Time to reform ESG by reporting values created for each stakeholder

Market players have gradually adopted concepts and practices related to “responsible management” to reverse the trend of “maximizing shareholder value”. Among other initiatives, many companies spend considerable resources on environment, social and governance (ESG) activities, and this is a trend to which the capital market also pays close attention. ESG practices not only have potential environmental and societal benefits; companies adopt ESG metrics to enable more efficient resource allocation, better risk management, and more sustainable corporate growth.

In theory, investment in ESG would lead to lower corporate returns in the short run but would produce more long-term sustainable values for stakeholders. However, ESG reporting requirements, with multiple, complex standards and metrics, are both a source of debate and an area of growing interest in the market. As many of the inherent concerns regarding ESG reporting have not been addressed, it is doubtful to what extent piecemeal revisions of the requirements by the stock exchange or other regulatory bodies can significantly improve the cost effectiveness and value of ESG reporting, especially in achieving social and environmental progress.

Concerns and insights such as those above highlight the need for a revised ESG model that embodies the core values of responsible management. This article seeks to take a critical view of the current ESG reporting mechanism, considering that any such mechanism should be aimed at first uncovering the extent to which management acts ethically and responsibly toward different stakeholders leading to sustainability.

Problems with existing ESG reporting indicators

While recognizing the popularity and general acceptance of ESG, the concept so far lacks a robust theory and conceptual framework. Consequently, ESG is arguably a loose and convenient buzzword, and lacks clarity regarding its purpose, assumptions, elements, and limitations. Most ESG reports focus on “environmental sustainability” and on investors’ information needs, and demonstrate little concern for business ethics and responsibilities to each of the different stakeholders.

ESG has been growing in popularity since 2015, especially following the launch of the United Nations’ 17 Sustainable Development Goals in 2015 extending ESG integration to a broader scope of environmental and social impacts.

However, there has never been any serious discussion in either the market or the literature regarding why the three domains of “E”, “S” and “G” are put together, why in this particular order, and how they interrelate with one another. Consequently, many individuals confuse it with terms such as benefit corporations, corporate social responsibility, creating shared values, corporate sustainability, or impact investment. The current ESG disclosure requirements by the Hong Kong Stock Exchange do not specify whether “G” should be disclosed together with “E” and “S” in a single report and in what order.

Lacking an integrated conceptual framework, the major problem with the existing ESG reporting and other similar concepts is that it is not based on a company’s purpose, responsibilities to stakeholders, and social contract.

Revising the ESG model using responsible management concepts

To address the current shortcomings, the first step in revising the ESG reporting model is to identify a sound and comprehensive conceptual framework.

We believe that corporations are important social institutions that have the capacity to benefit various stakeholders, including society. In recent years, some business and academic leaders have suggested redefining the purpose of corporations from the perspective of social contracting. That is, companies, which enjoy privileges such as limited liability, unlimited life and independent legal-person status, should implicitly agree to bear responsibilities for various interdependent stakeholders. Thus, corporate leaders should not concentrate solely on shareholders’ interests, but rather should optimize sustainable value for all stakeholders upon whom corporations’ existence depends. In other words, corporations need to balance the interests of all major stakeholders and aim for sustainable growth.

We also believe that decisions based on responsible management is the cornerstone of stakeholder-based corporate governance. We therefore propose a revised ESG model based on the integrated conceptual framework of responsible management developed by this author in 2020. This framework stems from the umbrella concept of social contracting and examines the purpose and the core values of responsible management.

Thus, in the integrated framework, three core domains are identified: ethics, stakeholders’ value, and sustainability. On top of these three domains comes the existing governance domain, which provides the overall corporate direction and leadership of “responsible management”. A brief definition of each of these domains is given below:

Ethics represents the moral principles or conscience that govern a company’s behavior, represented by the implementation of appropriate business policies and practices not obliged by law.

Stakeholder value emphasizes disclosure of the sustainable value created for each of the stakeholder groups, including shareholders/investors, senior management, employees, customers, suppliers, creditors, community, regulators and the government.

Sustainability means to meet the needs of this generation without compromising those of future generations. It is centered on the core concept of the triple bottom line, i.e., the goals of “people, planet, and profit”. It enables organizations to take a longer-term perspective and thus evaluate the future consequences of decisions.

Together with the umbrella concept of governance, these different domains are complementary, mutually reinforcing but distinct, each with its own core concepts and execution.

‘S’ is ‘stakeholder’, not ‘social’

Besides environment (E) and governance (G) performance indicators in the existing model, the “S” or “social” domain of the existing ESG model is arguably too broad and hence confusing, as it consists of a number of loose reporting elements such as human rights, employee training, equal opportunities and diversity, corruption prevention, occupational health and safety, product liability, charity, and volunteering, which do not necessarily relate to each other. Currently, the expectations and information needs of different stakeholders are not systematically addressed or reported. We advocate to change the letter “S” to represent “stakeholders” instead of the broad, potentially confusing “social”.

The “stakeholder value” (S) indicators should be classified according to the extent of ethics practiced and the amount of sustainable values created (or reduced) for each of the following stakeholder groups: shareholders, employees, senior management, customers, suppliers, creditors, community, and government and regulators. Together this would lead to ultimate sustainability of “people, planet and profit” as described in the earlier section.

It is evident that across the globe, the current ESG reporting model has fallen short of the expectations of society at large. Different stakeholders are desperately waiting for new direction on this matter.

Based on the integrated conceptual framework of responsible management described, the revised ESG reporting model links ethics, shareholder value, and sustainability effectively. This robust framework should effectively address some major shortcomings of the present model. This ESG reform should begin today.

The author is president of The Hang Seng University of Hong Kong.

The views do not necessarily reflect those of China Daily.