New Data on the Quality of ESG Audits Catches Regulators’ Attention

All publicly traded companies in the United States are legally required to have their financial statements vetted by independent auditors. And plenty of other firms hire external auditors to enhance their credibility in the eyes of investors and other stakeholders. But what about the ESG reports that most large firms now voluntarily publish? How commonly are such nonfinancial disclosures subjected to third-party verification, or “assurance,” as accountants call it? And does that scrutiny have any effect on the quality of those disclosures?

Brandon Gipper, an associate professor of accounting at Stanford Graduate School of Business, and Shawn Shi, PhD ’23, an assistant professor of accounting at the University of Washington, tackle those questions in a pair of recent papers that have already influenced the debate about whether corporations should be required to report on their environmental and social impact.

Before it was published, their research was cited no less than nine times in the final climate disclosure rule adopted by the Securities and Exchange Commission in March 2024. The rule requires companies with a publicly traded equity value of $75 million or more to disclose information about their greenhouse gas emissions and imposes increasingly stringent audit requirements on those disclosures over time — features that are in keeping with the implications of Gipper and Shi’s work. “We were very happy that they took a look at the papers as they were doing the rulemaking,” Gipper says. (The SEC voluntarily paused implementation of the rule in response to legal challenges, which it intends to fight in court.)

When Gipper and Shi began investigating ESG assurance in 2019, they quickly realized that there was a lack of standardization in reporting and verification practices. Coupled with the absence of a central database of detailed information on who performs ESG audits, how they conduct them, and which metrics they verify, this meant there was almost no data to work with. So they set about gathering it themselves.

The Rise of ESG Assurance

With help from Samantha Ross, a former staffer at the SEC and the nonprofit Public Company Accounting Oversight Board, Gipper and Shi compiled 4,000 ESG reports published by 750 S&P 500 firms between 2010 and 2020. They then mined those reports for information on the firms’ ESG assurance practices, using a team of research assistants to manually collect data on 11 different environmental and social metrics ranging from greenhouse gas emissions and total energy use to employees’ racial and gender demographics.

Their analysis of the data revealed a striking increase in ESG assurance over the period. In 2010, only 16% of ESG reports in the sample were verified by third-party assurors, putting U.S. firms well behind their European counterparts. By 2020, they had pretty much caught up, with 46% of ESG reports undergoing assurance — a finding that challenges the claim by opponents of the SEC’s climate disclosure rule that mandatory disclosure and verification would impose burdensome new costs. “We showed that firms were already voluntarily doing this,” Shi says.

The number of environmental and social metrics being audited also increased over the decade, with a clear emphasis on environmental over social measures. Gipper suspects that firms tend to focus on “E” over “S” partly because environmental factors are easier to quantify than social ones — and partly because “there’s a lot more emphasis around ‘E’ in capital markets regulations,” as evidenced by the SEC’s climate disclosure rule.

A relatively small proportion of reports (less than 20% in 2020) were audited by traditional accounting firms like Deloitte and KPMG. Instead, most were verified by environmental engineering and consulting firms with expertise in environmental factors like carbon emissions.

Gipper and Shi also explored why firms chose to undergo ESG assurance in the first place. Two factors appeared to be paramount: peer pressure and the adoption of ESG reporting frameworks. Firms were more likely to have their ESG reports audited when other companies in their sector did so and when they adopted reporting frameworks that prepared them for third-party verification.

Having gotten the lay of the land, Gipper and Shi decided to find out whether inviting external auditors in to conduct site visits, review documents, and sift through data improved the quality of firms’ ESG reports. They teamed up with Stanford GSB PhD student Fiona Sequeira to examine the impact of third-party verification on the quality of an especially popular type of ESG reporting: the disclosure of carbon emissions.

More Disclosure, More Accuracy

To understand how assurance affects the quality of carbon accounting, the team developed a model for estimating a firm’s Scope 1 and Scope 2 carbon emissions based on its industry and production levels. (Scope 1 emissions come from sources the firm owns or controls directly, like its vehicle fleet. Scope 2 emissions derive from the production of the energy that the firm purchases, like the diesel fuel that it buys.)

“Emissions are largely driven by the operating activities of a company, like how many widgets they make,” explains Gipper. The team then compared that estimate with the hand-curated data from their first paper to determine how accurate the firm’s reported numbers were.

Given the lack of standardization in the field, there was reason to doubt whether assurance would have a positive effect on the quality of carbon accounting. Yet much to Gipper and Shi’s surprise, it did: Assurance improved the quality of Scope 1 and Scope 2 disclosures by 26% to 34%, respectively. And the more rigorous the assurance, the more accurate the accounting became.

“When you have a third party come in and help you verify these voluntarily disclosed numbers, the quality of those disclosed numbers goes up. And when the assurance is more thorough, the effect is stronger,” Shi says.

A review of emissions data from 42 other countries showed a similar effect internationally, with the quality of carbon accounting improving even more when assurance was mandatory, as in Italy, France, and Spain.

The impact of carbon assurance appears to be twofold: On the one hand, the auditing process allows firms to identify and fix problems with their carbon accounting procedures. On the other, it allows them to go back and revise their historical emissions numbers to make them more accurate.

Gipper and Shi can’t be sure exactly how much their work influenced the SEC’s climate disclosure rule. Yet it’s notable that the agency did decide to make assurance mandatory for large firms and to impose progressively higher standards for assurance over time.

Regulators aren’t the only ones who can learn something from Gipper and Shi’s work, however. Tomorrow’s business leaders might also want to pay attention. Gipper points out that while ESG reporting and verification were largely aspirational concepts for previous generations of b-school students, today’s MBAs “may be going into a work world where this stuff is more tangible.” As the quality of the available information continues to improve, the next generation of emerging business leaders may find it easier to effect change on the ESG front “because they’ll have something to look at to tell them how they’re doing.”

Shi agrees. “The business world is going to shift,” he says. “More information is going to have to be disclosed, and this kind of reporting is going to become more rigorous.”

With additional reporting by Patrick J. Kiger