as they do its financial performance. Most companies already issue sustainability reports, of course, but these are divorced from their financial reports, making it difficult to see the relationship between financial performance and sustainability performance. The SSB would make it possible for the ideal of integrated reporting to be realized. And the FASB would be able to build on this work in the United States.

The proposal has the support of some major heavyweights in the investment and corporate communities, among them Anne Simpson, who currently serves as Investment Director for Board Governance & Sustainability at CalPERS, and who is a former member of the IFRS Advisory Council and the SEC’s Investor Advisory Group. “At CalPERS,” Simpson told us, explaining how the SSB would enable better investment decisions, “we know as a long-term investor that sustainable value creation relies upon the effective management of three forms of capital: financial, physical and human.  Investors are making the case for sustainability reporting for IFRS and also at the SEC. In global capital markets, both are needed.” Another prominent proponent is Paul Polman, the former CEO of Unilever, who believes that the SSB will change the dialogue between companies and their investors. “Investors are increasingly asking companies to report on their sustainability performance,” Polman told us. “Having a set of standards will greatly improve this dialogue and enable both to better understand the relationship between sustainability and financial performance.” Additionally, Oxford University’s Saïd Business School has submitted a letter to the IFRS Foundation in support of creating the SSB.

As in any effort to promote a new idea, this one presents challenges for the IFRS Foundation. An important issue of scope requires recognizing that not all sustainability issues would fall into the remit of the SSB. FASB and IASB exist to serve the information needs of investors. SSB would do the same. But not all sustainability issues are relevant to investors. The Sustainability Accounting Standards Board (SASB) has identified which ones they are, and they vary by industry. In contrast, the Global Reporting Initiative (GRI) is focused on the entire range of sustainability issues that matter to society as a whole.

That said, an issue that is not currently relevant to investors can become so for many reasons, including system-level effects on all companies regardless of industry (e.g., climate change and inequality), changing social expectations of customers and employees (particularly the Millennials), and laws and regulations (e.g., carbon taxes and minimum wage rates).

The solution to this is for the SSB to work within its remit of providing information to capital markets while coordinating with groups like GRI, which have a concern for sustainable development that extends beyond investors’ focus on enterprise value creation over the short-, medium-, or long-term. Creating visibility for these issues can enable civil society to spur regulations and laws that may make these issues material for investors, thereby supporting both public and private sector initiatives to address to challenges of sustainable development.

These issues also connect with financial accounting itself. The Impact-Weighted Accounts Initiative (IWAI), incubated as a project at Harvard Business School, is developing methodologies for financial accounts that also reflect a company’s social and environmental impact. There are already about 100 large companies that have measured or are developing their impact-weighted financial accounts including a dozen companies in the Value Balancing Alliance (VBA). This work should be monitored by both the IASB and the SSB.

The impact of sustainability reporting standards will be enormous. Executives will be better able to factor sustainability issues into strategy and capital-allocation decisions. This will help to ensure the sustainability of corporate financial performance, particularly over the long term. Boards of directors will see sustainability not as a side issue to be managed in a committee but as a major issue that the entire board needs to focus on. The companies that are most effective at managing sustainability will be more attractive to investors. Since sustainability performance can be a leading indicator of financial performance, investors will want the same consistency and clarity in a company’s sustainability reporting as they now expect for its financial reporting. Investors will want this information from the CEO and CFO, and will want to discuss with them the company’s financial and sustainability performance, and how they are related to each other.

These changes will be further enabled if compensation is tied to sustainability metrics. Today, executives and board members are rewarded almost entirely in terms of a company’s financial performance. Rigorous standards for measuring and reporting on sustainability will make it possible for them to be used in determining the compensation of executives, board members, and investors.

Although the IASB has great expertise and credibility in setting financial accounting standards, it does not currently have the capabilities to set sustainability accounting standards. Fortunately, the IFRS Foundation does not have to start from scratch. SASB, GRI, CDP, the Climate Disclosure Standards Board, and the International Integrated Reporting Council recently published a paper which provides a solid  conceptual foundation, and their work continues through the facilitation of the Impact Management Project, Deloitte, and the International Business Council of the World Economic Forum.

The world faces enormous challenges in securing a sustainable future. But the adoption of the SSB, a little known but vastly important revolution in accounting, would represent an essential early step in the right direction.