June 2022 | 

Measuring ESG

Measuring ESG

Determining corporate value has never been an exact science. But the growing practice of including non-financial factors has made valuation even more complex. For many investors, so-called ESG (environment, social, and governance) issues are now being considered along with discounted cash flows and asset valuation, as is evident by the ESG questions posed in the last analyst earnings calls of 25 percent of companies in the S&P 500. “But,” says Wharton management professor Witold Henisz, “at the same time, people don't feel they have the data and the insight to know how to measure it.”

If you’re a director or senior executive, that means those ESG questions, which are also being asked by employees and other stakeholders, can be very difficult to answer. “We are still developing the tools, the systems, and the processes to value ESG,” says Henisz. “Being tempted by a simplistic answer today can be an expensive mistake. But that doesn’t mean you can’t address ESG concerns and be able to convey your progress to those asking the questions.”

The History of ESG Measurement

Henisz explains that thus far, measuring ESG has been about two different types of ratings. The first simply identifies and creates a checklist of “good” and “bad” companies to help investors who want to avoid specific things like landmines and fossil fuels in their portfolio. “Then,” he says, “some academics got the idea that we should add up the goods and bads or subtract the bads from the goods and come up with a score, and they started using that in research. But their intent was the same: give investors information on whether the firm meets a category.”

The second rating type is more complicated. It goes beyond labels of good or bad, acknowledging that some bad things are riskier than others and affect opportunities more than others. Measuring ESG, according to this rating system, should try to capture the value associated with climate risk, worker rights, or diversity in hiring, for example.

“These two ratings have been produced by competing data providers who then started merging with and acquiring one another,” says Henisz. “Today there are about four or five of them who use combinations of the two types of ratings in some kind of proprietary ‘secret sauce.’ Everybody just wants a simple number that looks a lot like bond ratings. But that means we're not being precise about what we're measuring and why. All of those secret sauces lead to different answers: one says Facebook is good, and another says it’s bad. And the correlations between the ratings and what the companies are actually doing are really frighteningly low, especially outside of carbon.”

A Better Way

If we shouldn’t rely on those ratings, how can we measure ESG? Henisz, who founded the Wharton ESG Analytics Lab, developed a data-driven approach with investment firm Engine No. 1, for whom he is an advisor. Called the Total Value Framework, it is described in a white paper as integrating “non-traditional but financially material ESG data, methods, and systems into traditional analysis.” Henisz says it’s a better way of thinking about ESG measurement: “It considers and ‘dollarizes’ the harm or the benefit caused by the company to its stakeholders, to its customers, to its communities, to the natural environment. When a company creates a lot of harm, at some point, there could be feedback effects onto shareholder value. Customers may sue the company or they may stop buying its product. Governments may come after them. By contrast, if the company creates value for communities, they may see higher top-line revenue growth or faster regulatory proceedings. So, there are feedbacks between positive and negative externalities and shareholder value, and we need to model them. That's what we try to do in the Total Value Framework.”

Henisz says we need more accepted standards for measuring impacts and more models that link feedbacks to shareholder value. “I think we have clarity on where we're going, but we're at the very early stages of that process. If we incorporate these feedbacks, if we build models that do that, we can achieve stakeholder harmony and increased shareholder value. Over the last five to 10 years, there has been a recognition that we've been missing that and we need to do better.”

“When we start talking about stakeholder impacts that destroy shareholder value,” he continues “we're creating a majority coalition. It's no longer us versus them. We all agree externalities that destroy shareholder value are bad. Then there are cases that involve a trade-off, and that require hard choices — the kind that Disney is facing right now in Florida. But where there's alignment, let's grab the low-hanging fruit. Right now, we're leaving money on the table, and we could make stakeholders and shareholders happier. When that’s the case, why wouldn't we do it?”

Good ERM Is Good ESG

Good practice among boards increasingly involves creating a risk committee that receives reports from the chief risk officer and the enterprise risk management system. But, says Henisz, to take action on those risks, the committee must be skilled and high functioning. The enterprise risk management (ERM) system of the company must be sophisticated in identifying and quantifying ESG risks in addition to financial and operational ones. Then they must vet those risks, assess mitigation mechanisms, and report to the board.

“Good ESG is good ERM,” says Henisz. “This is a discussion we have in the Corporate Governance: Essentials for a New Business Era program. Good ESG risk and opportunity management is part of enterprise risk management. We don't need to recreate a new system. We don't need to start from scratch. We've learned a lot about good ERM. Just make sure ESG is part of it.”