April 5, 2024
Q&A: The growing trend of environmental, social and governance assurances in corporate America
ESG assurance recently entered the spotlight when the U.S. Securities and Exchange Commission approved a rule that will require public companies to report their climate risks and greenhouse gas emissions.Pixabay
Voluntary reports that discuss environmental, social and governance issues — or ESG issues — have become a major trend in corporate America over the past decade. It’s also increasingly common for firms to ask for ESG assurance, in which a third party verifies metrics disclosed in ESG reports, such as greenhouse gas emissions or employee diversity.
Shawn Shi, UW assistant professor of accounting in the Foster School of Business, is conducting ongoing research on the topic along with Brandon Gipper of Stanford University. The two are among the first to study the landscape and evolution of ESG assurances – as well as how these assurances shape the quality of reporting – among U.S. public companies in large sample.
ESG assurance recently entered the spotlight when the U.S. Securities and Exchange Commission, citing research from Shi and Gipper, approved a rule that will require public companies to report their climate risks and greenhouse gas emissions.
UW News spoke with Shi to discuss the evolution of ESG assurances, the SEC ruling and more.
What are ESG reports, and why are third-party assurances a growing trend?
Shawn Shi: One of the most salient trends in corporate America is firms increasingly disclosing issues related to environmental, social and governance topics. Firms voluntarily issue these standalone reports called ESG reports. They are also referred to as sustainability or corporate social responsibility (CSR) reports. Some part of the report is qualitative, so not hard numbers. They’re just talking about what they’re doing in the ESG space: What are their plans and goals? Other elements are more quantitative and disclose specific metrics, such as how much greenhouse gas the firm produces in a year, diversity and racial pay discrepancies, among others.
The critical question here is, How can firms signal to external stakeholders that these numbers are credible? That’s one of the reasons why companies engage a third party to come in and verify some of these numbers. This verification is ESG assurance. A lot of what my co-authors and I are doing is trying to understand ESG assurance as a phenomenon. What is the landscape and evolution of ESG assurance? What motivates firms to voluntarily seek assurance? What are the economic consequences of having ESG metrics assured?
Can you explain the recent SEC ruling and how your research was cited?
SS: The SEC’s recent disclosure mandate is about public firms’ climate risk exposure. Climate risk could be a physical risk, meaning events like fires, heat waves or floods. It could affect a firm’s economic operations and hence their financial performance. Climate risk could also be a transition risk, which is essentially the costs associated with an economy’s transition to a low-carbon future. For example, in the future there could be an environmental regulation that affects your business. Could your business model survive the regulatory requirement? The SEC’s disclosure mandate is about helping investors better understand the climate-related risks firms face.
Part of the disclosure mandate is for firms to disclose climate risks in financial reports if management thinks that climate risk is important — or material — to the company. Another piece is for firms to disclose their carbon emissions quantitatively. On top of that, firms would need to have those numbers assured by a third party.
Our research supports the SEC’s disclosure mandate in a variety of ways. For example, the SEC cited our paper on the landscape and evolution of ESG assurance to describe voluntary ESG assurance practice in the U.S. before the mandate to disclose greenhouse gas emissions. As it turns out, reporting of these greenhouse gas emissions is already pretty common and assurance is becoming increasingly common. Meanwhile, heterogeneity exists.
This rule is controversial. One week after the rule came out, people took it to court. The rule faces opposition, and one of the arguments is that reporting and assurance are costly. But our research shows firms are already producing these numbers voluntarily, and that more and more firms are starting to voluntarily verify these numbers. Traditionally, people think large firms will incur higher costs when they comply with mandates like this, because their businesses are more complicated. But our research shows that the largest firms are the ones already doing this work, which pushes back against some of these arguments about prohibitive costs.
The SEC also debated on whether to require assurance of carbon emissions and what kind of assurance should be required, which is another example of how our research contributed. In one of our studies, we show that assurance of carbon emissions is associated with improved quality of carbon emissions reporting. We also document that, the more thorough and pervasive the assurance is, the higher the quality of carbon emissions reporting. These findings provide justification for requiring high-quality, independent assurance.
What do you see as the future of research on this topic?
SS: There are plenty of things that we don’t really know about in this space. First, are ESG assurances relevant to decision-makers? Are they useful to investors, consumers, suppliers, or even firms themselves? Because ESG assurance is currently voluntary and there is a lot of diversity in terms of how it is being conducted and which metrics are assured, I would expect the answer to vary depending on the setting. In addition, there are different types of ESG assurance, such as assurance over green bond issuance, audit of carbon credits, among others. In my opinion, these are all growing phenomena that we have limited understanding of.
It’s also interesting to think about who provides ESG assurances. Financial statements are audited by auditors like Deloitte and PwC. The market is somewhat concentrated with the four largest auditing firms and a few smaller players. Our research finds that only 25-30% of ESG assurances are conducted by these traditional financial statement auditors. The rest are provided by environmental engineering and consulting firms. They have a lot of expertise in environmental knowledge but follow different kinds of procedures. There are discussions about their independence. So this market is very different in many ways. Which type of assurors provide better ESG assurances? What will happen to the market for ESG assurance as we transition from voluntary assurance to mandatory assurance? My co-authors and I look forward to tackling these questions in the future.
For more information, contact Shi at shawnshi@uw.edu.
Tag(s): Foster School of Business • Shawn Shi
