“CFOs are in a unique position to make a difference – by taking steps to understand what reporting requirements are out there and how various risks may affect companies now and in the future, they can help safeguard their companies and advance the future of sustainability,” says Rodney Irwin, MD, Redefining Value at the World Business Council for Sustainable Development.
The financial system is not broken but, in many ways, its objective is too narrow – it allocates financial capital and that’s pretty much it. The system was not designed to be equitable so it doesn’t necessarily consider impacts and dependencies on other forms of capital - from society or the environment, for example. As a result, it misses a lot of pertinent and appropriate information.
Focusing solely on financial performance has, for too long, meant that companies have blind spots with regards to their performance and risk profiles. They have overlooked important aspects of material risk and opportunity management, reinforcing patterns that contribute to serious global issues like climate change and resource scarcity. But all of this is changing. Across the globe, business have learnt – sometimes at their cost – that they cannot be successful in societies that fail.
As such, governments and other stakeholders are increasing the pressure for corporate transparency. Environmental, Social and Governance (ESG) issues are entering into the mainstream, and business is increasingly expected to know how to reduce negative social and environmental impacts. What’s more, investors are beginning to demand better information on ESG risks and opportunities.
According to EY (pdf), 60 percent of surveyed investors called for companies to disclose environmental and social risks more fully.
Many companies are beginning to grapple with these issues and are working to inform their strategic decision-making by looking at information such as environmental impact, societal value and sustainable development.
South African companies are ahead of the game under the new King IV Governance Code (pdf), where good corporate governance is central to running a business, upholding an ethical culture, enhancing performance, and building trust. In fact, 450 companies listed on the Johannesburg Stock Exchange (JSE) are required to apply the King Code, which encourages companies to produce integrated reports that include financial and sustainability information.
This is an excellent starting point. By acknowledging that the management of ESG risks and opportunities is part of fiduciary duty, South African CFOs can help fill important information gaps, transform their companies, safeguard against material risks, and open new channels to create value for customers, shareholders and society at large.
Here’s how to go further:
Understand what’s out there
The ESG and corporate reporting worlds are complex. Over the past 25 years, there’s been more than a ten-fold increase in the number of corporate reporting requirements on ESG issues – never mind the additional requirements businesses face in mainstream accounting and disclosure. Lack of coordination makes it frustrating, overwhelming and time-consuming for businesses to keep up.
Over 1,000 reporting requirements – both mandatory and voluntary – across 60 countries, means there’s bound to be overlap and redundancies in the way companies are asked to disclose ESG information. According to the Business and Sustainable Development Commission’s Better Business, Better World Report, 79 percent of investors say they’re unhappy with their ability to compare sustainability reporting between companies in the same industry.
CFOs need to ensure they’re encouraging their teams to report on the most decision-useful information out there, not only to meet the demands of their investors but also to better understand their risks and opportunities while adhering to their fiduciary duties.
There are resources that can help. The Reporting Exchange is a new, free, online global platform that helps business leaders find guidance on what, where and how to report. It’s the single most up-to-date and comprehensive source of sustainability reporting requirements and resources currently available. By using the Reporting Exchange, CFOs and other business leaders can ensure they’re not duplicating their work, and that they aren’t inadvertently missing important disclosure standards and guidelines.
Zeroing in on key reporting requirements and using available resources to help embed sustainability into corporate management approaches will go a long way towards improving sustainability reporting disclosure and decision-making.
Explore integrated reporting
Including financial and non-financial information in annual reports is key for understanding the range of different events, factors, risks or developments that can affect a company’s ability to create value. These are the material issues.
Tools like the Integrated Reporting Framework help companies understand where they derive much of their value – whether from manufactured capital, financial capital, intellectual, human capital, natural capital or social and relationship capital. These are the areas where companies should be paying close attention and disclosing relevant information.
By incorporating this wider set of metrics into corporate reporting and decision-making, companies make themselves more resilient against global challenges while equipping themselves with the best information for accurate decision-making.
