In this podcast episode, CPABC's president and CEO, Lori Mathison, speaks to Rahul Arora, partner with ERM (Environmental Resources Management) a multi-national sustainability consultancy firm. Rahul shares his global insight on the benefits companies are experiencing from adopting ESG, as well as the latest international developments in disclosures and reporting frameworks. Part of our Coffee Chats with CPABC podcast series.
Businesses across the globe are increasingly facing pressure from investors and customers to increase their sustainability-related actions. And these businesses are increasingly incorporating ESG into all aspects of the business, as a way to address really complex sustainability challenges as well as opportunities.
Recently I spoke about this topic with Rahul Arora, partner with ERM (Environmental Resources Management) a multi-national sustainability consultancy firm. Rahul leads sustainability, ESG, and climate change services in Canada and across North America. He shared his global insight on the benefits companies are experiencing from adopting ESG, as well as the latest international developments in disclosures and reporting frameworks.
How are you seeing companies incorporate ESG and what are the results?
Rahul: Fundamentally, ESG is a business approach that generates long-term value by managing risks and capitalizing on opportunities associated with ESG, which are generally intangible assets. And what we've seen over the years is that company valuations have started to focus more on intangible value such as natural, social, and customer-related factors, as well as partnerships, trust, and innovation. The 2020 study by Ocean Tomo found that 90% of a corporate's valuation was focused on intangibles; when you compare that to 1975, that was as low as 17%.
We've also seen more and more empirical evidence linking ESG and financial performance, which has caused a significant acceleration in the demand for ESG data, tools, and integration. We also know that many investment managers today are considering ESG data when making investment decisions.
So let’s focus in on the “E” in ESG. What are your thoughts around how climate change presents challenges to the world's financial markets?
Rahul: It’s becoming more and more evident that if businesses don't take an action on climate change, we won’t have businesses to look after. Climate plays a critical factor whether it's the physical risks of climate change, or the transition risks associated with the shift to a low carbon economy.
While there are risks, there are also opportunities, and these can be understood by frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD) which focuses on different aspects for strategy, governance, and disclosures to improve and increase reporting of climate-related financial information.
You mentioned physical risks and transition risks – what are some challenges and opportunities associated with these?
Rahul: In regards to risks from transitioning to a low-carbon economy, we are seeing market conditions associated with reducing emissions, whether it's efforts by governments, central banks, or financial systems. Most countries are setting a target for 2040 or 2050 to achieve net zero greenhouse gas emissions. There will be major impacts to decarbonize their entire operations. This also calls for a structural change that will require unprecedented amounts of investment in every single economic sector, meaning there will be risks and opportunities for every sector. 2050 is going to be a landing point, but in the interim, 2030 is going to be critical to measure our progress. It's going to be the decade of action.
When we look at physical risks, if we don’t mitigate climate change, we're going to see more severe effects. Whether it's hurricanes or floods, it's only going to worsen for people and for companies across the board. We're going to see drastic impacts on livelihoods, demographics, migration, and geopolitical stability, as well as economic stability.
Recent data from insurers and central banks shows that rising temperatures could reduce global GDP as much as 14% by 2050. So, in a way, both the transition and the climate factors will influence how businesses go forward. Successfully addressing these risks is going to be a joint effort between governments, investors, financial institutions, and leading corporations.
How are you seeing key stakeholders drive the demand for disclosure of climate risks and opportunities?
Rahul: Recently we’ve seen a lot of investors and investor-led initiatives around corporate disclosures, climate risk, and ESG risks, including business risks. The UK recently made an announcement for TCFD mandatory disclosures. We've also seen Canada requiring banks and insurance companies to provide disclosures on climate-related risks beginning in 2024. The US Securities and Exchange Commission has drafted related rules that are out for comment. We're also seeing action from the Net-Zero Banking Alliance, which represents 40% of the global banking assets; they’ve outlined how they will align their lending and investment portfolios with net-zero emissions by 2050.
The market is also driving some disclosure. Can you share how stakeholder demands can be addressed, and how the long-term value of climate disclosure can be demonstrated to stakeholders?
