Understanding the opportunities presented by ESG

Jeremy Osborn, FCMA, CGMA, wants to make sure finance professionals are prepared for all that's coming their way. Osborn, AICPA & CIMA's global head of ESG, joined the FM podcast for a two-part discussion on the rising importance of ESG initiatives.

In part one of the interview, Osborn explained why ESG, along with related auditing and assurance opportunities, is becoming mainstream. In this part, he discusses his early interest in ESG topics, describes the current landscape of ESG reporting, and shares three reasons people take ESG seriously.

Osborn also explains how ESG has had a role in the shift that has happened related to understanding a company's value.

What you'll learn from this episode:

• An overview of the reporting requirements of the UK's Task Force for Climate-related Financial Disclosures (TCFD).
• How activities such as skiing in Switzerland have been affected by climate change.
• Why sustainability-related concerns are no longer simply "a risk to be managed", according to Osborn.
• How an understanding of ESG information can shed light on the value of an organisation.
• Why the growing importance of ESG is, according to Osborn, one of the most significant changes the accounting profession has faced.

Play the episode below or read the edited transcript:

— To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.

Neil Amato: Welcome back to the FM podcast. This is Neil Amato. This episode is part two of a discussion I had with AICPA & CIMA's Jeremy Osborn on several aspects of ESG. Make sure you hear part one of the conversation, which we will link to in the show notes for this episode. Now, in part two, Osborn continues by sharing how those charged with ESG reporting and assurance, and even those who are sceptical about ESG, can apply the skills they already have to provide value to their clients and their companies. Here's the rest of the interview with Jeremy Osborn.

We've mentioned the word urgency earlier in this conversation, so what to you are some of the aspects, if you could further explain them, the aspects of ESG initiatives that in your mind come with the need for urgency?

Jeremy Osborn: That partly depends on where one's based as to what's urgent. In the UK where I'm based, for example, this year is the first year that companies are required to report against TCFD, this financial reporting, and that's the Task Force for Climate-related Financial Disclosures. What that does is it frames the issue of climate in a business context and requires businesses to explain, how is your strategy responding to this? How is your governance structure responding to this? How is your performance management and your risk management responding?

In the UK, there's clearly a pressing need for organisations to understand what TCFD is and then to work through the various, they're called recommendations, but the UK regulator requires these to be published. Part of that is scenario analysis. That's looking at different climate change scenarios and the impacts of those scenarios could have or are anticipated to have on the business. That's quite technical work. It really depends where one is in the world.

For anybody within the EU, clearly, I would be using the time now to familiarise myself with those 13 Corporate Sustainability Reporting Standards on the assumption that they will be mandated within my member states and then I will have to or my client as the case may be, will have to report on those. But I think the general movement is towards thinking about sustainability within a context of the materiality of the sustainability issue to the business, and the materiality of the business's operations and its value chain to the issue.

Thinking through and applying essentially all of the skills and the technical expertise that accountants have, and essentially translating those into this context of ESG, so, for example, accountants are familiar with the concept of materiality. They're familiar with the concept of reliable, consistently prepared data. They're used to working with colleagues within a business to help ensure the strategy is executed. They understand that complex interaction between the business model and value creation or value preservation, or the avoidance of value erosion. It's applying all of those skills in a slightly different context, which is the context of sustainability.

I think accountants will bring huge value to their organisations. They'll bring huge value to their clients in an advisory capacity as auditors to the imperative sustainability issues.

Amato: There are probably still some people who are like, I don't see the imperative, why is this such a big deal? But there are legitimate business opportunities. This is something that is becoming, as you said, far more mainstream. But what are some of the other ways that the case for ESG can be framed beyond what we've already been discussing?

Osborn: I would agree with you, Neil. In my client work, I found people respond to sustainability in all different ways. I tend to think about this in probably three or four main ways. I think the first is one's own experience of climate change. As I said, I live in London. In December this year over Christmas, the Swiss Alps had no snow. There are heartbreaking pictures of skiers trying to ski on grass in places like Gstaad. These are high-end Swiss resorts. One has the actual experience of climate change.

