Regulation & Standards

Time to act: treasury’s role in integrating financially material ESG data

Published: May 2021

Sustainable reporting has grown over the last decade. Now investors see it as increasingly financially material, and the pressure is on companies to integrate it into their corporate accounting models. It involves the expertise of sustainability teams with the processes and rigour of treasury and finance.

Close up of old vintage pocket watch

The pace economies decarbonise is set to pick up in the years ahead. Corporate success will increasingly depend on companies’ ability to articulate to all stakeholders how they are adapting to the new business model coming down the track. It means finance and treasury teams will need to publish corporate accounting models and balance sheets that put financial numbers on their sustainability data and information.

“Companies should prepare for the same legislative and regulatory overhaul in corporate accounting ushered in after the 1930s US stock market crash,” says Leon Saunders Calvert, Head of Research & Portfolio Analytics at London Stock Exchange Group (LSEG). “Back then, reporting via balance sheets and cash flows was challenging. Eighty years on, public companies face another drive in transparency because decarbonising is financially material.”

Of course, sustainable corporate reporting has been growing steadily over the last ten years with some 80% of global companies now reporting on sustainability, according to KPMG. Of this cohort leaders have emerged, already integrating their financial performance with their sustainability performance in a single, annual report. However, it is the pace of this convergence that is about to pick up, as standard setters increasingly eye ESG reporting as financially material, and financial statements no longer giving the full picture. “There are developments towards a more integrated form of reporting,” says Arjan de Draaijer, Global Co-lead, Impact, ESG and Sustainability at KPMG in the Netherlands. “Financial reporting standard setters and sustainability reporting standard setters like GRI (Global Reporting Initiative) and SASB (Sustainability Accounting Standards Board) are increasingly looking at the similarities and connections between financial and sustainable reporting. It all points towards a more integrated perspective on reporting that caters to all stakeholders.”

However, de Draaijer doesn’t believe this means companies will produce one document. “I expect there will be a portfolio of different reports,” he says, predicting a myriad spanning human rights in the supply chain to the financial impact of climate change and, going forward, the impact of biodiversity and inequality on financial statements as well.

According to KPMG, currently only around one quarter of companies at high or medium risk from biodiversity loss currently disclose that risk in their corporate reporting. “This is another element that should be on a treasurer’s mind in the future,” he says. As for the reporting burden, he believes digital publishing and linking reports from corporate websites will make the process easier. “Stakeholders will just be able to search for the information they need.”

Outside in

Another important shift in reporting is also under way. Companies have traditionally approached disclosure and reporting from an inside-out perspective. This typically involves measuring and reporting a firm’s impact on the outside world – like its carbon emissions. Increasingly, companies are using new disclosure requirements (namely the Task Force on Climate-related Financial Disclosures, TCFD) which focus on disclosure through a different, outside in-lens that reports on how climate change will impact the company’s financial performance.

This could entail disclosure on how rising temperatures could impact suppliers in developing nations, or how changing consumer behaviour will impact demand for a core product. “The indicators that are related to this type of reporting are of a different nature,” says de Draaijer. “A carbon footprint is still useful information in terms of detailing the carbon intensity of a product and its vulnerability to a low carbon economy, but this new type of information and data is increasingly appearing,” he says.

Investor pressure

Treasury and finance departments need to be able to articulate how sustainability data and numbers are integrated into the company’s business strategy to investors and lender banks. The best way to do this is to make externalities directly financially material and view them as a liability on the balance sheet, urges Saunders Calvert.

Most companies have only just begun. Positively, Saunders Calvert estimates around 41% of the 10,000 companies LSEG covers already report their Scope 1 and Scope 2 carbon emissions associated with energy consumption in their own operations. “There is a demand for this kind of information from investors,” he says. “Investors are telling companies that this is financially material information regarding their cost of capital.”

In contrast however, he says a much smaller proportion of companies have a cost of carbon internally that they manage to; deploy a liability to the balance sheet and seek to offset emissions by, say, paying carbon credits. “Only a small proportion of companies recognise the cost of carbon in the way they manage their financials.”

Nevertheless, he is convinced this is the direction of travel and it matters more that firms have embarked on the journey than their position en route. “If treasury actually have this information on the balance sheet; if they have it as a proxy, or even if they can just show they are on a journey to treating carbon as a cost to the organisation, it will demonstrate to investors they are somewhere on the road to internally quantifying and internalising these externalities,” he says. “Data points around carbon emissions will make their way in time, into actual corporate liabilities. It won’t be a separate statement; it will just sit there as financially material next to other liabilities.”

Case study

Philips logo

Dutch health-tech multinational Philips has taken a pioneering lead in sustainability reporting. The company now reports its environmental impact on society at large via a so-called Environmental Profit & Loss (EP&L) account which includes the complete environmental costs associated with its activities and products from cradle to grave. The Philips Environmental Profit & Loss (EP&L) account guides the company’s efforts on all things ecological; it is an economic valuation of the impact that Philips has on the environment, and an environmental footprint of Philips’ complete value chain expressed in monetary terms.

