Why ESG is broken — and how to fix it

If they handed out awards for most-used climate buzzwords, “ESG” would win, hands down. ESG, or Environmental, Social, and Governance, principles have skyrocketed in importance for businesses, investors, and consumers. Last year, investors put a record $120 billion into sustainable investments, easily doubling the $51 billion they invested in 2020. Consumers, too, increasingly value ESG. Last year, 53% of consumers surveyed reported that they consciously consider whether a company is committed to doing the right thing before they make a purchase.

In addition to these market pressures, companies now have to plan for the proposed new carbon reporting rules from the Securities Exchange Commission (SEC). In March, the SEC proposed rule changes that would require companies to report on both the climate-related risks facing their business as well as their greenhouse gas (GHG) emissions.

This is a fascinating move in the lifetime of the SEC. To me, it says that companies need to not only pay attention to their financial bottom lines, but they also need to pay attention to their climate bottom lines. The SEC is going to require that companies report on their climate bottom lines accurately and completely.

However, accurate, complete reporting on ESG is not so simple.

ESG measurements are the wild, wild West

ESG covers three very, very different topics. If you look at the range of components covered underneath each topic, they’re extremely broad. They include everything from GHG emissions and energy used as a business to the diversity of a company’s workforce and data privacy practices to the processes governing how a company is run. And within each topic, there is very little standardization in the way that companies are going about measuring how they are doing.

To improve performance in any area — whether ESG, Software, Operations, you name it — there’s a well-established 3 step approach: 1) Measure where you are today, 2) Determine where you want to go, and then 3) set a path from A to B. But for ESG, there is no consistent way for companies to measure where they are. The only consistency is that this holds true across just about every dimension of ESG.

Take GHG emissions. Companies choose all sorts of ways to define and measure their GHG emissions, which means accuracy is often very low. If you measure GHG emissions a little bit wrong, that’s one thing. But if you measure it very wrong, you run the risk of drawing the wrong conclusions and taking the wrong actions. Take the example of an investor looking at ESG funds. An ESG fund could include an energy hog of a company that measures its GHG in a way that’s inappropriate. That company isn’t really following ESG practices; it’s doing creative accounting with its carbon reporting. Look no further than the fact that oil giants Exxon and BP have aggregate BBB ESG ratings even though they’re actively advancing the climate crisis.

The solution: Standard measurement using actual energy consumption

To do ESG in a way that’s truly meaningful, we need standard measurements. Basically, we need Generally Accepted Accounting Principles (GAAP) for ESG. GAAP accounting is a set of accounting principles that companies have to follow to adhere to SEC requirements. They govern corporate accounting and financial reporting. We need a climate equivalent so that every company can measure the same thing the same way.

“But for ESG, there is no consistent way for companies to measure where they are. The only consistency is that this holds true across just about every dimension of ESG.”

Take carbon accounting. To determine the GHG emissions of your energy consumption, you can use a really simple equation: how much energy you use times the carbon intensity of that energy. Easy enough, right? But when it comes to filling in those variables, a lot of companies, including third-party GHG accounting firms, rely on assumptions. They’ll look at information such as number of employees, office location, and expenses on various line items, then make a bunch of assumptions about energy use and carbon intensity based on those factors.

But this information doesn’t have to be assumption based — certainly the electricity consumption part of the equation doesn’t. If you’re a company and you have several locations, you shouldn’t look at the square footage and location of each location and infer how much energy they’re using. Those numbers exist; there are actuals. We should be using actual energy consumption figures when calculating GHG emissions.

Determining the carbon intensity of the energy used is also increasingly possible. When assessing carbon intensity of the grid, there are varying levels of accuracy available. At the most generalized level, you can use an aggregate national figure for the amount of carbon per kilowatt hour of energy. Or, you can start to get more refined based on two factors: geography and time. With geography, you can utilize annual carbon per kilowatt hour by state, because different states have different energy mixes. We all know the energy mix in Kentucky is different from the energy mix in Oregon, and that should be reflected. But even when you double-click on a single state, the carbon intensity of the grid can vary dramatically based on time. Is it summer or winter? Three in the afternoon or five in the morning? Factors influencing carbon intensity reflect both the amount of energy demand, and the mix of supply available at any given time.

Theoretically, you can get as specific as the carbon intensity exactly where you are — more granular than the state level — and the five-minute interval around your consumption to get a very, very accurate cleanliness measure of the energy you’re using. For companies looking to make their carbon accounting more accurate, it’s about moving down the spectrum of specificity in a smart, stepwise manner, from a single, gross figure of national carbon intensity per kilowatt hour to more specific carbon intensity measurements by state, geography, and time.

We’ve taken the first step, but there’s more work to do

The SEC’s proposed rules on carbon reporting are a good step forward, but they need measurement standards to be truly meaningful. The same held true for financial reporting. Prior to the introduction of GAAP accounting, publicly traded companies weren’t exactly forthright about their financials. Historians consider that one of the factors behind the Stock Market Crash of 1929 and the subsequent Great Depression. GAAP accounting was developed in response to those financial crises.

We’re already in a climate crisis; we don’t need to add financial woes caused by inconsistent, inaccurate carbon accounting. Measurement standards based on actual energy consumption data is critical. Arcadia’s API platform, Arc, can enable companies to automatically, on an ongoing basis, access their energy usage data at scale.

That kind of data access will be key as companies plan for how they’re going to adhere to the SEC’s new rules. Climate reporting is here; it’s not going away. Companies need to plan for the immediate term as well as the mid and long terms in a way that is not just compliance-based, but that’s beneficial for their business. It’s not about point solutions — “I need to develop data point X to execute on the SEC regulations.” Instead, the question that companies should be asking is “How am I going to get my arms around my climate footprint and make it better as an ongoing initiative?”

Establishing how we measure the environmental component of ESG will help companies answer that question.

“We’re already in a climate crisis; we don’t need to add financial woes caused by inconsistent, inaccurate carbon accounting. Measurement standards based on actual energy consumption data is critical.”