Australian CFOs Hold The Key To Unlocking ESG Value

ESG (environmental, social, and governance) is now a priority of many corporate leadership teams, playing an important part in a company's financial reporting, risk management and corporate messaging.

The latest government federal budget featured a substantial focus on addressing climate change in Australia, from increased budgetary support for relevant government departments, to funding devoted to the development of climate reporting standards in Australia by the Australian Accounting Standards Board. The Board, which appointed five new directors for such purpose, will look to develop climate reporting standards for large businesses and financial institutions, in line with international reporting standards. This follows similar developments in the US and the European Union.

Adherence to high standards for ESG is critical for demonstrating positive corporate citizenship, appropriate risk management, resiliency and responsiveness to the investment community. Mandated reporting on ESG issues will create a baseline for the quality and completeness of disclosures provided. However, companies can differentiate themselves from peers and lower their actual and perceived cost of capital by establishing robust processes for risk identification, assessment, prioritisation, the assignment of oversight, and related internal and external reporting.

Increasingly, CFOs can play a particularly important role when it comes to ESG, as finance functions have the necessary skills, systems, and processes to track and report key ESG-related metrics, and much of the information needed to track and measure ESG goals can be found in financial systems. Given the centrality of financial analysis and reporting to sound ESG programs, leadership and direction from CFOs are becoming an increasingly important factor in driving a company's successful management of data and thus target-setting and reporting. In practice, finance and accounting teams skilled in managing large data sets and tying financial metrics to non-financial measures are moving to centre stage as key business partners attempt to define how and where to source necessary data for ESG strategy development and reporting. For CFOs and their teams to successfully contribute to and empower a company's ESG strategy, they need to be well-versed in ESG metrics and related international standards and reporting frameworks. Among many other critical areas of focus, knowledge-building within finance and accounting functions and the development and continuous improvement of systematic ESG data collection, tracking and reporting processes will likely be front and centre, given that:

• Reporting of climate-related financial risks for companies might soon be required in Australia, which is likely to be aligned with the recommendations posed by the Task Force on Climate-Related Financial Disclosures (TCFD) and guidance from the Greenhouse Gas (GHG) Protocol;
• Nine other international jurisdictions have announced adoption of TCFD-aligned reporting requirements: Brazil, EU, Hong Kong, Japan, New Zealand, Singapore, Switzerland, the UK and Canada;
• Many large asset managers such as Blackrock, Vanguard and State Street have requested that portfolio companies respond to the TCFD's recommendations and, in some cases, have threatened to vote against directors in situations where such implementation and disclosures are lacking;
• The importance of ESG-related due diligence is increasing within the M&A process, including assessing a target's ESG reporting, disclosures, transparency, commitments, and ultimately the value at risk and the cost to align the target's ESG profile with that of the acquirer;
• Credit rating agencies (CRAs) like Fitch, Moody's and S&P are beginning to roll out ESG evaluations and scores that have the potential to impact broader credit ratings and thus the borrowing terms that companies receive on their debt from banks and other lenders.

Understanding TCFD

The recommendations of the Task Force on Climate-Related Financial Disclosures have quickly become one of the most utilised and well-regarded frameworks for reporting the potential financial impacts a company may face due to risks and opportunities associated with climate change. The value in the TCFD's recommendations stems from its design, which replicates quarterly disclosures already being discussed and provided by finance and accounting functions internally: governance, strategy, risk management, and related financial metrics and targets. These same categories are the four substantiating pillars of TCFD, but through a climate- focused lens. Regardless of organisational structure, CFOs have key oversight, responsibility and partnership on each of these corporate functions. They are also responsible for communicating with investors, shareholders, creditors and supply chain partners, making them an incredibly valuable part of the process.

Figure 1 - TCFD Core Elements of Recommended Climate-Related Financial Disclosures

The TCFD recommends 11 related yet distinct disclosures across four pillars. Each disclosure from TCFD is thought- provoking in its pursuit of properly identifying climate- related risks and opportunities, establishing relevant oversight, quantifying the resilience of an organisation – along with the potential financial impact of these risks and opportunities under certain scenarios – and then disclosing metrics and targets that enable stakeholders to evaluate a company's current standing and its path forward. A market shift is currently underway whereby public companies are being pressured to pivot from pure disclosure of discrete metrics to thoughtful analysis and reporting of climate impacts on the company as a going concern. Privately held companies should be mindful of the TCFD as well, as it helps frame discussions around operational resiliency and responsiveness with investors and creditors while also preparing them for ESG discussions during due diligence. Additionally, given that many companies subject to climate- related reporting requirements may ultimately report financially material indirect value chain GHG emissions (Scope 3) and any related targets, supply chain participants— even those privately held — may be pressured to begin reducing their own GHG emissions (Scopes 1 and 2) and disclosing efforts and progress accordingly. For all the reasons above and many more, CFOs will likely play a central role in responding to and implementing the TCFD's recommendations.

ESG Is the New "Must Have" for Due Diligence

ESG issues can impact acquisition value, as they can shed light on previously unforeseen risks or opportunities, and thus may impact whether deals go forward. Whether CFOs are sell-side or buy-side of an M&A engagement, confirming pertinent ESG information is critical when evaluating potential legal and reputational risks related to the sale of an entity or acquisition of new operations and facilities1. This also applies to capital expenditures required to maintain ongoing emissions-reduction projects. CFOs can assist in three commonly occurring ESG due diligence scenarios:

• Benchmarking the target against peers: Benchmarking is a critical exercise to identify gaps between the target's ESG risks, opportunities, strategy, reporting and commitments and those of its peers. As with financial due diligence, CFOs and supporting functions can leverage publicly available data and industry-specific resources to examine exposure to and management of relevant ESG risks and opportunities, including those related to climate change, anti-bribery and anti-corruption, among many others. Key questions to consider include: Is the target an ESG "laggard," "leader," or in the middle of the pack? Does the combined entity's ESG risk and opportunity profile change materially? If so, what implications for ESG ratings, reporting and sustainability reporting frameworks may exist?
• Assessing value and risk when a target lacks an ESG program: If the potential target does not report ESG or climate-related metrics, this decisive lack of action requires diligence as well. Key questions to consider include: Do we adjust our purchase price multiple due to unreported or unaddressed ESG issues? What investments do we make to collect relevant ESG data and consolidate with the acquiring company's existing analysis and visualisation processes? Do accurately measured Scope 1–3 GHG emissions and realistic and quantifiable reduction pathways exist?
• Aligning the target entity's ESG initiatives with the acquiring company: When the target has reported ESG or sustainability metrics, financial due diligence can verify the sources for these metrics and calculations. Key questions to consider include: How comparable are the source data and calculations to the acquiring company's metrics? What adjustments need to be made so they can be compared on a similar basis? How will the underlying data and processes be integrated post-acquisition?

CFOs can be a natural fit for guiding and defining a company's material ESG issues and setting corporate sustainability goals where key issues and critical room for improvement exist. With oversight of and insight into personnel, systems and processes that can accurately capture and analyse the metrics to track progress and confidently set and report on targets, CFOs play a significant role in providing decision-useful and transparent disclosure to the investment community. They also have influence over corporate governance, financial reporting, regulatory compliance and M&A activities. This positions them well to partner with the executive team and board of directors to ensure that strategies related to ESG issues are fully integrated into broader corporate strategy and planning discussions and models.

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