What boards should know about climate change and value creation
Extreme weather risks have been on the rise for businesses worldwide, and regulators and standard setters are taking steps to keep investors updated. The recent merger of the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC), which formed the Value Reporting Foundation, was a step towards consistency in environmental, social, and governance (ESG) and sustainability reporting.
In this episode, Jeremy Osborn, FCMA, CGMA, director of business relationships and networks with the Value Reporting Foundation, suggests that integrated thinking and reporting can help corporate boards create long-term value, particularly when they consider potential consequences of climate change as they devise business strategy.
This is part of a series of podcasts that explore how the finance function can drive sustainable business success and account for ESG issues.
What you’ll learn in this episode:
- Integrated thinking is a management philosophy that helps boards and senior executives lead a business so that it uses resources in a way that creates long-term value.
- In the past five years, more and more corporate boards started relying on sustainability committees to ensure sustainability strategies are implemented.
- International regulatory efforts to standardise integrated reporting are picking up and are focusing particularly on climate change reporting.
- Climate change poses risks but also opportunities for businesses.
Play the episode below or read the edited transcript:
To comment on this episode or to suggest an idea for another episode, contact Sabine Vollmer, an FM magazine senior editor, at Sabine.Vollmer@aicpa-cima.com.
Sabine Vollmer: How much should board members know about integrated thinking principles, the integrated reporting framework — which I think both come from the IIRC and sustainability accounting standards — and why should they know this?
Jeremy Osborn: Integrated reporting and integrated thinking have always gone together. We reference integrated thinking in the integrated reporting framework. Essentially, integrated thinking can be thought of as a management philosophy in which value creation, preservation, and erosion is thought of in the round rather than with a sort of rather narrow perspective focus on financial accounting value.
The rules for financial accounting value have been long established. They've been around since the great heyday of the Victorian engineers who built all the railways in the UK and were first codified in the ’20s and the ’30s. But they take rather a narrow view. They only focus on value creation as defined by the financial accountancy profession.
In the 100 years or so since they've come into being, not just accountants but regulators, governments, citizens — everybody's become conscious that value creation, preservation, or erosion is a very complicated affair and value can be created in one area, such as financial accounting value, at the expense of another, such as natural capital.
Society is best served where value creation is approached in the round and businesses and organisations do the best they can to optimise value creation across as many capitals as possible in the hope that if a value is put on all of them, the net value created would be north of zero rather than south of zero.
Businesses are getting much better at doing that. Integrated thinking is really a management philosophy in which businesses and particularly those charged with the leadership of businesses and the oversight of those leaders approach what their organisation — their business — does, how it's organised, how it manages its supply chain and its value chain in a way to think about or manage resource use in order to create value across as many capitals as are relevant to the business model of the particular organisation, not to only focus on financial value creation.
If I may, I've got a wonderful quote. Last week, we launched a new report on integrated thinking based on case studies from 11 very significant European companies. In conversation with the CEO of Leonardo, which is one of Italy's largest defence companies, the CEO, who is a great fan of integrated thinking, said that the only route to sustainable value creation was through integrated thinking.
We didn't prompt him to say that, but I think it's very telling when a CEO with whom I've had no relationship — so this is his own experience that he's reflecting on — talks so clearly about the benefits from his perspective as a leader of a very large organisation from embedding integrated thinking into the way Leonardo goes about doing business.
Vollmer: Can you give me a quick example of how this works and how it is different from not using it?
Osborn: It can be helpful to think about where there's change within a business. Perhaps an organisation is considering a major capital investment or it's considering branching into a new type of service. What we've seen and others have seen from case studies is when businesses approach decisions like this, perhaps it's an investment decision around siting a factory in location A versus location B. When it's done purely on the basis of what we might think of as sort of rather a traditional approach to accounting, the answer might be that we should be located in region X.
But when the same decision is put through a slightly different set of calculations and the organisation looks at what would the impacts of this decision be, for example, on natural capital erosion. What benefits would we create for the society that will help staff and service this factory and what employment might we create, etc., or in the value chain? What will this do for our reputation in terms of society at large? Rather than leading necessarily to the same conclusion that it should be located in region X, the answer might be region Y.
