Dealing with climate change is non-negotiable for business. A transition to low-carbon economies is underway with politicians, regulators, institutional investors and asset managers rapidly committing to net zero emissions by 2050. My company, Standard Chartered Bank, has committed to reaching net zero carbon emissions from our operations by 2030, and from our financing by 2050. As part of our Transition Finance Imperative, we have already started working closely with companies to help them reduce their emissions and reach their own net zero goals.
Every organization needs to steer toward net zero. To succeed, CEOs need to empower their CFOs to ensure that the organization and its investors have the information needed to deliver a business model that is ultimately compatible with a net zero economy. The mainstreaming of climate as a systemic risk with potentially enormous financial consequences has led to investors scrutinizing climate risk. The result is that companies will increasingly position climate and sustainability under the CFO’s oversight to mainstream climate risk within business (see Acciona calls on finance chief to make sustainability add up).
At IFAC’s recent Professional Accountants in Business Advisory Group meeting, which I chair, we discussed with KPMG the role of accountants and finance leaders in delivering on climate change (see our report, Enabling Purpose Driven Organizations). The main challenge for the capital markets is that companies and their investors typically lack robust climate impact insights to understand how it will affect business resilience and long-term value creation.
Currently, climate risks and opportunities have not been fully taken into account in valuations because companies are generally not adequately reflecting the actual and potential impacts of climate change in their financial reporting. Company valuations in a 2-degree Celsius or lower world will be very different given the potentially significant implications on future cash flows.
With climate being a significant financial concern and threat to long-term value creation, CFOs need to provide actionable information and insights on the opportunities and risks and potential financial impacts. With the right insights and understanding of climate risk and opportunity, companies can steer towards decarbonization and tell their story to investors.
For CFOs there are four key areas of focus to be able to oversee the climate response in your organization:
Know your emissions. Emissions arise from the business model related to products and services, and fixed assets. Both absolute emissions reduction and carbon intensity provide a benchmark for targeted actions for decarbonization. Assumptions about emissions affect accounting estimates and asset values. CFOs need to monetize emissions data to include in financial analysis and planning, and in financial reporting (see Carbon Quotient: Accounting for Net Zero).
Establishing a reliable carbon footprint for an organization, or for a product, can be a complex task but is critical. A carbon footprint (or GHG emissions inventory) measures the energy consumption of an organization’s activities and the GHG emissions associated with the business model. A huge challenge for companies and investors is understanding the absolute emissions arising from its business model including across its value chain (i.e., beyond its Scope 1 direct emissions and Scope 2 electricity indirect emissions).
Collecting robust data of Scope 3 or other indirect emissions is challenging but gaining importance for many organizations. Scope 3 data ties to emissions in their supply chain, and how customers use their products, which represent significant risks and opportunities to reputation and license to operate. Consequently, more large corporates are working closely with customers and suppliers to help them address emissions in the consumption and supply parts of the value chain.
Setting KPIs that improve performance and linking these to incentives is also critical. For example, an airline might be reducing its emissions per passenger mile traveled, but its overall emissions might be increasing because of increased number of passengers. CFOs need to ensure that GHG management plans are in place so they can prioritize carbon reduction projects, quantify them, and place numbers on cost savings, carbon savings, and implementation costs.
Integrate climate information into strategy and risk management. Understanding and incorporating climate risks and opportunities in strategy and risk analysis is the foundation for decision making that leads to decarbonization.
A comprehensive understanding of climate risk assessments and scenario modeling supports robust analysis of opportunities and risks in relation to different transition pathways. Scenario analysis is a critical element in bridging risk management and strategy and provides useful insights into how resilient strategies and business models are in the context of physical and transition climate risks.
Risk assessments help to quantify climate impacts and their potential financial impact in relation to revenues, expenditures, assets and liabilities under various climate scenarios. The adaptive capacity of the business model in different scenarios is highlighted by the extent to which weather events and increasing carbon costs impact expected cash flows and asset valuations.
In turn, information on climate risks needs to be embedded in strategic decision-making processes such as capital investment. Existing physical assets such as buildings, machinery and equipment and vehicles are stores of future emissions which will continue over their remaining use. Climate risk and opportunity is likely to have important implications for capital investment decisions. Asset impairment and replacement costs of various existing assets, and the appraisal of new assets, will be a fundamental part of achieving net zero. The quantification of climate risks and events helps to drive medium and long-term planning, and improves financial-related information about profits and valuations.
Understand your decarbonization options. Decarbonizing a business requires knowledge of climate financing and new ways of doing business. A business with a decarbonization strategy and plan can respond and adapt to the opportunities and challenges around different approaches to achieving net zero emissions reduction.
In terms of business models, it is important to be familiar with various options for permanent carbon reduction and removal and their associated cost and benefits. Investments in low-carbon and novel solutions can often appear economically unviable because of high up-front capital costs so measuring economic returns, and other potential benefits over a longer period become important. Investments in R&D and innovation can be directed at enabling greater resource and energy efficiency, migration to circular business models, avoiding use or production of virgin materials (e.g., using bio-based raw materials like mycelium leather), and diversification into other energy forms.
Decarbonizing future capital expenditures needs money. Climate finance is the key to unlocking resource mobilization and capex decisions to finance low-carbon investments and products such as electric fleets or renewable energy generation. Mobilizing equity or debt finance to support new technologies and processes is usually critical to changing business models and supply chains. Options for green finance have significantly increased over recent years through green bonds such as the bond and sukuk issuances we use at Standard Chartered, and sustainability-linked loans, for example, Virgin Money has launched such loans in Europe. Companies will need a credible transition plan in order to access finance.
Tell the story – communicating how your company is becoming compatible with a net-zero economy is going to be part of a CFO’s conversation with boards, investors and other key stakeholders. This involves being able to explain the business risk and opportunities from emissions, targets and KPIs being used to track progress, where capital investment is prioritized to support the transition of the business model, and the financial impact of climate change.
When it comes to financial impact, the assumptions and estimates used in planning and capital allocation need to be consistent with those used in financial reporting. Qualitative information on risks and opportunities should flow through to accounting judgements on asset valuations and useful lives. Investors ultimately need to know how climate matters relate to their own forecasts of cash flows and risk.
The current valuation challenge exists because companies are generally not incorporating material climate-related matters in financial reporting under existing IFRS Standards. As the transition risk escalates with new taxes and regulations and changing consumer behavior, climate change will likely have a material effect on financial performance and position particularly for high emissions industry sectors. The CFO is the person to explain how the strategy and risk management on climate change relates to the accounting estimates and judgements used in the preparation of financial statements and reports.
For climate to move beyond a marketing exercise to one that provides the information that boards and investors need to enable economies to decarbonize, CFOs need to be part of the equation and be empowered by their CEOs.
