Many in the business community consider environment, social and corporate governance (ESG) reporting and disclosures as being similar to corporate social responsibility (CSR). Jane Ren, chief executive at Atomiton explores how, while CSR emphasises a business’s contribution to societal goals through self-regulation, ESG is much more about smart business strategy that manages business risks as well as captures opportunities.
- Climate related risks are becoming a critical concern for businesses.
- Sustainability reporting is evolving from a CSR to a core strategic function.
- It is the data underlying climate reporting that can underpin effective business strategies.
At the centre of this is the concept of climate-related business risks. The disclosures of the “E” or “Environment” in ESG is as much about understanding how climate change affects businesses as it is about how businesses impact the climate. This two-way relationship is called “double materiality”.
Most companies produce sustainability reports that focus on their actions to protect the environment and add positive values to society and the community around them. However, there is a lack of understanding of how they should properly evaluate their exposure to climate risks and adapt to the changes that may materially impact their business performance.
The teeth of climate change are biting into businesses
Companies are not isolated from their physical and social environments, both of which can be significantly altered by climate change. From Sydney to Dallas to Pakistan, this year alone has given ample examples of the damages caused by severe flooding, which are exacerbated by climate change. Sydney is estimated to have suffered a $4.8 billion loss from the flood earlier this year. The financial term to discuss how such events can substantially affect a company’s bottom line or asset value is called “materiality”.
It’s been said that if climate change is the shark, water is its teeth. We are seeing the teeth are starting to bite into businesses. Although water is a leading factor in such risks, other events such as wildfires and droughts can be equally disruptive to business operations. For example, its liabilities from a series of catastrophic wildfires eventually pushed PG&E, a major utility provider into bankruptcy.
In July 2022, the World Economic Forum warned that a large percentage of the world’s business was exposed to water risk due to the impact of climate change. They estimated that 69% of global equity is subject to water risk. They are now calling for investors and companies to start taking action to mitigate these risks, which has elevated the situation to high on the corporate financial agenda.
A well-understood concept
This concept is not new. In the early 2000s, a framework called the Task Force for Financial Climate Related Financial Disclosure (TCFD) was formed. This was created by the Financial Stability Board, which realised that a company’s financial picture is incomplete if it does not correctly disclose climate-related risks.
In that framework and so many related frameworks, this kind of risk is often divided into two categories, physical risk and transition risks. The direct risks from the climate are primarily physical, from rising sea levels, increased temperature, wildfires, floods and drought. Water is involved in more than 70% of all this research and, interestingly, when you do not act on carbon, the level of risk arising from water issues increases.
As a corporation, it can impact their business when they start to respond to the stress or reality of climate change. This transition risk includes several factors, such as government regulation to meet Paris Agreement obligations that may make a company responsible. In this event, the business must adapt, which may require investment.
Another transition risk comes from the growing environmental awareness of consumers demanding low-carbon products. If the firm does not adjust to this emerging trend, it risks losing market share. These are the transition risks that companies, if they do not take care of them, also may be subject to the risk to their shareholder value.
Having identified the trends that affect their sector, a company must decide if they are subjective or objective. Do they affect the more rigorous part of the CFO organisation? The answer is yes, and this is what we see as the trend. The quantification of these risks into dollars is already taking place, but the discussion has mostly been by sustainability professionals
Quantifying financial risk
One framework that has long assisted organisations with environmental reporting is the Climate Disclosure Project (CDP), which runs the global environmental disclosure system. Each year CDP supports thousands of companies, cities, states and regions to measure and manage their risks and opportunities on climate change, water security and deforestation.
CDP asks organisations to quantify the risk they are subject to in financial terms, which could vary depending on the business. For example, if you source coffee beans, you may be much more subject to water risk. Or if you have properties in certain places, California, for example, you may be subject to property damage risk. In general, when they quantify all of this, the conclusion is that it is usually much more costly to deal with the consequences of the risks than to take actions to mitigate the risks.
If any risk is not adequately quantified, a company’s annual report will not provide a complete picture for investors to value the stock. Therefore, if you have a significant risk that can substantially impact your business operations or the value of your assets, then you need to divulge it.
It would help if you also calculated related metrics; those metrics may include both backwards-looking and forward-looking factors. Backward means the cost has already been incurred, which also needs to be pointed out from your financial statement discussion if this is due to a climate-related event. Then there is a forward risk, which has not yet happened, but there is a certain probability of the event occurring.
Two sides to the equation need to be considered carefully in the form of impact versus risk that are not always proportional. That means companies with a significant environmental impact on their business may also attract considerable risk. But because a company does not substantially affect the environment, it does not mean they do not have risks; the environment is a larger picture, so it may also subject them to risks. It is time to look at this as a two-way street so that companies know what climate-related issues they must address to protect their shareholder value.”
The environment does not only present risks; it also offers opportunities. First, companies that can adapt to lower carbon or more climate-friendly products will gain market share where consumers’ tastes are changing, and government regulations are evolving. That is a significant opportunity if a company can capture and exploit it. A second opportunity comes in becoming more carbon efficient through work and investment that could lead to the company becoming more efficient in their production or cost-efficient.
The pressure on companies to comply will undoubtedly grow with planned legislation in the United States from the Securities and Exchange Commission (SEC) and the European Commission with the Corporate Sustainability Reporting Directive (CSRD). For companies to comply and take advantage of the opportunities offered requires a robust data backbone that can deliver insights across the entire value chain of an organisation on a product line and geographical basis.”
Atomiton, offers an ESG data sourcing and management platform to help companies improve the quality of their sustainability data through automation. The US-based organisation has worked with clients from a wide range of industries to achieve carbon footprint reductions, including food and beverage, manufacturing, energy, supply chain and process industries.