We have previously lamented that none of the scoring metrics for governance offered by ratings agencies and financial data suppliers include a serious attempt to measure accounting manipulation.
A company that manipulates financial accounts will hardly be scrupulous with ESG reporting. In that discussion, we omitted an important dimension of the problem, which is that incentives to cheat on ESG reporting are growing.
A recent article on executive pay notes that ESG metrics are increasingly a part of company incentive plans.
According to ISS, a company specializing in data analytics, in 2022 profitability and other business measures represented just 42% of the metrics used to determine executive pay in 2022.
This figure was down from 64% in 2015 and 59% in 2019. Environmental and social metrics, meanwhile, accounted for 20% of executive pay determination in 2022. This is up from just 4% in 2015 and 8% in 2019.
Based on current trends, environmental and social metrics could eclipse profits as a determinant of executive pay by 2025.
ESG metrics
We see big problems ahead because ESG metrics are typically far easier to manipulate than accounting data for the simple reason that every number reported in a set of financial statements is related to another.
However cunningly connived, the numbers in a company’s financial statements have to add up, they have to make sense and they have to be consistent with the business performance a company is attempting to portray.
We see big problems ahead because ESG metrics are typically far easier to manipulate than accounting data
Whenever a company misrepresents its true financial performance, it leaves a trail of evidence that sticks out like a neon light to a good forensic accountant (or fraud-detection software such as that offered by Transparently.AI).
Environmental and social metrics are not subject to the mathematical strictness of financial accounting metrics.
Many are stand-alone numbers easily attained by hiring and firing the right kinds of employees, by adding a layer of costs, or simply by making numbers up.
In the words of Ben Colton, head of stewardship at State Street Global Advisors, environmental and social metrics are often “very subjective, fluffy and easily gamed.”
Poor governance on executive pay
The relative ease of attaining environmental and social metrics versus financial metrics, which require executives to perform against competitors in the real world, suggests that the trend towards increasing reliance on these metrics will persist.
The real elephant in the boardroom here is that governance is nowhere to be seen in executive pay incentives. At no point in this entire process are executives encouraged to be truthful.
Governance is nowhere to be seen in executive pay incentives. At no point in this entire process are executives encouraged to be truthful.
Human nature being what it is, the prevalence of fraudulent ESG reporting will increase in line with the incentive to manipulate ESG metrics.
The only solution, as we see it, is to judge the governance of companies in an impartial and consistent manner by assessing the truthfulness of metrics that they publicly report.
This is a job for big data, a job for automated software and a job for AI. Unfortunately, the truthfulness of mushy ESG data is difficult to assess. We can only assess the integrity and transparency of a company by looking at the public financial statements.
In our view, this is the ultimate measure of governance and it should be an essential determinant of executive pay. Until it is, executives will be incentivized to lie and investors will be misled.
Our mission at transparently.AI is to put some real G into ESG.
