ESG & Climate Risk: What CFOs need to know (2023)

Companies face up to $1T in potential financial losses in the next five years due to climate change (CDP)

Environmental, Social, and Governance (ESG) standards have become a hot topic amongst senior executives. Stakeholders demands, the rise of ESG investing, the impacts of climate change, and new regulations all present a new set of risks for companies. This has resulted in sustainability being listed a top challenge 51% of CEOs (IBM Institute for Business Value).

ESG is redefining the way companies operate. This includes most company functions - from HR, to operations, to procurement. But perhaps, no role is facing greater change that that of finance and the CFO. This makes ESG a priority for many CFOs in 2023.

Why are so many CFOs talking about climate risk?

In recent years, investors have shown an increasing interest in climate risk. Their choices are increasingly influenced by sustainability and other ESG factors.

ESG investing focuses on identifying companies with low carbon emissions that are socially responsible that also see shareholder rights as paramount. ESG factors now impact investment decisions of asset managers, institutional investors, and public markets investors on Wall Street and across the global investment community. Learn more about How Green Companies Attract Investment, in this resource.

Institutional investors in particular are driving demand for investment products with an ESG lens. If current trends hold, in 2026 ESG-focused institutions will manage US$33.9 trillion, 21.5% of the world's total assets under management according to PwC. The best and the worst companies for greenhouse gas emissions and other ESG factors are coming into the spotlight. ESG corporations are seeing increased financial analysis from mutual funds and other types of ESG investing.

Along with their annual reports, shareholders and other stakeholders now call for ESG information and accountability on ESG metrics and other non financial factors. These disclosures should strictly align with ESG ratings and reporting frameworks to be considered by investment managers in the sustainable investing industry.

In addition, corporations are increasingly held accountable by governments and regulatory bodies who are now taking a more active role in legislating, monitoring, and enforcing climate-related risks. The Securities and Exchange Commission (SEC) in the United States, for example, has proposed a new disclosure rule that requires publicly traded companies to disclose certain climate-related risks. Companies now have a growing number of obligations and are held to higher standards than they were in the past.

The economic considerations of not adhering to ESG factors can also be considerable. Not only is the cost of capital higher but so are insurance premiums. The fines from regulatory and government bodies from not making progress on ESG can also expensive. There is also a cost to talent acquisition and employee engagement, as well as customer loyalty and acquisition. Simply, many people now only want to associate themselves with a company who is sustainable.

This new layer of complexity adds to the pressure on companies to understand how their operations could be affected by extreme environmental events or other ESG-related issues. This is why every CFO in 2023 should have a plan to evaluate, monitor, and, manage ESG related risks.

The best way to start is by looking into the company’s ESG performance. This will give the CFO an overall snapshot of how well the company is doing in terms of its environmental, social, and governance initiatives.

The evolution of companies in the ESG era

The evolution of companies in the ESG era is now becoming more apparent. To remain competitive, CFOs must be proactive in understanding and managing the risks associated with ESG factors, that differ from industry to industry. With greater transparency and increased demand from stakeholders, companies that don't implement a strategy to manage ESG risk will not survive in this new era of business.

It is now critical for CFOs to take an active role in ESG analysis and management if they are to remain competitive. Here are some of the main risks to look out for:

Environment

Environmental issues include climate change policies, energy consumption, waste, pollution, and natural resources conservation. Companies should consider their environmental policies and practices to ensure that they are reducing the impact of their operations on the environment. This could involve evaluating energy consumption, waste management, pollution control, natural resources conservation and animal welfare.

Social

Social issues involve the consideration of human rights, labor practices, and diversity and inclusion. Companies should assess their policies and practices to ensure that they are taking into account social issues such as employee welfare, health and safety, working conditions, child labor regulations, gender equality and diversity in the workplace.

Organizations can also take steps to protect human rights by making sure their supply chain is compliant with international standards. They should also be mindful of how they interact with the communities in which they operate, and take into account any potential issues that may arise.

