For years, the sustainability field has obsessed over standardizing ESG metrics. From the ISSB’s standardized climate and sustainability-related financial disclosures to ESG ratings regulations, the assumption is that the more standardized, the better. The reasoning makes sense. How do we compare metrics if we aren’t measuring the same way? However, a new study in the Review of Finance questions this traditional wisdom. It argues that metric transparency may lead to systems gaming. This is particularly so in the context of executive compensation tied to Environmental and Social Performance (ESP):
“The model has normative implications for the regulation of ESP measures including ESG scores and ratings. Indeed, it is harder for the manager to game ESP incentives when there are different ESG raters that use a variety of data and methodologies to produce ESG scores and ratings of a similar quality. This suggests that the harmonization of ESP measures may have a counterproductive effect. This should be taken into account at a time when a uniform standard is considered. For example, the objective of the International Sustainability Standards Board (ISSB) is to develop a global standard for sustainability reporting.”
When I was about seven, my mother wanted me to clean my room. She told me to “clear all this stuff off the floor so you can walk in here.” Being too clever for my own good, I shoved everything under the bed. Technically, I fulfilled the metric of clearing the floor, however, I didn’t comply with the spirit of the request. None of my things were where they belonged, and the room was still a mess.
That anecdote essentially sums up the thesis of this paper. By standardizing ESG metrics we narrow the criteria for measuring “success.” If executives know exactly how progress is measured, there is a risk they cater to the factors that feed into those metrics. This would artificially inflate company performance, while not solving any actual environmental or social issues. This is a challenge for the standard setters. Metrics need to capture the whole picture, and complementary metrics used to supplement blind spots. Ultimately, standardization may come with some downsides, but seeing as it is the prevailing current, standard setters must use fail-safes and think creatively.
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