It may be that the financial — the immediate to short-term financial value calculation is less strong in region Y, but when looked at in the round, in terms of long-term sustainable value creation, that might be the right answer. Case studies — this has got a lot of case studies now of organisations that said, “We’ve looked at both and have actually gone with the second approach, because it's given us a more informed picture of where we can best use our resources in the interest of long-term sustainable value creation, not only for us as an enterprise and for our shareholders, but also for society at large.”
Vollmer: What is a sustainability committee, and how does it work?
Osborn: This is something that is relatively new. I would suggest that in my experience, sustainability committees have really come to the fore over the last five years or so. They tend to be the route by which the governance arrangements of an organisation hold those who are responsible for the sustainability strategy to account. Typically, a sustainability committee would be a board-level committee or would report through to the board. It would be chaired by a member of the board, although the operational aspect — the actual doing of the committee's activities — would most likely be left to what's now often referred to as the chief sustainability officer.
Again, these are relatively new terms.
I think we're at a point of development now where a well-informed sustainability strategy is intertwined with the core business strategy and is mutually reinforcing.
Vollmer: What can integrated reporting do that enterprise risk management cannot do?
Osborn: Enterprise risk management is an aspect of integrated reporting, but again, it's a subset.
Risk management is still an integral part of integrated reporting and integrated thinking, but it often tends to be rather defensive. It's a defensive move to ensure that the organisation has covered its back in terms of potential risk, and it can demonstrate to those charged with governance that it's been through a formal process to assess the risks.
There can be a tendency for the risk to be a little bit anodyne at times and less company-specific than I think is helpful for investors and stakeholders. What integrated thinking I think adds to this is, number one, it asks the question, what are the opportunities? Risk management and opportunity management are two sides of the same coin. Climate change is a very good example of this. There can be an assumption that climate change is a risk to be managed. That's not necessarily the case for all businesses.
For some businesses, climate change is also a huge opportunity. If one thinks about the transition, for example, that the most advanced economies are working through or will be working through in the coming years from a high-carbon intensity in terms of energy production to a lower-carbon intensity — these are largely political decisions because they affect the energy security of a country. But much of that low-carbon energy is going to come from alternative energy sources. If you're in the business of making wind turbines, the economic upside of that is gigantic.
Also, if you were a traditional carbon-based energy producer, the opportunity to gain competitive advantage, first-move advantage, etc., from transitioning out of fossil fuels and into alternative energy sources is also not just significant but it's an integral part of surviving the global transition to a low-carbon economy.
Integrated thinking and integrated reporting would also look at opportunity management. Risks tend to be stuff that can be viewed and quantified in the here and the now. Often, when a company goes through its risk management process, it might be looking really over the next 12 to 36 months of the key things that are likely to affect its ability to operate successfully. That's a fairly narrow time scale in the scheme of things.
So, what are the major issues which an organisation or its industry or the environment that sustains it — the society that sustains it — is likely to have? That tends to look at macro issues. These might be — I don't know — urbanisation, or perhaps as we've seen in the last year — I live in London — for example, it's something like half a million people have left London during the pandemic and nobody knows if they're going to return. Some will have gone back to their home countries because of Brexit.
Others will be temporarily living in second homes outside London and some under the impact of changing working passes will probably not return. That's quite a significant proportion of London's population. If you're a business that's centred around selling products and services to densely populated urban environments, what impacts might that sort of quite seismic change have on your business?
That just sort of brings to life the difference between a risk — the risk is the temporary absence from city centres of office workers — and the issue of whether that creates long-term changes to working patterns. And therefore a business model which may have been fit for purpose prior to March 2020 may not actually be suitable from the summer of 2021 onward.
Vollmer: Why would external auditors recommend that a company adopt integrated reporting?
Osborn: The external auditors, as part of the management feedback that they provide at the end of the annual auditing process, will advise management and counsel them on significant changes which are occurring within the external reporting environment. The audit firms, particularly the big six audit firms, have been very integral to the integrated reporting movement going right back to the beginning of this in the aftermath of the great financial crash of 2008 and 2009.
The simple answer is that they have a responsibility to help the clients for whom they work understand what changes are going on within the external auditing environment. I think the more substantial answer, though, is it really comes back to this question of value and whether the auditing profession itself feels that the way things have been, by and large without a great deal of change in substance for the last 100 years or so, albeit it with the movement of the last 20 years towards the internationalisation of financial accounting standards, but whether that is a sufficient approach as we head through the third decade of the 21st century.
