The U.S Securities and Exchange Commission (SEC) proposed rules governing climate-related disclosures from all public companies on March 21, making environmental, social, and governance (ESG) reporting a necessary part for healthcare company corporate boards to address.
Whether it’s understanding efforts to combat climate change, diversity in the company’s leadership, or corporate policies, investors, customers, and even employees want transparency into the ESG impacts — good and bad — of the healthcare company’s activities and its sustainability initiatives.
To fully understand the standards for healthcare company corporate boards need to meet in their ESG reporting, we first need to understand what’s wrong with the current system.
The state of ESG reporting today
When healthcare companies disclose ESG reporting in annual reports, proxy advisory firms, such as Institutional Shareholder Services (ISS), take that information and basically put it on a rating system, where all the healthcare company’s ESG efforts are graded on an ABCD+- level.
Some proxy advisors including ISS also assess companies for overall positive or negative social impact and assign them a score. For example, just by visiting ISS’s ESG Gateway1, you can see that ISS assigns Johnson & Johnson a “B-” ESG rating and was judged to have a +8 significant positive social impact. Moderna’s ESG Corporate Rating is a C and is judged to have a +2.7 limited social impact.
Proxy advisors rarely delve deep into the reasoning for companies’ ratings which poses a challenge for investors attempting to ascertain which companies are the most environmentally or socially conscious. For a healthcare company’s board of directors, this challenge is even more significant. Because proxy advisors are opaque about their standards for obtaining high ESG marks, it is very difficult to know which factors are most critical. Case in point, Johnson & Johnson and Moderna have relatively similar corporate diversity, pay levels, and operations yet have different ESG and social impact scores from ISS.
Because proxy advisors’ standards are so opaque, a cottage industry has formed of ESG consultants who help companies achieve higher ESG rankings. The challenge is that proxy advisors such as ISS also offer these services. Many, including the SEC, have taken issue with this business model because of the potential for conflicts of interest.
Today’s ESG reporting mirrors the example of energy-trading company Enron Corp. and accounting firm Arthur Andersen LLP from two decades ago, when Enron kept debt off its balance sheet when reporting annual financial earnings, which prompted a federal investigation and led to a new set of standards to maintain financial integrity.2 Similar to the Enron example, companies may try to do anything they can to earn a better ESG grade and impress their investors, and they are managing to do so without credible environmental and social change. To fix this, the current ESG system needs to be updated.
What needs to change?
With the current ESG evaluation system seemingly more focused on ratings than bringing about change, proxy advisors issuing these ratings need to consider reforming their organizations to focus on either ESG ratings or ESG consulting, as both operations create the challenges seen with companies trying to leverage the system for their own beneficial evaluations rather than actually identifying true change. Just like the Enron story, consulting firms were helping the company boards prop themselves with false reporting, leaving shareholders to hold the bag of worthless stocks and company valuations at the end of the day.
Even though ISS is not the only proponent of ESG ratings, proxy advisors use their own methodologies to rank and score healthcare companies, in which the reports produced are at times rife with inaccuracies and ultimately sow confusion in the markets. These inaccuracies then consume the bandwidth of healthcare companies as they scramble to address misstatements that surface in these reports — taking valuable time that could be much better spent on actually improving ESG performance.3
Healthcare company shareholders and stakeholders, who actually want to see companies adhere to a set of ESG standards, are the losers in the current system. Without more transparency around ESG standards and changes to mitigate conflicts of interest, ESG ratings will not credibly mean much.
New ESG standards for healthcare companies
When thinking of the standards healthcare company corporate boards need to focus on in their ESG reporting, there needs to be checkbox standards across each environmental, social and governance branch that the healthcare company reports, where any investor can publicly verify that reporting. Without transparency, the system will continue to hurt companies that are supporting ESG goals while benefiting those willing to “game” the system. A transparent system will instead give ESG-conscious investors a leg up in understanding their investments while benefiting companies truly committed to doing the right thing.