Sustainability and environmental, social, and governance (ESG) reporting is top-of-mind for CFOs right now. According to a recent Reuters article, a record $649 billion poured into ESG-focused funds worldwide in 2021 and ESG funds now account for 10% of worldwide fund assets. With sustainable finance on the rise comes a need for more—and better—financial reporting.
“Sustainability reporting has been an effective differentiator in attracting investors,” said Kyle Hulme, Partner, Strategy Consulting at BDO Canada. “As the world faces more frequent extreme weather, changes in consumer preferences, and increased regulations—ESG factors are increasingly impacting companies’ operations in the short and long term. That’s why it’s imperative to understand how ESG-related risks and opportunities impact your business today, how they will impact you in the future, and how they impact your current financial reporting,” he added.
In this article, our examples focus on climate risk as it’s one of the most significant sources of risk and opportunity for businesses and their stakeholders. But that doesn’t mean that social (e.g. diversity and inclusion, external political trends, and humanitarian issues in supply chains) and governance (e.g. board governance and accountability, internal controls, and financial audit) issues don’t also significantly impact your business and its financial statements. Learn more about the three pillars of ESG and how they impact your business here
Below, we also provide clarification around non-financial reporting frameworks and explain how to incorporate sustainability issues in your financial statements today.
What you need to know about sustainability reporting standards
Currently, a number of voluntary and diverse non-financial reporting frameworks exist. Some companies have chosen to adopt certain frameworks, but the variety in reporting makes it difficult to track impact and progress and some say this can lead to greenwashing.
Changes are underway and globally accepted sustainability standards are being developed. On Nov. 3 2021, at COP26, the UN global summit to address climate change, the International Financial Reporting Standards (IFRS) Foundation announced the formation of the International Sustainability Standards Board (ISSB). Given their experience creating accounting standards used in more than 140 jurisdictions, The IFRS Foundation is aiming to bring a much needed, globally comparable standard for reporting on ESG matters to the financial markets.
The Foundation will now have two standard setting boards (the IASB and the ISSB) that will set two separate IFRS standards, the first dealing with financial statements and second dealing with disclosures outside of financial statements:
- The International Accounting Standards Board (IASB) develops the IFRS Accounting Standards
- The ISSB will develop the IFRS Sustainability Disclosure Standards
Even though the IFRS Sustainability Disclosure Standards will cover disclosures that fall outside of financial statements, climate-related risk and other ESG matters can impact a company’s assets, liabilities, costs, and the ability to generate revenue—and therefore could impact your company’s financial statements.
Net-zero emissions targets and ESG goals
Countries around the world, including Canada, have committed to achieving net-zero emissions by 2050. According to the government of Canada, achieving net-zero emissions means our economy either emits no greenhouse gas emissions or offsets its emissions, through actions such as tree planting or employing technologies that can capture carbon before it is released into the air. To achieve this goal, significant transformation of all parts of society will be required and every part of the economy will be affected.
This is no longer hypothetical. Since 2019, every jurisdiction in Canada has had a price on carbon pollution that will rise $10 every year until it reaches $170 per tonne of CO2 in 2030. Canada also announced it will be mandating 100% zero-emission passenger vehicle sales by 2035.
Not only has the government set targets, but many companies have committed to their own significant climate and social-driven goals. Companies have made these commitments publicly and they are currently reporting on those efforts. If you are a supplier to those entities, it could impact your operations and if it impacts your operations, it impacts your financial statements.
Companies looking to sell into private equity (PE) firms also need to incorporate ESG into their financial reporting. PE firms are not only looking at ESG strategy for risk management purposes but also, increasingly, for the value creation opportunities. Sustainability trends such as low-waste, net-zero, diversity and inclusion, and clean technology all offer real value that PE firms are looking for.
Risks, opportunities, and your financial statements
Two types of climate risk categories exist:
- Physical risks: Arising directly from acute (wildfires, flooding) and chronic (rising temperatures and sea levels) weather events
- Transitional risks: Arising from the transition to a lower carbon economy (carbon pricing, changing customer preferences)
Companies need to consider such risks in the context of their financial statements rather than solely as a matter of sustainability reporting.
To help investors make sense of the potential impacts of ESG issues on corporate profits, companies should:
- Understand the ESG risk and opportunity landscape for your sector
- Analyze the financial implications of any actions you take to address an ESG-related issue
- Consider whether these implications impact amounts recognized or disclosed in your financial statements
The visual below focusses on climate-related risks and opportunities and demonstrates how they will ultimately impact a company’s revenue, expenditures, assets and liabilities, and capital and financing:
Understanding the timelines is essential
“In addition to the risks, what concerns me the most is understanding the timelines,” said Armand Capisciolto, National Accounting Standards Partner at BDO Canada. “Companies that have longer-lived assets may be impacted, and impacted sooner than they think, from a financial reporting standpoint.”
Take for example and oil and gas industry, the risks they are facing are mainly transitional (changing consumer behaviour and policy changes). These risks don’t eliminate the demand today. However, over time, the demand for oil and gas and will decrease and the cost to extract resources will increase. If demand decreases and costs increase this will decrease expected future cash flows. In addition, as the financial sector attempts to meet its targets to reduce financed emissions, this will also increase the cost of capital for the oil and gas industry. If expected future cash flows decrease and interest rates increase, this will increase the probability of these assets being impaired. If impaired, this will impact the measurement of the assets in the financial statements. If the assets are not impaired, disclosure of how these risks have been considered may need to be disclosed.
Consider the risks now: Don’t wait to be mandated
Some businesses incorrectly perceive that the effects of climate change will not be relevant for a long time and may be tempted to wait for sustainability reporting to become mandatory. However, just because reporting outside the financial statements is not mandatory doesn’t mean you don’t have to consider how these factors impact your financial statements today.
To learn more about how BDO can help you activate your ESG program and incorporate ESG into your financial reporting, reach out to: