There has been a radical change in the investment market in recent years with investors measuring business performance with traditional financial factors, and the way companies manage risks related to environmental, social and governance (ESG) issues. Economies and businesses are now more cognizant of the importance of decarbonization strategies, value creation, and climate-related investments in achieving long-term sustainable growth.
Businesses that focus on ESG issues such as climate change are considered forward-looking and perceived as having a competitive advantage. Despite the economic pressures brought about by the ongoing pandemic, the philosophy of stakeholder capitalism has gained more support with these non-financial factors considered critical to business resilience and long-term recovery. This shift has increased the demand to make accounting for climate risks a mainstream measure of performance and not just a measure of corporate responsibility.
Companies committed to sustainability may have a better-defined margin and may achieve a lower cost of capital. Financial reports no longer just focus on short-term financial parameters alone, but also consider the long-term importance of investing in clean technologies. When business leaders take into consideration market mechanisms like carbon pricing and emission caps, which can result in financial incentives as well as the lasting positive engagement with stakeholders, they can see that ESG factors now have a direct impact on a company’s cash flows, financial position and financial performance.
CLIMATE-RELATED MATTERS IN FINANCIAL REPORTING
The integrity of financial statements that provide transparency on climate-related matters are becoming increasingly critical for efficient resource allocation and sound decision-making. International Financial Reporting Standards (IFRS) require businesses to report climate-related matters when their effect is material to the financial statements. According to “Effects of climate-related matters on financial statements” published by the IFRS Foundation in November, information is considered material if “omitting, misstating or obscuring it could reasonably be expected to influence the decisions investors make on the basis of those financial statements.”
For instance, the publication mentioned above states that companies must include in their report climate-related issues that may affect estimates of future taxable profits, estimates of recoverable amounts to assess impairment of goodwill and impairment of assets, levies imposed by governments, effects of climate-related matters on the measurement of expected credit losses and on the fair value measurements of assets and liabilities in the financial statements, among others. The use of narrative reporting or management commentary can likewise fill the gaps in financial statements.
CHALLENGES IN CLIMATE RISK DISCLOSURES
Unfortunately, despite the existing IFRS requirements and encouragement to adopt the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), which provides a framework to help companies more effectively disclose climate-related risks and opportunities through their existing reporting processes, a number of publicly listed companies still lack comprehensive and transparent climate risk disclosures, simply adopting a “check box” approach in reporting. Businesses need to realize that for many investors, transparency, quality and depth of disclosure warrant credit and not criticism. In addition, disclosing material information on climate change scenario planning enhances risk management, helps execute strategies, and leads to long-term increases in shareholder value.
Although multiple disclosure frameworks and standards such as the Sustainability Accounting Standards Board, Global Reporting Initiative, International Integrated Reporting Council and the TCFD provide recommendations on climate risk accounting, there is still a lack of standardized metrics in ESG reporting. Investors require more information from the data presented to them while the complexity and costs of reporting ESG matters against multiple standards and frameworks are often frustrating to businesses.
This situation calls for developing and adopting structured and universal reporting standards to measure corporate sustainability performance. Standardization will not only improve the clarity, comparability and consistency of figures and information but will greatly enhance dialogue between investors and companies.
According to Erkki Liikanen, Chair of the IFRS Foundation Trustees, there is a growing demand for standardization and cooperability on sustainability reporting. A consultation paper on sustainability reporting was published by the Trustees of the IFRS Foundation on Sept. 30, and it sets out possible ways forward, including the plan to create a new separate Sustainability Standards Board. This entity will initially focus on climate-related risk disclosures and will work in parallel with the International Accounting Standards Board under the IFRS Foundation. Consultations are currently being conducted in order to determine global demand and develop possible interventions, with the aim of collaborating with existing national and regional initiatives to develop global standards in sustainability reporting.
Globally applicable standards will guide companies in identifying and mapping out financially material climate scenarios and sustainability topics, as well as in assessing their implications on business risk management. These standards will also minimize complexity and provide the primary users of financial statements (existing and potential investors and creditors) and other stakeholders (customers, suppliers and employees) with a qualitative discussion of ESG topics and key performance indicators (KPIs) that are material to the company’s operations.
In the absence of a globally accepted set of standards, EY and the Coalition for Inclusive Capitalism worked together in 2018 to prepare the Embankment Project for Inclusive Capitalism (EPIC) report to identify common metrics by which companies can measure long-term value. Leveraging the insights from 31 asset management participants from the US and EMEIA, the EPIC report focused on creating new metrics for demonstrating long-term value in four key areas, two of which were Society and Environment, and Corporate Governance.
Uniform standards on climate-related disclosures will also enhance business confidence and efficiency as there will be a consensus on what constitutes an ESG investment. A standard ESG lens will also help companies translate theory into action since businesses will be guided on how their commitment to ESG goals will impact society and the planet. These standards are critical in assessing and communicating climate risks and opportunities as well as in developing strategies to build long-term resilience while facilitating the transition towards a low carbon economy.
THE FUTURE OF SUSTAINABILITY REPORTING
The undeniable strong connection between ESG performance and financial risk and returns calls on the corporate sector to take a huge leap towards securing long-term success by creating more climate-resilient portfolios, integrating holistic and sustainable solutions to the investment process, and ensuring transparency and compliance with reporting requirements. Through these efforts, companies can effectively manage risks and generate sustainable, long-term returns. As stakeholders seek to understand how companies manage ESG risks, transparent, credible and compliant ESG disclosures will be essential in building confidence in what is reported.
Given the foreseeable impact of climate change, and the mounting pressure from investors, employers, leaders, consumers and policymakers to address it, companies, more than ever, are called upon to clearly and transparently integrate ESG considerations into their overall business strategy. As the global economy transitions to a decarbonized future, those who do not keep up will risk being outperformed by companies that embrace climate resiliency.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Benjamin N. Villacorte is a Partner of SGV & Co.