The EP&L account is based on Life-Cycle Assessment (LCA) methodology which are in turn used to steer the company’s EcoDesign efforts and to determine the Green Focal Areas (GFAs) of the Philips product portfolio. The GFAs are product characteristics like energy efficiency, weight and product lifetime that determine the environmental impact of the company’s product portfolio. They form the basis of a steadily growing green solutions portfolio. The EP&L account is a logical next step to extend the scope from individual product value chains to Philips’ complete value chain. It will support the direction of the company’s sustainability strategy by providing insights into the main environmental hotspots from an overall business point of view.

Philips also has a well-established methodology to calculate the number of lives the company positively touches with its products and solutions. It is the firm’s aim to look into valuating these societal benefits in monetary terms as well, including them in future EP&L accounts where possible.

In its 2020 annual report, Philips reported its Green Revenues, generated through products and solutions that offer a significant environmental improvement in one or more Green Focal Areas – Energy efficiency, Packaging, Hazardous substances, Weight, Circularity, and Lifetime reliability that also deliver a contribution to SDG 12. Green Revenues increased to €13.9bn in 2020, or 71% of sales (67.2% in 2019), reaching a record level for Philips and exceeding the 2020 target of 70%.

https://www.philips.com/c-dam/corporate/about-philips/sustainability/downloads/ecovision-methodologies/epl-methodology-2020.pdf

Scope 3

Disclosing emissions as a liability on the balance sheet becomes even more complicated around Scope 3, a data set ESG reporting leaders are only just starting to get to grips with. Under Scope 3, companies disclose the emissions in their supply chain – the carbon footprint of both the components in their products and of their products once in use.

For example, a coal mining company won’t produce huge emissions in its mining processes, but its product has a profound impact on emissions. In contrast, Tesla’s production processes, says Saunders Calvert, typically score poorly in ESG ratings because manufacturing the electric car is a carbon intensive process. In Scope 3 reporting, this is counterbalanced by a Tesla having minimal downstream emissions. In carbon intensive industries, having a high carbon footprint today isn’t necessarily a bad thing so long as a strategy for decarbonisation is aggressive and credible. Interpreting the data and its financial consequences requires nuance and expertise, he says. “Treasury teams really need to be able to address all sides of the story.”

It will get even more complex with Scope 4 reporting – although this is not a formal category yet. The idea is that when companies report sales of products that have a positive impact on climate or society like, say, insulation, it should carry a benefit on the balance sheet. “Reporting Scope 1 and 2 is mainly about making sure you have the right information from your internal systems around fuel use and energy bills. Scope 3 requires more effort and is quite a struggle,” says de Draaijer.

Industry standards and regulation

Companies have resources to help them get reporting right. Industry standards like TCFD and SASB articulate what good disclosure looks like and are gaining traction, helping companies disclose and map their data to specific frameworks. But take up is still slow. According to a report from the corporate governance team at FTI Consulting and Sentieo, a financial and corporate research company, fewer than 50 UK public companies currently comprehensively report on climate risks and set targets in line with the TCFD.

Regulation coming down the track will force the process. By 2025, climate risk assessments will be mandatory across the UK, including for listed companies, large private companies, pension schemes, insurance companies and banks. Elsewhere, the EU’s giant taxonomy will land through the course of next year, introducing a classification system of what constitutes sustainable economic activity. Cue the associated EU regulatory drives in support of the taxonomy like growing pressure for mandatory sustainability reporting requirements under the Non-Financial Reporting Directive (NFRD). Under the EU Taxonomy companies will have to articulate what proportion of their revenue is green, says Saunders Calvert. “Revenue is a good proxy for a company’s products or services and is a different set of data points to reporting their carbon emissions,” he says. “Regulation is going to drive clarity around what kind of information is required.”

Collaboration

Of course, gathering data and disclosure won’t only sit with treasury, but much of the responsibility could head treasury’s way. Although many firms have set up reporting systems out of their sustainability departments, as ESG reporting becomes more financially material it is increasingly the focus of CFOs, finance and control departments. “It involves a combination of the subject matter knowledge of the sustainability team with the processes, rigour and risk of treasury and finance,” says de Draaijer, who observes that many of the initial ESG corporate laggards without sustainability departments have fast tracked their sustainable reporting and accounting processes by placing the issue directly with finance teams. “Banks and investors want to know how aligned to the future decarbonised economy a company’s business model is. Are they backing the Netflix of tomorrow – or Blockbuster Video,” concludes Saunders Calvert.

The international initiatives pushing convergence of reporting standards

The European Union is updating the EU Non-financial Reporting Directive.

The World Economic Forum has released its paper on common metrics and consistent reporting for sustainable value creation, defining 21 core metrics.

The five major non-financial reporting organisations (GRI, SASB, IIRC, CDSB and CDP) have published a Statement of Intent, committing to work together towards comprehensive corporate reporting.

The IFRS Foundation’s consultation, still in process, on establishing a global non-financial reporting framework has already received strong support from other organisations, including IOSCO.

Source: KPMG Survey of Sustainability 2020

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