Last summer, most of Europe was in drought conditions, and these remarkable stones emerged from the rivers of Central Europe. They're called hunger stones. They've been in the riverbed for hundreds of years. On them, is written a warning, and the photos I've seen are in German and it says, if you can read me, weep. Because the hunger stones are advising people living around the rivers, that if the river has got that low, your crops are going to fail and therefore you're going to starve.

Now, we don't quite face that in the 21st century, but what happened in Central Europe [last] summer in rivers like the Rhine is canal boats carrying all of the necessary supplies for German industry couldn't navigate them and that had a really significant impact on the ability of major European companies to actually operate. There's one's own experience, and that will vary obviously from person to person. The second, as we've been talking about, is the regulatory push. Whether one has the experience at any aspects of climate change or one thinks that sustainability is just a distraction, there is the regulatory driver, which particularly, say within an EU context, becomes a requirement in terms of reporting, so one can't do anything about that, whatever one might think.

The third area, as you've said, really is the business opportunity, and I think it's worth all organisations thinking this through, and again, this is an interesting shift there has been in how people have been framing sustainability issues. For much of the last 15 years, sustainability has been seen as a risk to be managed, and, therefore, it's on the risk register, it's the chief risk office that deals with it. It's a secondary consideration to the main imperative of the CFO. That's changed because sustainability-related issues are also a huge commercial opportunity.

As I said, across the world, the opportunity is thought to be worth $50 trillion. Within the EU's Green Deal, and this is incremental investment, it's not business as usual, is worth a trillion dollars.

These are huge sums of money, and there are huge commercial opportunities for organisations. Again, if I just think about a UK context, one of the remarkable things that's happened over the last ten years or so is the development of the UK's offshore energy industry. The UK is a global leader now in the space, 30% of our national energy supply is being driven, created by offshore wind farms. That creates a whole industry in itself, because great depth of expertise is required to manage and create these offshore wind farms. There's a big commercial imperative as well. For me, those are the three big drivers, is one's own experience or one's organisational direct experience of climate change. The regulatory requirements that often they are hot on the heels of climate change in the first, but there's a myriad of other system issues as well. Then, the commercial opportunities, particularly thinking about the opportunity side of that risk-opportunity equation.

Amato: More and more, if you want to truly grasp an organisation's value, you're looking at things that are not on the balance sheet. How can understanding ESG help to really learn and know where a company's value resides?

Osborn: That's a great question, Neil. There's a really well-known study by an organisation called Ocean Tomo that looks across the S&P 500 at the proportion of tangible to intangible value and how each of those, respectively, helps understand the market value of an entity. They have taken the data back to the mid-'70s, and in the mid-'70s, about 90% of an organisation's market value could be accounted for exactly as you've said, through the balance sheets, the P&L, the cash flow, etc. Now, I like to think about this as the working week of an auditor. In the mid-'70s, if I was an auditor, and I was going to work, I reckon that I add great value to my clients through about tea time on Friday, but from tea time on Fridays, that last 10%, I'm not adding a great deal, but it doesn't matter because it's basically the end of the week by then. However, as Ocean Tomo reran this data, they've looked at it decade by decade, but they reran it about two years ago.

This is for a typical S&P 500. There will always be exceptions, but for across the patch of S&P, there has been a complete inversion in that. So 90% of the market value of a typical S&P 500 company is now bound up in the intangibles and only 10% in the tangibles. If one thinks about the auditor of today, so he goes to work on a Monday morning, and I reckon they add tons of value till about elevenses on Monday morning. They sit down for their morning cup of coffee, then they might as well go home because from that point onwards, they're not actually helping their client understand the source of the market value of the company.

Now I'm obviously saying this a little bit tongue in cheek. But it just gives a sense of how value has changed over the last 50 years. Now, that's where sustainability and ESG have a really interesting role to play. Because what is that 90% of intangible value? Some of it accountants are quite good at accounting for — a trademark or a patent, etc.

Accountants, obviously, and corporate valuation specialists will help a company when it's buying another company, selling a company, buying the brand, selling a brand. At that point they have to calculate the goodwill. When one gets to a point of understanding what the intangible value is, but for all the times in between, the best route to understand where that intangible value comes from is to start thinking about value creation through a sustainability lens. Now, the way that's done is through a concept called multicapitalism. Now, that's just a fancy way of saying there's more ways of encapsulating value than financial capital alone. As you said in your opening remarks [in part one], I'm a management accountant, and when I was training 20 years ago, value was pretty much seen as exclusively a shareholder value creation.

