.svg){kind=avatar}
ESG Accounting is the practice of measuring, analyzing and reporting a company’s social and environmental impacts. Currently, ESG Accounting is voluntary in the United States. Although select companies are choosing to participate, the mechanisms for incentivizing companies to report and report accurately are severely inadequate. This optionality, coupled with the overwhelming number of accounting standards and frameworks, makes this an almost unrealistic expectation of complex organizations. With increasing pressures from investors and sustainability institutions, the requirements are fast approaching, but with several coordination and implementation concerns and complications.
SEC: Published on March 21, 2022, the SEC’s proposed rule on climate disclosures will require public companies to disclose information on climate risks and carbon emissions. If a company has publicly communicated a climate-related goal or target, they will also be required to disclose detailed transition planning and annual progress toward this goal, dissuading “green washers” from obfuscating their actual efforts and results. The proposed rule is closely aligned with the Task Force on Climate-Related Financial Disclosures (TCFD) methodologies and the Greenhouse Gas Protocol.
CSRD: The EU’s Corporate Sustainability Reporting Directive (CSRD) was proposed in April of 2021. This rule is intended to strengthen existing reporting requirements by covering more emissions data (including scope 3 emissions disclosures) and other climate-related topics. Under the CSRD, all public companies, and some larger private companies, would be obligated to report; unlike the former rules that only applied to large public-interest companies with more than 500 employees, which was only about 11,000 companies. Under the CSRD, nearly 50,000 companies are covered across public and private markets. Overall, the EU’s CSRD will require companies to report on how sustainability topics impact their business while also providing information on how their business affects the environment and other sustainability topics. The CSRD is closely aligned with the Global Reporting Initiative (GRI) framework.
ISSB: The International Sustainability Standards Board’ (ISSB) Sustainable Disclosures Requirement (SDS) is another pending disclosure regulation that is not specific to any geography. The ISSB is an independent, private-sector body that was created in 2021 at COP26 to provide universal sustainability standards to be governed by the International Financial Reporting Standards organization. The standards are intended to provide a global baseline for sustainability disclosures. These standards include reporting on climate risks, greenhouse gas emissions, climate resilience planning, and industry specific targets and guidance. The ISSB SDS is closely aligned with TCFD and the Sustainability Accounting Standards Board (SASB) frameworks.
TCFD: The Task Force on Climate-Related Financial Disclosures (or “TCFD) is a guidance framework that helps companies communicate and disclose climate-related financial risks to investors. The TCFD framework focuses on governance, strategy, risk management, metrics, and targets.
SASB: The Sustainability Accounting Standards Board (or “SASB”) is another reporting framework, however, SASB organizes topics based on ESG impacts across seventy-seven different industry standards. TCFD, on the other hand, assesses only how climate change might impact a business’s ability to generate value.
GRI: The Global Reporting Initiative (or “GRI”) assesses the economic, environmental, and social impacts a company has on sustainable development. All of these reporting frameworks, including others that are not listed, are complementary to each other and have agreed to continuous coordination to provide a more standardized approach to sustainability reporting.
Right now, most sustainability disclosures are focused on climate change and carbon accounting. As ESG accounting practices become more robust, we will begin to see more standards regarding biodiversity, social dynamics, and more holistic sustainable development concerns. The myriad of standards and potentially duplicitous or contradictory requirements present significant challenges to producers, distributors and consumers of energy.
Mandating climate disclosures is the first step toward achieving climate change mitigation. It is a mechanism for incentivizing companies to honestly reduce their emissions levels and quantify their climate risk, however the real mitigation will come from setting targets and tracking key performance indicators.
If a company is forced to be more transparent on its emissions, risks, and sustainability claims, investors could divest significant amounts of money based on newly available information, should the company fail to accurately report or deliver on its climate obligations. This would force companies into keeping their decarbonization promises. If companies do not decarbonize quickly enough, many of them could be materially impaired from negative investor sentiment and / or find themselves with stranded assets.
It is almost impossible to quantify the hypothetical reduction of emissions that will come from climate reporting because it will be an indirect method. Climate disclosures are simply designed to leverage market forces to price in climate change and its effects. By sharing this information, companies that are actively fighting climate change will be rewarded and those slower to respond will face financial consequences. To summarize, climate disclosures can only incentivize companies to decarbonize.