Rahul: ESG is becoming more and more mainstream. For example, in 2020, the pension fund CEOs of Canada issued a joint statement calling for portfolio companies to start adopting TCFD and Sustainability Accounting Standards Board frameworks from a climate and ESG perspective. Climate change is becoming an effective way of monitoring and addressing the risks that are associated with your business.
Eventually, these risks will become part of your business model and how you create a market for the future for your business. The market is creating this unique value through sustainability and key stakeholders, whether investors, customers, partners, or the community at large, are increasingly demanding adoption of sustainable business models.
Generally, it takes a company a long time to transform its business model. Companies that are already adapting are moving at a much faster pace and are able to leverage the benefits of adopting sustainable business models. This is the time for us to start evolving our business models and to start learning how we can transition towards a low carbon economy.
Can managing climate risk also put you in a better position to increase share price?
Rahul: Ultimately, yes. If you're managing your climate change risks, you can expect to be in a better position to increase the overall value of your company, including valuations. You will be in a better position because you know your pain points and the risks impacting your business.
We also look at preventive measures to mitigate or reduce risk for a business. The Sustainability Institute by ERM conducted research into the challenges companies face in their net zero commitments. We found that challenges come from internal management teams that are unsure of how to attain the desired outcomes. And the external regulation, technology, and guidance for companies is falling short on what's needed. So even when companies are ready to make the change they may not know where to start or about the roadblocks they will need to overcome.
So those are some of the challenges. Could you give us some examples of how ESG has led to business success?
Rahul: Recent research by McKinsey found out that incorporating ESG can positively affect operating profits by as much as 60%. So there's a lot of financial data that's available now which links ESG to successfully addressing risk, taking advantage of opportunities, and deriving value.
As an example, Unilever changed its portfolio by implementing ESG factors and a sustainable business model; by doing so, it has reduced costs by more than €1.2 billion since 2008. They have also achieved lower levels of risk by using 100% renewable energy across all their operations. In terms of profitability, a classic example would be 3M, which has saved more than $2.2 billion by reformulating their products, reducing waste, and recycling waste.
In regards to the financial market, what are some other trends that you're starting to see with ESG?
Rahul: One trend gaining momentum right now is definitely “no ESG, no capital.” Companies are being questioned on why they are not incorporating it, because elements such as diversity, equity, and inclusion, climate, and effective governance are critical to a company’s operations and how they conduct business.
Deutsche Bank estimates that 95% of all investment decisions will incorporate ESG factors by 2035. We’ve seen that the ESG funds have outperformed the MSCI World Index by 16.8% in an active cumulative returns over a ten-year period. As a result, more money is being driven to ESG funds, which means there will only be more scrutiny on ESG.
Let’s talk more about compliance and mandatory disclosure. Are there any regulatory developments that we should be aware of?
Rahul: Overall, there's an increasing push from different governments to measure ESG data that's important to investors and to regulators. We've seen regulatory developments across Canada, which joined the G7 in committing to net zero emissions by 2050. There is also the 2030 Emission Reduction Plan which provides a roadmap on how Canada will meet its enhanced Paris Agreement target to reduce emissions by 40 to 45% from 2005 levels by 2030. The government has also launched an $8 billion net zero accelerator fund to help large emitters reduce their emissions. And there is also the minimum national carbon pollution price increase from 2023 to 2030; it will rise from $65 per ton to $170 per ton in 2030.
In the United States, the US Securities and Exchange Commission has proposed a new regulatory framework for climate disclosure which aligns with the TCFD framework and its governance, strategy, risk management, and metrics and targets; this would standardize many elements of industry practices. Its disclosure requirements will be phased in over the 2024 to 2028 filing years.
What's your view in terms of the combined effect of all this market level, regulatory mandatory change?
Rahul: It will produce a lot more focus and a lot more investments driven by businesses. There will also be more jobs emerging as a result of the process because the current levels of data maturity and disclosures are not yet adequate. As that becomes more stringent, it will create jobs in these areas, including for CPAs who have strong understanding for data and reporting.