What have I done as an accountant to support the growth in the value of the dividends that the company is able to distribute shareholders or the market price and therefore the market cap of the organisation? That's the monocapitalist approach. It just thinks about financial capital. Multicapitalism thinks about other types of capital and the primary ones are natural capital, human capital, social and relationship capital, and intellectual capital. That really helps frame organisations' understanding of where that other 90% resides. Because if one thinks about any company has at least one employee, and that one employee will have hopefully at least one customer. Say if you've already got some human capital, you've already got some social and relationship capital. Obviously, if we're talking about a big company, then one can multiply that many, many times, manyfold.

All organisations depend on natural capital, because that's the very essence of life. It's the air we breathe, it's the water we drink. There isn't an organisation on this planet that doesn't depend on natural capital in some capacity or other.

These other capitals, I think we all intuitively understand them. It would be very odd, for example, if I went to work and said, there's no such thing as human capital. Or I don't believe in intellectual capital. Or I poo poo the idea of natural capital. Of course, that's part and parcel of how any organisation functions in the 21st century. That's where the concept of integrated reporting really comes into play. Integrated reporting is a holistic approach to understanding how an organisation is making a very difficult balancing act between short-term value creation and long-term value creation. Thinking about value creation from the perspective of whatever capitals might be really material to the business model of that organisation.

If I'm a metals and minings company, for example, natural capital is the absolute bedrock of my business. If I don't have access to natural capital, I don't have a business model in its current form. Whereas, if one takes their professional institute like our own or audit firm, our intellectual capital, human capital, our social and relationship capital with our members or as an audit firm with my clients, those are the essence of how we create value, and everything else is a means to achieve that. But the real value we create is the social and relationship capital. If we managed that really well, we also create financial capital. If I manage my audit relationships really well, I also create financial capital. That's how what we've been talking about today can really help shine a light on where that 90% of intangible value resides in a typical company today. But I've just framed it within the context of that Ocean Tomo study, which is looking at the S&P 500.

Amato: That's great, Jeremy. We've covered a lot of topics today. We've learned about multiple capitals. Gosh, but is there anything that you'd like to leave our audience of the global finance profession with as a closing thought?

Osborn: When I reflect on the change I've seen over the last 20 years and the acceleration really over the last probably two or three years of what we've been talking about today, I really believe, and as you can probably tell, I'm very passionate about this. This is an exciting opportunity for the accountancy profession in a way to re-invent itself for the 21st century. Accountancy is remarkably good at adapting to change. It's been doing that very effectively for the last 500 years since Luca Pacioli, the Venetian monk, laid down the standardised approach to T-accounts, which for 300 years was the Bible that was used to understand how to account for credits and debits. The profession is very good at adaptation. There's probably been about five significant movements over the last 500 years, which the accountancy profession has seized and responded to and given itself another lease on life in a way.

My view is that this is one of those moments in time. I think it's probably the most significant change that the accountancy profession has needed to grapple with for about the last 100 years. I think it's a really exciting opportunity, and I think finance professionals of all persuasions have the right skills, they have the right experience to understand how to apply this to their organisation. We're not necessarily asking accountants to wake up tomorrow and to be tree huggers, etc. But what we are asking them to do is to think about, for a business in 2023 and beyond, how they can take these concepts on board of multicapitalism, of value creation over time, ESG, how they can absorb all of these different ways of thinking about the role their business, their organisation plays in society and in the environment and apply that for their organisations really to help support sustainable value creation.

But to do that within a framework of how the organisation interacts with the environment, with the society that it depends on, and on which it impacts as well. That ultimately creates a virtuous circle, in a way, a positive feedback loop, which should lay the groundwork for the sustainability of the organisation's business model. I think it's very exciting. It's something in my view that accountants really should think through. How is this going to affect my future career? How is it going to affect my organisation or the future organisations I might work for? And to see this as one of those very rare moments in time when the profession as a whole has an opportunity to re-invent what it does, what it represents. And in doing that, help sustain the value creation of the organisations they work for.

Amato: Jeremy Osborn. Thank you very much.

Osborn: Thank you.