Allocated Responsibility: Several companies in the US do not currently have the resources to effectively measure their climate impact let alone disclose information regarding climate change and mitigation measures. Very few companies have full-time employees dedicated to sustainability topics. Nor do companies have historic ESG data readily available. The collection, cleaning, and monitoring of ESG data is a cross-functional effort that will require coordination mechanisms across an organization.
Unreliable Data: Often, when companies start reporting on their carbon emissions, it will look like they are emitting more than their baselines. This discrepancy is from lack of accurate historical carbon emissions data. So as the reporting gets stronger, emissions will seem worse, but this is because they were under-reported before; making current baselines unreliable and inaccurate. As climate reporting becomes the standard, data collection and availability will be stronger, providing people with clearer pictures of their carbon footprints. This learning curve needs to happen before companies truly acknowledge their progress. How can a company improve if it does not know what baseline it is improving upon? This is the main problem with ESG data now.
To further complicate matters, data from Scope 1 and Scope 2 emissions tend to be readily available and (relatively) easily obtainable. Data for Scope 3 emissions however can be a completely different story. Scope 3 emissions are by definition outside of the control boundary of the reporting entity (meaning the company disclosing its carbon footprint) which means that the company needs to rely on emission factors and / or assumptions (which would discourage actively measuring and improving upon those emissions), or rely on data provided by third parties that was probably calculated based on different, less robust guidance (especially if it comes from smaller, less sophisticated suppliers that might find data requirements burdensome).
External Auditing: The SEC proposed rule and the CSRD proposal would require a third-party to audit the provided ESG data. Not only would this be a tremendous cost to companies, but major accounting firms are not yet equipped to provide this kind of guidance. For reference, PwC announced a $12bn investment plan to improve its ESG capabilities. This plan includes hiring 100,000 more employees and offering more ethical training to employees. KPMG announced a rigorous “climate learning program” for 300,000 employees. Major accounting and consulting firms are ramping up their climate practices with big investments and talent diversification to prepare for pending climate disclosures.
Varying Standards: Compliance could become very expensive as climate disclosures are developed and mandated. In addition to being an enormous cost of capital and human resources, mandated climate disclosures will be tremendously confusing for investors and businesses. As new disclosure rules are introduced, they are heavily influenced by the existing frameworks, but variations still exist.
Government Coordination: Even though sustainability institutions have agreed to be collaborative in standardizing guidance, it is highly unlikely that any one framework will be accepted as the one source of truth. Experts have started to urge governments to standardize the basics of climate reporting, including climate models, materiality, and climate risk definitions. Additionally, several of the existing frameworks are merely accounting standards and not regulatory bodies. Enforcing these standards will require government coordination.
The ESG Accounting and Regulatory Environment is quickly maturing. Several companies in public and private sectors are attempting to get ahead of these reporting requirements by leveraging existing frameworks such as the TCFD, SASB, and GRI guidance. Although these attempts are well intentioned, the variety of standards and optionality to participate limits what companies, investors, and consumers can infer about a business’s sustainability impact. The regulated requirements will attempt to standardize reporting and provide a more accurate view of climate change’s effect on businesses; and in the CSRD’s case, the impact of businesses on the environment.
Innovation is poised to play a crucial role in preparing businesses for these reporting requirements. Here at Energy Capital Ventures, we are constantly looking for start-ups that are tackling these challenges and providing clarity to ESG accounting through improved data collection, emissions calculations, sustainability reporting, and transformation planning. We welcome the opportunity to discuss new technologies that were built and designed with these pending regulations in mind. ESG Accounting will be a coordinated effort, with multiple solutions required.
Although the proposal of climate disclosures is well-intentioned, the confusion and approval process to follow will be highly politicized and contested. We strongly encourage our investors, advisors, entrepreneurs, and readers to submit comments to all pending disclosures. Information on how to submit commentary (agreements, disagreements, suggestions, etc) can be found below:
Provide commentary on the ISSB’s proposed rule here.
Provide commentary on the SEC’s proposed rule here.
