The Growing Importance of ESG Assurance in Corporate Reporting

As public scrutiny over corporate responsibility intensifies, Environmental, Social, and Governance (ESG) reports have become integral to many firms' annual disclosures. Independent auditors are legally required to vette financial statements, but the assurance of ESG reports is largely voluntary. However, recent research by Brandon Gipper and Shawn Shi highlights the increasing prevalence and impact of third-party verification of these nonfinancial disclosures.

The Evolution of ESG Assurance

Gipper, an associate professor of accounting at Stanford Graduate School of Business, and Shi, an assistant professor of accounting at the University of Washington, have significantly contributed to understanding the landscape of ESG assurance. Their research has even influenced the Securities and Exchange Commission's (SEC) climate disclosure rule, which mandates that companies with a publicly traded equity value of $75 million or more disclose their greenhouse gas emissions and subject these disclosures to escalating audit requirements.

Their investigation into ESG assurance practices began in 2019, revealing a lack of reporting and verification methods standardisation. They collected data from 4,000 ESG reports published by 750 S&P 500 firms between 2010 and 2020 to address this gap. Their analysis uncovered a dramatic rise in the adoption of ESG assurance, from 16% of reports in 2010 to 46% in 2020, challenging the notion that mandatory disclosure would impose burdensome costs.

Why Firms Opt for ESG Assurance

Peer pressure and adopting ESG reporting frameworks appear to be the main factors motivating firms to choose ESG assurance. Companies are more likely to have their ESG reports verified if their industry peers do so and if they follow reporting frameworks that facilitate third-party verification.

Interestingly, environmental metrics are more frequently assured than social metrics, likely due to their quantifiable nature and the regulatory emphasis on environmental factors, as evidenced by the SEC's climate disclosure rule. Most ESG reports are not audited by traditional accounting firms but by environmental engineering and consulting firms specialising in areas like carbon emissions.

The Impact of Third-Party Verification

The critical question Gipper and Shi sought to answer was whether third-party assurance improves the quality of ESG reports. They developed a model to estimate a firm's Scope 1 and Scope 2 carbon emissions based on industry and production levels and compared these estimates with reported figures. Their findings were striking: assurance improved the quality of carbon disclosures by 26% to 34%, with more rigorous assurance leading to more accurate accounting.

The U.S. was not the only country experiencing this positive effect. A review of emissions data from 42 other countries showed similar improvements, especially in nations where assurance is mandatory, such as Italy, France, and Spain. The auditing process helps firms identify and rectify carbon accounting issues, enhancing current and historical data accuracy.

The Future of ESG Reporting

Gipper and Shi's research has implications beyond regulatory frameworks. As the quality and rigour of ESG reporting improve, future business leaders will have better tools to measure and manage their environmental and social impacts. This shift towards more reliable and standardised ESG disclosures represents a significant step in corporate accountability and transparency.

As the business world evolves, the importance of ESG reporting and assurance will only grow. Companies proactively embracing these practices will likely benefit from enhanced credibility and trust among investors and stakeholders. For today's MBAs and emerging business leaders, understanding and navigating this landscape will be crucial in driving sustainable and responsible business practices.

Conclusion

The rising trend of ESG assurance reflects a broader shift towards accountability in corporate behaviour. As Gipper and Shi's research demonstrates, third-party verification enhances the quality of ESG disclosures and prepares firms for a future where such reporting is the norm. For companies and investors, embracing rigorous ESG assurance practices is a step towards greater transparency, improved performance, and a more sustainable future.