Companies also need to be careful about the kind of data they are putting out there and have control of the quality and integrity of their data. The last thing we want to see is companies going back on their data, for example, by presenting something this year and then two years down the line doing a flip and reporting something else.
The landscape is changing quickly. What would you say to companies looking to take the first step in their ESG journey and where's the best place to start?
Rahul: The best time to start is now. The first step we always recommend to organizations is to do a thorough materiality assessment to identify the ESG topics that are most important and relevant to your business. Next, it is wise to set goals, develop policies, and to begin to measure and track your performance against those KPIs. Reporting on your progress, goals, and future plans is also critical both from an accountability and a transparent standpoint. And after disclosing, the focus should be on looking at any gaps and how to address them.
Companies can also use scenario analysis to give them insights into uncertainties facing their business. This often generates new data and scenarios that companies were not aware of and helps them think through how they would address these risks. ERM recently launched a new blueprint for climate scenario analysis that meets growing expectations to articulate ‘real-world’ impacts and improve C-suite engagement on climate topics.
For companies that are already in the ESG space, how can they up their game?
Rahul: There are four major recommendations. The first would be to leverage a structured framework to identify the material ESG risks and opportunities, whether it's SASB, GRI, the IIRC, or the TCFD framework. Develop a scenario analysis for climate-related financial risks and opportunities and use them to inform financial planning. Companies need not have different strategies for a sustainability strategy and a business strategy. It’s ideal to have a single strategy that addresses ESG and climate that is embedded within the larger business strategy.
The second recommendation is to integrate material ESG risks and opportunities into corporate strategy, using ESG analytics for decision-making.
The third recommendation is to use ESG performance to be better position the business to accessing sustainable finance. A lot of companies want to develop their understanding of sustainable financial products. And how can you leverage your own company's ESG story and performance into your finance strategy and your communication plans?
The last piece is ensuring you have comprehensive disclosures and reporting that meets the needs of all stakeholders. Whether it's by defining a reporting baseline, engaging with your regulators, investors, rating agencies, key stakeholders, or customers, it needs to have the same level of rigor as financial reporting, and should include reasonable assurance of ESG data. Ideally, ESG data should be integrated in your annual report or published on the same day, and not six months or a year later, to demonstrate that ESG is a priority for the firm.
Can we expect to see more streamlined reporting?
Rahul: Absolutely. The oldest standards, the Global Reporting Initiative (GRI), have existed for 25 years. They are now linking, or tying up, with different frameworks. Recently they tied up with the International Sustainability Standards Board, to begin delivering a memorandum of understanding which will focus on using technical aspects in IFRS S1 and IFRS S2 and will be mapped out with the GRI standards. This will address alignment of disclosures, guidance, concepts, and definitions.
GRI is also consulting other reporting bodies such as the European Financial Reporting Advisory Group and the EU Sustainability Reporting Quoting Standards and linking to the TCFD and Sustainable Development Goals. They are connecting with all of these bodies so that companies that have been using the GRI framework will encounter fewer challenges when they're looking to adopt one framework to the other.
Finally, could you talk a bit more about the need for organizations to start developing their ESG data and data integrity?
Rahul: The first piece is having the right level of assurance on the data. When we put data out there, are we 100% convinced that the granularity of the data is correct? The last thing we want to see are lawsuits questioning a company's integrity. Data quality is something that can be only managed by use of technology and a dedicated team of analysts. There are consultants, specialists, and rating agencies out there that can look at your data and assess whether it makes sense.
Data is the lifeblood of markets and companies are going to be assessed on the integrity of their data and how their ESG metrics are aligned. For example, when you talk about a net zero goal by 2050, what are your interim targets by 2030? Do they align? What is the operational roadmap? Your company may have an end goal, but what is your mid-point goal?
A structured and strong roadmap that incorporates technology and sound data is going to play a critical part in your ESG journey. We’ve covered a lot of ground today, and hopefully the information we’ve discussed will give companies a deeper understanding of the benefits of adopting ESG, as well as recent international developments in disclosures and reporting frameworks.
Lori Mathison, FCPA, FCGA, LLB is the president and CEO for the Chartered Professional Accountants of British Columbia (CPABC).
