Fair Targets for ESG Performance: An Introduction

The need for non-financial reporting

Modern corporations are incredibly powerful; able to produce, in the aggregate,
a dazzling array of sophisticated goods and services. But the externalities
associated with their activities (i.e., impacts to the environment and human
beings as non-market stakeholders) are cannibalizing our natural capital; while
the fruits of production are being distributed with less and less fairness.

Non-financial reporting (of which ESG is the latest flavor) has the laudable
goal of shining a light on the often-seedy underbelly of a corporation’s
externalities in the hope that through transparency will come change. One
positive aspect of ESG reporting is the tacit understanding that a company not
only acknowledges prior performance problems but also lays out targets for
improved future performance. Targets are essential — they indicate where a
company is trying to go; the reduction in negative externalities it is trying to
achieve.

The problem with ESG reporting

The problem with ESG reporting as currently practiced is threefold.

1. It is difficult if not impossible to move the needle with self-selected
   company
   targets
   without broader
   context.
   Whether we’re talking about land use, freshwater abstraction, toxic
   pollutants, fishing, employment practices or carbon emissions, corporate
   targets need to reflect relevant local, regional, industry and/or global
   conditions. Take water, for example: Just announcing a target for water
   abstraction (e.g., seeking a 15 percent reduction over the next two years)
   does not make it the right target. The right target would need to reflect
   water
   availability
   and competing demands — and some goal, stated in real terms that referred to
   bio-available water. This brings up the second problem.

2. ESG efforts report on company behavior (e.g., that it abstracted 5 acre-feet
   of water in a year). But behavior is only one component of impact; the other
   is the state of the non-market stakeholder (e.g., the watershed, forest,
   demographic group or the atmosphere) impacted by the behavior. The same
   behavior will impact different stakeholders (e.g., an arid plain or a flood
   zone) in different ways (e.g., hurting one and helping the other).
   Therefore, companies need to report on facility performance, so that it can
   be combined with local stakeholder constraints (e.g., watersheds) to infer
   actual and target impacts.

3. There are no standards to ensure comparability between ESG reports (for
   either performance or target data). Units of measurement, comparative time
   frames (e.g., year over year or relative to 2017) and denominators (revenue,
   earnings, units of output) differ widely between reports, which makes it
   difficult to combine them for the purposes of aligning the aggregate of
   corporate targets with sector goals.

As a result of these problems, ESG intentions far outpace ESG results.

ESG reporting needs fair targets

To transform ESG reporting from a feel-good marketing exercise into a
forward-looking financial assessment of a corporation’s environmental, social
and business risk and an ESG-risk-aware capital-budgeting strategy (which is
where the rubber meets the road and change happens), ESG targets need to reflect
non-market stakeholder needs at a local, regional and global level and align
those needs with the capabilities and behaviors of facilities and their
corporate aggregates. We call these kinds of multi-tiered, multi-stakeholder
targets ‘fair.’ Fair targets consider the operational realities of facilities,
the financial health of the company, local ecosystem and human conditions, the
technology substitution possibilities per facility, and the needs of markets
local to the facility (e.g., coal-fired power plants may need to continue
operating so long as alternatively fueled plants do not exist in the local
grid). Emitting less carbon and toxics and consuming less water and land per
unit of output is hard; resource-inefficient growth will be curtailed. Fair
targets mean the burden is shared equitably.

The process of setting fair targets for ESG behaviors should look similar to
corporate budgeting reconciliation, which aligns bottom-up budget requests with
top-down resource allocations in an iterative process intended to converge on an
optimal set of multi-tiered targets. ESG analysts should be able to query the
aggregate of corporate carbon targets by sector (or region) to see if targets
are aligned with science-based targets (or the Paris accord). And if they’re
not, signals should be sent (e.g., by analysts, investors or governing
authorities) to adjust corporate (or sector or regional) targets.

This article series will lay out a general computational framework for
establishing practically producible and universally comparable environmental and
social targets from widely available third-party data (e.g., CDP and
SBTi) and from internal data that all public companies collect (e.g.,
electric power produced or used per facility) that are fair and actionable
(i.e., they can be incorporated into resource-allocation decisions); and which,
if followed, will yield the aggregate results we all seem to be looking for
(e.g., avoiding environmental calamity by keeping global warming to 1.5°C
while fairly sharing any material burdens). The targets can be used to drive the
actions of facilities, companies, industries and regions by investors, governing
authorities and companies themselves across a wide range of relevant industries
and a wide range of spatial and political geographies.

One requirement to being not just a fair but also an actionable target is to
have been accurately converted from its source form — namely, that of a real
quantity of a real unit (e.g., 25,000 tons of emitted carbon) into its
analytical use form; namely, that of a quantity of a financial unit (e.g., a
$100 mm increase in costs or a $50 mm reduction in residual asset value) that
can be incorporated into business risk assessments and capital budgets and
budgeting processes (in the form of probabilistic amounts of some
internationally exchanged currency).

The series will begin in the next article with fair carbon targets for the
electricity industry — the earth’s largest emitter of greenhouse gases.