By Andrew Harding – Environmental, Social, and Governance (ESG) initiatives have grown exponentially in recent years, driven by a heightened awareness of sustainability and ethical considerations among stakeholders and investors.
However, integrating ESG into financial analysis presents unique challenges, particularly when attempting to measure their impact and outcomes using traditional financial metrics. Traditional metrics, such as revenue, profit margins, and return on investment may fall short of capturing the full scope and complexities of ESG initiatives.
This poses a significant challenge to the finance and accounting profession in how it adapts to lead greater organisational outcomes and enable decision-making that creates, measures, and maintains value for a sustainable world.
With the rise of social and investor activism, the very meanings of ‘value’ and ‘return on investment’ are undergoing dramatic changes, and the shareholders and the financial services community have had to adjust their expectations about how enterprises create value and measure the impact of their ESG initiatives.
The Environment and Social components within ESG are driving the shift towards value defined by a much wider set of stakeholders than only shareholders.
Unpacking the complexity of ESG reporting
Historically, the finance function’s focus has been around promoting organisational efficiencies and reducing operational costs. However, today’s finance and accounting professional’s role is having to expand to be at the centre of an organisation’s ESG and sustainability activities, helping to define, enable, and articulate how an organisation creates and preserves sustainable value for both the entity and society.
An important aspect of this will be how an organisation measures and manages its intangible value that ultimately drives long-term success and profitability. In an ever-changing and complex business environment, we can no longer solely focus on financial data to assess business performance, drive long-term strategies, and generate sustainable value.
In a world where ESG is fast becoming the lens through which an organisation is judged, there is no disputing that ESG has the potential to impact financial value. The challenge for finance and accounting professionals lies in how to clearly and effectively share this information, clearly articulate the value of such investments, and demonstrate their commitment to ESG priorities.
Some of the challenges that ESG presents in terms of integrated reporting include:
* Multidimensional nature of ESG factors – Traditional financial metrics are primarily quantitative, focusing on measurable financial data and outcomes. In contrast, ESG factors, particularly environmental and social, encompass a broad range of qualitative and quantitative elements that are not necessarily easily measurable, and the outcomes are often long tailed in nature. For example, carbon footprint, water usage, and waste management practices are complex and multidimensional. Similarly, aspects such as community impact often involve subjective assessments and long-term societal changes that take place over an extended time frame that cannot easily be directly reflected in financial terms.
* Long-term horizon of ESG impacts – Traditional financial metrics are typically focused on short- to medium-term performance, such as quarterly earnings reports and annual revenue growth. ESG initiatives, however, often yield benefits and outcomes over a much longer horizon, often years in the making. Environmental initiatives such as investing in renewable energy or sustainable agriculture can take years or even decades to show significant financial returns. Social initiatives such as supporting community development may improve community relations over time, but these effects may be gradual, and not immediately apparent in financial metrics. Governance improvement initiatives can lead to enhanced corporate resilience and reduced risk, but these benefits are often realised in the long term, and often incrementally.
* Intangible benefits and risks – ESG initiatives often generate intangible benefits and mitigate risks that are not easily captured within a traditional financial purview, such as reputational enhancement. Companies with strong ESG practices can build a positive reputation, attracting customers, investors, and talent. This reputational capital is invaluable, but not directly measurable through conventional financial metrics.
Furthermore, business strategies which effectively integrate ESG initiatives can reduce operational and regulatory risks, such as avoiding environmental fines or penalties, or labour disputes. These risk mitigations contribute to long-term stability but may not be reflected in financial performance indicators.
Complex interdependencies
ESG factors are often interdependent and interconnected, creating complex relationships that traditional financial metrics are not designed to capture. For example, a company’s environmental practices can have significant social implications, such as the impact of pollution on local communities.
These interactions and their impact require holistic analysis beyond financial metrics. Strong governance can enhance overall ESG performance, but this relationship involves multiple variables and feedback loops that are not easily distilled into integrated reports.
While ROI and financial sustainability of the business are rightfully important considerations for every finance and accounting professional, understanding the interplay between ESG performance and ESG impact is key. ESG Performance is easily measured and quantified – for example investing R1-million in crime prevention measures in a local community.
However, measuring the ESG impact of the R1-million investment (performance) is challenging as outcomes and impacts are not the same. Outcomes are the intended and unintended results and consequences of your activities, and are categorised into short-, medium- and longer-term results. Impacts are long-term outcomes with a wider impact on the community or environment.
In this example, the short-term outcome might be reduced crime rates in the local community; while the longer-term impact may be a stronger sense of community, a deeper perception of personal safety and an increase in families participating in social activities in the evening.
Furthermore, interdependent factors also add to the complexity. For example, there may be a reduction in crime statistics in the community, but can this be solely attributed to the R1-million investment, when there are many parties working towards the same goal such as local churches, community policing forums, security providers and the like? Finance and accounting professionals need to be aware of the attribution risks around their performance, especially for listed companies where there is potential for impact on share price and reputation.
Charting the way forward
AICPA & CIMA’s latest whitepaper ‘Future of Finance 2.0: Re-defining finance for a sustainable world’ highlights that organisational performance is no longer being judged purely on short-term financial returns to shareholders. Now, an organisation’s customers, workforce, and investors — as well as governments and society at large — all demand greater transparency beyond the traditional financial metrics.
Finance functions are stepping up to meet the challenges that having a greater corporate sustainability focus presents, acknowledging that it is the lifeblood of resilient organisations. This adoption requires finance teams to fully embrace their stewardship role.
Finance and accounting professionals must be able to participate not just in reporting how the organisation has created value, but also in the co-creation of long-term value. An important aspect of this will be how an organisation measures and manages its intangible ESG value that ultimately drives long-term success and profitability.
ESG initiatives and corporate sustainability have a significant strategic impact on the office of the CFO and the finance function. It demands that finance leaders shift from a cost and compliance focus to a resilience and systemic risks focus, from siloed thinking to systems thinking, and from assessing financial performance to assessing performance in the wider economy and society, while understanding their organisation’s impacts on environment and community.
To successfully make this shift, organisations require finance and accounting professionals with the appropriate skills and knowledge to embed best practices within their operating models and build trust with all stakeholders. To this end AICPA & CIMA are working to provide educational resources to upskill the profession and support its work in helping organisations and economies grow sustainably. Because ultimately, how an organisation manages corporate sustainability and its ESG pillars has a direct impact on the value it creates – or erodes.
* Andrew Harding, FCMA, CGMA is the chief executive: management accounting at AICPA & CIMA, together as the Association of International Certified Professional Accountants