South African companies will already be familiar with the concept of integrated reporting, as companies listed on the JSE are encouraged to produce an integrated report in place of their annual financial and sustainability reports. The challenge here is identifying which issues are the most meaningful.
More information isn’t always better. Companies should carefully choose and disclose the most meaningful information they can – focusing only on the factors that could potentially impact their company. When this is done right, CFOs gain a better view of their corporate risk profiles and can take into consideration which factors may affect value creation both now and in the future.
Include climate-related risks
Just because a particular risk may not be material today, doesn’t mean it won’t be in the future. Take climate change, for example. In 2015, the Financial Stability Board Chairman, Mark Carney warned that climate change could significantly impact financial stability. The G20 then created the Task Force on Climate-Related Financial Disclosures (TCFD) to help businesses understand and quantify climate-related risks and opportunities. On 29 June this year, the TCFD released its final recommendations and guidance to help businesses understand their climate-related financial risks. The TCFD Recommendations aim to create a standardised framework for aligning climate-related financial disclosures across G20 countries – but the recommendations fit with existing reporting frameworks the world over.
By creating a set of uniform recommendations and guidance, the Task Force has made it easier for businesses to deliver on investor demands for climate-related information, and smart business leaders will capitalise on that.
Look into the future
No one can predict the future, which is why it’s important for C-suite executives to explore how a range of future scenarios could impact their business. Most companies already explore a range of different scenarios for crisis planning, stress testing or for understanding potential impacts of investments but companies should also engage in scenario analysis for ESG issues – including climate change, natural resource dependency and impact, talent, and so on. Doing so will help ensure that their companies aren’t blindsided by unforeseen transition and physical risks – including changing regulatory, social or environmental conditions.
An appropriate understanding of risks – present and future – as well as an appropriate risk management strategy, are key for the success and survival of any business. Companies should start experimenting with scenario analysis in the ways that make the most sense for them.
The TCFD’s Recommendations on Scenario Analysis are a great place to start. They encourage businesses to conduct sound scenario-planning by providing tools to help companies see what their operations would look like under various climate scenarios. They also go further and require businesses to disclose the results of these scenarios, if material, to the investor community.
By helping business lay out and understand a range of possibilities, the TCFD scenario analysis helps companies discuss climate-related risks in a quantitative way and provides transparency to capital markets.
Climate-related risk is a great first step, and may help open the door for other ESG considerations.
For companies which aren’t ready to pivot to integrated reporting, focusing on alignment between sustainability reports and legal/annual filings will be key.
Despite the fact that risk management experts from all over the world state that social and environmental risks are fast-becoming legal and economic risks for business, the way companies report and disclose tells a different story.
The World Business Council for Sustainable Development’s 2017 Sustainability and Enterprise Risk Management report compares over 180 companies’ sustainability and risk disclosures and reveals that, on average, only 29 percent of the areas deemed to be material in a sustainability report were disclosed in a company’s legal disclosure of risks. In addition, 35 percent of member companies did not disclose any of the sustainability risks identified in their sustainability reports in their legal filings. Evidently, many companies are failing to adapt to, respond to, and mitigate social and environmental risks.
Some of the reasons for this may include limited knowledge of sustainability risks, difficulty quantifying sustainability risks, short-term horizons and limited guidance for implementing risk management frameworks beyond the usual suspects. The result is that sustainability issues are often ignored or not disclosed.
This doesn’t have to be the story – CFOs can make a difference
Risk management and sustainability are important areas for improvement in corporate reporting and disclosure. CFOs are in a unique position to make a difference – by taking steps to understand what reporting requirements are out there and how various risks may affect companies now and in the future, they can help safeguard their companies and advance the future of sustainability.
It’s up to CFOs and other corporate leaders to be honest with themselves and transparent with their stakeholders, and to identify the risks. CFOs have an important role to play in bridging the gap between financial and non-financial disclosure. It’s time to radicalise the world of corporate reporting, and CFOs are in the lead.
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