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ESG Risks – The Reporting Challenge

Financial Reporting Brief January 2020

This article 'ESG Risks – The Reporting Challenge' considers the major and continuing evolution in environmental, social and related factors and how corporates need to meet the changing reporting demands.

Our Quarterly Financial Reporting Brief comments on the priorities of the financial reporting supervisors, proposed standard in relation to presentation and disclosure, thematic reviews of standards, developments in relation to the future of corporate reporting and many other matters. View the full Quartlery Financial Reporting Brief here.

ESG Risks – The Reporting Challenge

Changes in investors’ and society’s expectations have translated into a growing demand for better corporate reporting that responds to the need to understand broader risks and business impacts.

Investors and other stakeholders are demanding more, higher-quality information and insights about company performance, risks, opportunities and long-term prospects than are available from the conventional financial reporting process.

In its recently published Reporting Matters, the World Business Council for Sustainable Development (WBCSD) comments in the introduction that good reporting enables companies to show how they have integrated sustainability into their business and to communicate the value of their work. Transparent and accessible reporting is vital for assessing the risks and opportunities posed by today’s sustainability challenges to the value creation process of business models, providing impetus for meaningful and focused board-level conversations about business strategy and resilience.

International Perspective
The International Federation of Accountants (IFAC) comments in its recently released ‘Point of View’ that it sees a significant opportunity to enhance trust in companies and confidence in markets by including information in corporate reporting that is relevant, reliable and comparable with respect to measures derived from the financial statements (ie ‘non-GAAP’ or non-IFRS measures), other ‘key performance indicators’ connected to financial performance, and broader information related to value creation, sustainability and environmental, social and governance factors.

The International Integrated Reporting Council (IIRC) has recently commented that the conversation has shifted from why? to how? companies communicate their progress and prospects in terms of value creation and impact on various stakeholders. There has to be a consensus on the benchmark for companies and their stakeholders to evaluate various opportunities and risks and understand short-term versus long-term value trade-offs, and whether the company has a long-term strategy for value creation and positive impact through a resilient business model.

ESG – More than Disclosure!
The International Organisation of Securities Commissions (IOSCO) reminded issuers in a statement published in January 2019 that environmental, social and governance (ESG) matters, though sometimes characterised as non-financial, may have a material short-term and long-term impact on the business operations of entities as well as on risks and returns for investors and thus are important for their investment and long-term decisions. The ESG impact can be wide-ranging, for example:

  • Regulation can affect costs or require capital expenditure, or lead to impairment or stranded assets
  • Moving to new, more sustainable solutions may require increased capital expenditure
  • Crises or failures in production or supply chains, including natural disasters, can increase costs and undermine supply and demand
  • Failings identified in governance, performance or culture can lead to
    • Lost revenue
    • Exposure to litigation or regulatory fines
    • Damage to reputation
    • Loss of a company’s social license to operate

There is an increasing gap between current reporting and investor expectations as economies transition towards low carbon and climate resilient futures. Regulators expect that relevant information will be disclosed on both the impact of a company’s operations on the environment and on how environmental matters may affect the entity’s development, performance or position.

Financial Reporting Standards – Direct Impact
Some requirements in IFRS Standards that could require companies to consider climate-related and other emerging risks when making materiality judgements about what to recognise in the financial statements, about measuring recognised assets and liabilities and about what to disclose.

IFRS 13: Fair Value Measurement
When the fair value of an asset is affected by climate-related risks, or other ESG risks, a company may need to disclose how it factors such risks into the key assumptions underlying fair value calculations.

IAS 36: Impairment
A company’s exposure to ESG including climate-related risks could be an indicator that an asset or group of assets is impaired; that exposure could also affect future estimated cash inflows and outflows used for recoverable amount calculations. IAS 36 requires disclosure of the key assumptions on which cash flow projections have been based and management’s approach to determining the fair value assigned to these key assumptions.

IAS 16: Property, Plant and Equipment
ESG risks may affect and lead to renewed consideration of expected useful lives and estimated residual values, and also different perspectives on whether expenditure meets capitalisation requirements and represents an asset.

IFRS 9 and IFRS 7: Financial Instruments
Where there are climate-related or other ESG risks, credit risk may increase significantly and change the basis on which expected credit losses are estimated. Investment funds and insurance companies, as well as banks, could hold investments that are exposed to fluctuations in value arising from ESG factors.

IAS 37: Provisions and Contingencies
ESG risks, including climate-related, may lead to additional considerations on uncertainties relating to the outflow of resources for settling an obligation. Particular concerns may be onerous contract provisions, plant decommissioning, environment restoration or regulatory penalties.

IAS 1: Presentation of Financial Statements
IAS 1 requires disclosure in the notes of information that is not presented elsewhere in the financial statements but is relevant to an understanding of them.

Governance Considerations
Governance is an enormous challenge for corporates and their directors in making best efforts to cope with the enormity of continuing change. A prime illustration is under UK law, where large companies are required to include a statement within their annual Strategic Report in accordance with Section 172 of the Companies Act 2006 which relates to the duty to promote the success of the company. While not applicable to Irish companies, the principles enshrined within Section 172 are appropriate for consideration by Irish companies in fulfilling their obligations under Irish law to act in good faith for the benefit of investors . For Irish companies with Primary listings on the London Stock Exchange, the UK Corporate Governance Code may be considered as inferring a duty to report under Section 172.

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members as a whole, and in doing so have regard amongst other matters to:

  • The likely consequences of any decision in the long term
  • The interests of the company’s employees
  • The need to foster the company’s business relationships with suppliers, customers and others
  • The impact of the company’s operations on the community and the environment
  • The desirability of the company maintaining a reputation for high standards of business conduct
  • The need to act fairly as between members of the company

The UK law requires a clearly identifiable and separate statement within the annual report. It is noteworthy that Section 172 defines company success as promoting the interests of shareholders while taking account of a diverse group of stakeholders. A challenge for many companies may be managing the potential conflicts of interest that can arise.

Good reporting enables companies to show how they have integrated sustainability into their business and to communicate the value of their work.
Investors and other stakeholders are increasingly looking for information from companies about how they will evolve, adapt and respond over the longer term to changes in the external business environment.

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