Investors are flocking to companies with good environmental, social, and governance (ESG) scores and are threatening to shun companies with poor ones. For many investors, ESG scores are critical to a company’s long-term profitability, not to mention its impact on people and the planet. But there is good reason for skepticism about the trustworthiness of the underlying metrics. For example, there is little correlation among the scores that different ESG ratings services assign to the same companies.

This situation is not inevitable. Despite their huge differences, the practices developed in financial reporting over many decades can contribute to the emerging field of ESG reporting. In our view, a robust framework for ESG reporting has three requisites. First, it must establish a limited set of metrics that capture key environmental and social impacts. Second, the metrics should be defined by a standard-setting body modeled on FASB, the standard-setter for financial reporting. And third, the companies themselves must have auditable processes for collecting, reporting, and verifying the relevant metrics. There has been much discussion over metrics, but there has been less focus on these final two elements, particularly the need to develop auditable data.

A full-fledged social accounting framework would measure a company’s significant positive and negative effects on all stakeholders, not just investors. The indicators must be accurate, valid, and reliable. The information must be sufficiently objective and verifiable to allow auditors, regulators, institutional investors, and litigants to identify and correct material misreporting. These stakeholders must be able to compare the impacts of different companies within and across sectors. And to enable comparisons, the indicators should be convertible into money.

Current ESG metrics run the gamut from the highly precise to the very inexact. At one end of the range are greenhouse gas emissions, for which there is a widely accepted reporting methodology. At the other end lie issues of diversity and inclusion which, however important, do not lend themselves to either precise definitions or reliable determinations. In any event, there are a number of different entities in this area working to establish criteria across the spectrum.

Whatever standards are used, they must be developed and maintained by a standard-setting body independent of political and financial pressure. The history of financial accounting provides some insights into the necessary features of such a body. For example, the board of FASB’s immediate predecessor, the Accounting Principles Board, was filled primarily with part-time representatives from the major accounting firms, leading to predictable conflicts of interest. FASB’s relative financial independence and political insulation have allowed it to enact meaningful standards in the face of industry and political pressures. Also, while FASB sets the standards, the SEC mandates that U.S. public companies adhere to them.

If financial reporting is politically controversial and subject to immense lobbying, imagine the potential controversies relating to ESG reporting. At a minimum, any ESG standard-setter must be a financially independent institution with significant research capacity and full-time board members who represent a broad swath of stakeholders. We are heartened by the World Economic Forum’s collaboration with the Big Four accounting firms to develop metrics that “reflect not only financial impacts but ‘pre-financial’ information … material to society and planet.”  But while those firms can doubtless contribute to the design of the metrics, their involvement in the actual standard-setting process would undermine its impartiality.

The International Federation of Accountants has proposed the creation of an independent standard-setting body that would build on various existing organizations. One arguably promising starting place would be the decade-old Sustainable Accounting Standards Board (SASB), whose name signals its aspiration to become the ESG equivalent of FASB.

But any standard-setting body must ultimately rely on companies to report their data accurately, and many companies lack the internal systems needed to generate high-quality ESG data. For example, consider the difficulties companies have faced in reporting the most high-profile ESG disclosures required by the Dodd-Frank Act: the pay-ratio and conflicts minerals rules.

These difficulties illustrate the tremendous improvements that must be made to companies’ reporting systems for ESG data to be reported accurately at a reasonable cost. In the financial context, companies rely on internal controls and reporting systems to generate output in accordance with accounting standards and on auditing and regulatory enforcement mechanisms to verify and correct the reports. In the ESG context, these types of systems range from weak to nonexistent.

Internal controls are processes that provide reasonable assurance that the reported numbers are correct. The majority of financial restatements are due to internal errors rather than fraud, and there is strong evidence that internal controls improve the quality of reported information. Indeed, in the financial context, they are so important that large public companies must provide a separate audit attestation regarding the quality of their internal controls.

While audits can improve the quality of reported information, they require reliable internal data to establish a reliable audit trail. The current lack of quality internal information contributes to the high frequency of “limited assurance” audits in publicly available ESG reports.

Given their multifarious natures, ESG metrics as a whole will never have the accuracy, validity, reliability, and commensurability of financial metrics. While the efforts of the World Economic Forum, Harvard Business School, and other organizations to improve them are critically important, the metrics’ trustworthiness depends on strong internal reporting infrastructure and an independent standard-setting body.

This post comes to us from Professor Colleen Honigsberg and Emeritus Professor Paul Brest at Stanford Law School. It is based on their article, “Measuring Corporate Virtue—And Vice,” in Frontiers of Social Innovation (Harvard Business Review, forthcoming 2021), available here.