Really what it comes down to is a recognition that resources are not necessarily infinite. Again, if we think back to — we are working with frameworks with a social construct which stems from a time when the idea that there might be resource constraints would have been anathema. If one had asked a Victorian industrialist whether steel was going to run out or whether one day coal-fired trains, or trains powered by fossil fuels, would no longer be acceptable, he would have had no idea what you were talking about.
Perhaps the constraint then might have been on financial capital. In the 2020s, we're very conscious that resources can't be — resource abundance can't be taken for granted. We're all aware of the inherent constraints imposed by the world's population and the increasing wealth of the middle classes that are scarce. For many years as well, there's been a sense of — it's often given militaristic terms which I think are perhaps not entirely appropriate — the war for talent and this idea that there's a limited supply of talented people to work for an organisation.
I think any business leader would recognise that reputation and the social networks that sustain a business can never be taken for granted, because reputations, as we know, take years — decades — to create and they can be lost overnight. Business leaders would be very aware that there are resource constraints and therefore, if we only think about accounting for one element of that, which is what the auditors are currently looking at, which is the financial aspect — the financial accounting aspect — it's missing that bigger picture.
Vollmer: What's the relationship between the Value Reporting Foundation and country regulators like the Financial Reporting Council in the UK or the US Securities and Exchange Commission? What we've been talking about, none of this is mandatory, correct?
Osborn: It's not yet, but things will change.
The likes of the ISSB [International Sustainability Standards Board] will come to its own view of what the appropriate governance arrangements are and what the appropriate standards should be. We know they are going to start with what's called a building-blocks approach. They're going to start with climate change, which clearly is appropriate when the ISSB is going to be — the launch for it will be announced during the COP26 [2021 United Nations Climate Change Conference] meetings in Glasgow.
The regulators in each country will come to their own view as to whether those standards should be adopted.
Vollmer: What are the trends in climate reporting?
Osborn: The big impact here has been from something that's referred to as TCFD, the Task Force for Climate-Related Financial Disclosures. Mark Carney and Michael Bloomberg were the original chairs of this. TCFD is a set of recommendations on how businesses should think about what impact climate change is likely to have on them as an entity.
Prior to that, the question was flipped the other way around, which was what impact will you, as an entity, have on climate change. TCFD's recommendations revolve around four areas. The governance of how to assess the impact of climate change on the business, the business strategy, risk management, and metrics and targets.
It has been very successful. It's been adopted globally by organisations. It's like a rolling stone gathering speed rather than moss over time. The quality of disclosures which relate to TCFD, which the TCFD secretariat assess each year, is still not great, but it is forcing businesses to think about how climate is going to affect their future operations and performance.
It goes back to that earlier point that this is not only about risk. It could also be about opportunity. Basically, it asks businesses to think about the three different scenarios of changing global average temperatures that are the basis for the global policy decisions which are made around how to respond to climate change — the Intergovernmental Climate Change Committee.
It's gathering momentum and I think paves the way, effectively, for a standard for how organisations should report this. All of the underlying elements — the governance, the strategy, the risk management — will remain as important whatever happens when the ISSB comes up with its first climate change-related financial disclosure.
But I think what the launch of the ISSB in November and the subsequent publication of its standard, whenever that may be, will do is it will provide businesses with very clear information on what type of metrics, what type of things they should be measuring in terms of the impact of climate change on their business, and what format to report that in.
The key takeaway here is that standardisation of approach will provide investors, first and foremost, with the same quality of information about a business's perspective on the impact of climate change on its future performance and prospects that investors currently have when it comes to financial-related disclosures, again because of that standardisation of how the information is prepared — audited externally.
Given what a significant impact — some ill, some good — that climate change will have on just about every business and organisation in the world, it's essential that there is a standardised approach with how to do this.
So, everybody is experiencing something to do with climate change over the course of a year. It's clear that this is going to be a central focus of government policy, and therefore businesses have to respond to that and the ISSB and its climate change or climate-related financial standards will play a key role in basically shining a light on what businesses are doing in response to that — how they're doing their bit to minimise the impacts of climate change or adapting if necessary if the impacts of climate change are unavoidable and decarbonising — decarbonising their business model, decarbonising their supply chain, their value chain, which requires innovation, which in turn creates opportunity.
One must think of this from both sides of the coin. It's not just risk to manage. It's also opportunity to seize, depending of course on the business.