Previously published in The Digital CFO magazine (Winter 2023) | Authored by Daniel Chow
ESG, a set of standards and frameworks related to Environmental, Social and Governance criteria, is already a corporate hot topic.
Borne out of the realization and acceptance that business activities directly impact the environment and well-being of society, there is an increasing demand for ESG data and transparency from multiple stakeholders. Investors are increasingly asking for and factoring non-financial information into business analysis and valuation models to support their investment decisions. Business leaders are also assimilating ESG data into their management decision-making process to gain a holistic view of the risks and opportunities their companies are exposed to. Finally, consumers are demanding sustainability information to inform buying habits that are aligned with their values. This is especially true of Gen Z, 75% of whom say sustainability is more important than brand names (source).
The development of ESG regulations by standard-setting boards is likely to be a dynamic, evolving journey and is only just beginning. And it will likely fall to Finance teams – already well versed in risk management, governance, data management, accounting and reporting – to manage the completely new data sets and disclosures that will be required to meet the expected regulations and reporting requirements.
From voluntary to regulatory
Until now, ESG reporting has been mostly voluntary, reflecting the recognition that it can act as a key driver of enterprise value. However, standards boards and regulators are now moving to codify ESG regulations, and Finance functions are being tapped to lead compliance initiatives.
In addition to disclosure requirements, mandatory ESG ratings and certification processes are expected to increase. Companies that perform poorly will take hits to their share price and likely to be starved of capital. By 2030, poor performers are expected to be weeded out and C-suite and Directors to be personally liable for ESG breaches
More countries than ever are putting standards in place to require ESG reporting with the number of ESG reporting provisions issued by governmental bodies growing 74% over the last four years.
The status of the Standards Boards
Regulatory requirements on ESG management and reporting continue to take shape and can vary greatly depending on the aim and reach of the standards board.
Enterprise value-focused frameworks and standards like Task Force for Climate Disclosures (“TCFD”) and Sustainability Accounting Standards Board (“SASB”) are looking to demonstrate the link between sustainability issues and value creation, the result of which culminates in qualitative and quantitative disclosures that facilitate the assessment of the impact of non-financial factors on the current status and future prospects of businesses.
The International Sustainability Standards Board (“ISSB”) has undertaken the tasks of standardizing the myriad of sustainability frameworks and standards around the world with the aim of providing clarity and comparability over ESG
The European Sustainability Reporting Standards (“ESRS”) has a wider scope where, in addition to enterprise value, it also captures disclosures pertinent to the wellbeing of the environment and society. There are currently 13 exposure drafts under consultation with certain organizations needing to comply beginning on January 1, 2024.
Meanwhile, the US SEC has yet to announce mandatory climate-related disclosures but is expected to in the coming months.
More countries than ever are putting standards in place to require ESG reporting with the number of ESG reporting provisions issued by governmental bodies growing 74% over the last four years. For global organizations who will have to report under multiple standards, this will pose significant adoption challenges and regulatory risks.
Finance will likely be tapped to lead ESG
There is a broad consensus that while ESG represents a huge undertaking which will require cross-functional collaboration, Finance is likely to be the ideal function to drive the implementation of ESG initiatives. An Accenture 2021 survey reports that 68% of CFO respondents are currently responsible for their company’s ESG performance. That percentage is likely to grow as the regulations become more widespread.
As the role of Finance continues to evolve away from mere reporter of historical financial activities, ownership of ESG fits into the vision of Finance as a provider of business insights and overseer of business value. Moreover, Finance already possesses a multitude of skills required such as business analysis and a control environment mindset for operating ESG; as well as the cross-functional relationships necessary for execution.
Finally, given the expectation that ESG disclosures will need to be reported in financial statements which comes with the need for assurance, it makes sense to add ESG to Finance’s repertoire of responsibilities.
Procuring and handling data that is not traditionally encountered by Finance means they will need to lean on others with specific subject matter expertise in areas like emissions, energy, and community relations to understand and analyze the data points.
ESG considerations for Finance
ESG accounting, analysis and disclosures will require additional granular data. A portion of the ESG data will be non-financial in nature, so organizations will need to determine whether they own and store the data or if it will be provided by a third party. Given that a portion of ESG regulations have to do with a company’s vendors, suppliers, customers and clients, procuring the essential data points may become a complex task. Examples include the need to collect data around GHG emissions from consumers, product safety during consumer usage and ecological impact data sourced from NGOs. Procuring and handling data that is not traditionally encountered by Finance means they will need to lean on others with specific subject matter expertise in areas like emissions, energy, and community relations to understand and analyze the data points.
Then, procured ESG data will need to be linked to key financial drivers like revenue, costs, assets and liabilities, and cost of capital in order for Finance to assess its financial impacts, which means it must be captured within the Finance data flows. Finance will require a dynamic infrastructure and robust solutions to handle disparate ESG data at the right level of granularity in a way that provides clear audit trail and reconciliations.
In the near future, ESG regulations and best practices will evolve constantly as regulators and companies alike learn and adjust to what is practical and useful. In response, accounting rules will need to capture ESG-related dimensions alongside core accounting flows to accommodate innovative new products and services as well as new aspects like carbon emissions accounting and their associated new accounting treatments.
This means firms will need to be able to revise accounting rules rapidly to adjust to an ever-evolving landscape. Centralized accounting rules maintenance will need to be fully owned by a Finance team with the ability to maintain and update accounting rules in a controlled and auditable manner, without a dependency on IT. Additionally, Finance must have the ability to model scenarios to identify the impact of accounting approaches on balance sheet metrics.
Disclosures and Reporting
There is a drive to standardize ESG reporting and disclosures across regulators and industries to ensure clarity and consistency of information available to all stakeholders. As these requirements are defined and further clarified, firms will need to rapidly source required data points, integrate them with their current financial reporting flows, perform additional transformations and then provide the outputs for reporting and analytics. In addition, the ability to perform forecasts and scenario analysis on the balance sheet and income statement will be critical to enable Finance to adequately support the business in real-time decision-making.
Given the newness of ESG, Finance will also be tasked with managing the narrative with investors and illustrating the current status and long-term plans. A critical part of this will be continually connecting with industry peers and standards boards to ensure alignment with the market. Veering too far off course in the approach to ESG could make it hard to keep up with peers and may project a negative impression to the market.
Gone are the days of the CFO sequestered at their desk surrounded by spreadsheets. ESG mandates will require a strategic approach that takes into consideration areas previously far outside the CFO remit – from supply chain to human resources and engineering.
ESG is looking to be one of the most significant value drivers in the year ahead. A recent McKinsey article pointed to a strong ESG proposition as a potential value driver for topline growth, cost reduction, reduced regulatory risk, productivity uplift, and investment and asset optimization. For CFOs looking to earn their stripes as a transformation enabler and value-creator, ESG is certainly a good place to focus.