Governance

Governance issues include board structure, executive pay, corruption prevention policies, and transparency in financial reporting. By taking steps to ensure compliance with ESG governance standards, companies can demonstrate their commitment to sound corporate practices and long-term sustainability.

How ESG creates value for companies

The pathways to materiality from ESG are varied. As well as attracting more investment, providing greater long-term financial stability, there is a long list of benefits some of which we have laid out below.

Depending on the company, it may take significant short-term investment to realize the upside from ESG investments although this is a matter of not if but when. The sooner the costs are incurred, the greater a companies competitive advantage in the long run. An IMB survey reported that more than 80% of CEOs expect sustainability investments to deliver better business performance over the next five years.

Reducing costs and increasing efficiency

ESG can reduce costs and increase efficiencies by identifying areas for operational improvement. This could include adopting energy-saving measures such as installing LED lighting or investing in renewable energy sources, which can reduce long-term energy costs. Additionally, by reducing emissions and waste, companies can reduce their environmental footprint and help to protect the planet. These efforts can result in cost savings which can be reinvested into other areas of the business, driving growth and profitability.

Attracting customers and employees

Investing in ESG also has the potential to help companies attract new customers and employees. Customers are increasingly taking into account a company’s ESG stance when making purchasing decisions, so having a strong ESG policy can be beneficial in terms of attracting more customers. Additionally, by promoting an ethical workplace environment, strong values and demonstrating their commitment to ESG principles, organizations can attract more talented and ethical employees.

Developing new products, markets, and business models

By implementing ESG standards, companies can also be motivated to develop new sustainable products, services, and technologies. This could include developing green energy solutions or investing in renewable sources of energy, as well as new innovative business models such as the circular economy. They can also access new markets, customers, and industries who are motivated by environmental and ethical considerations. These efforts can help to improve the company’s financial performance in the long term.

Learn more about the benefits of sustainability in our resource, Why Businesses Should Embrace Sustainability.

How ESG is shaping the CFO role

While every company is different, the responsibility for ESG often sits with the CFO. This is because ESG and business performance are inextricably linked. In order to identify and assess environmental, social, and governance risks that are likely to affect their financing or business operations, organizations need to work together with senior management in the lead.

As ESG grows in importance, CFOs need to take it into account when making financial decisions. This means that they must be aware of social and environmental issues, as well as their potential impact on the company’s long-term performance.

Moreover, many CFOs are now responsible for monitoring and reporting on ESG metrics. This requires gathering a massive amount of data from across departments such as HR and procurement. CFOs must ensure that they accurately report on their company’s ESG performance as this can have a major impact investment. They must also ensure that they are in compliance with ESG standards, keep up with ESG ratings and take steps to mitigate any potential risks or negative impacts.

In addition, CFOs must take into account the wider implications of their financial decisions, such as potential impacts on the environment or society. This means that CFOs must be more strategic in their approach and take a longer-term view, rather than simply focusing on short-term gains.

ESG Challenges for CFOs

A big challenge for CFOs and other management is ensuring compliance with relevant ESG regulations and standards. This can be a complex process, as there are many different regulations and standards that need to be taken into account. There has been some movement towards a common standard with the International Sustainability Standards Board rallying regulators from around the world to accept a set of common rules they may help overcome this challenge in the future.

Accounting for indirect greenhouse gas emissions, or Scope 3 emissions, can also present some big challenges for CFOs. Emissions across a firms entire supply chain can be difficult to quantify and track, particularly as many vendors are not tracking their ESG information. Its also difficult for CFOs to measure the long-term impacts of their company’s activities on the environment and society, and the subsequent areas for improvement or risks to be addressed. Both of these factors make it harder for CFOs to build metrics and report accurately.

Finally, CFOs must navigate the tension between ESG considerations and financial performance. It is important to strike a balance between the two, as it is possible to take steps to improve ESG performance without sacrificing financial returns.

Conclusion

Overall, ESG is becoming an increasingly important consideration for businesses. CFOs must be aware of their role in this process and ensure that their companies are compliant with relevant regulations and standards. By taking steps to implement ESG principles, organizations can improve their financial performance and secure greater long-term sustainability.