In a conversation moderated by Elias Papaioannou,co-Academic Director of the Wheeler Institute, Mark Carney – UK Prime Minister’s Finance Adviser for COP26 and UN Special Envoy for Climate Action and Finance and former Governor of the Bank of England – and Lucrezia Reichlin – Professor of Economics at the London Business School and Chair of the European Corporate Governance Institute – discuss the guiding principles of international sustainability standards based on enterprise value.
The financial community has a crucial role to play the climate crisis and will be highlighted in COP26
COP26, scheduled for 1-2 November 2021 in Glasgow, is the annual conference of the decision-making body of the UN’s Convention on Climate Change. Glasgow COP is intended to be a high ambition – at the core is mitigation, anchored around country policies to support substantially increased NDC targets. Carney states that as the physical impacts of climate change continue to mount, amending capital commitments and policies will become ever more important, as will emphasising government and indigenous collaboration under Article 6 of the Paris Accord. Finance will be a core pillar of the conference; first, completing the $100B annual Government to Government transfers as agreed in Paris, and second, aligning the private financial system with the intention of achieving net zero emissions. In order to achieve climate targets, we need to equip the private system with the information, tools and markets – such as voluntary carbon markets – so that each decision can take the climate crisis into account. There is growing momentum within the private system to support the transition and mitigate potential risks to achieving net zero, which requires proper climate disclosure.
Involving the private sector in addressing climate-related risk is essential for the continuity of capital markets
Until this point, accounting standards have understood climate as an externality, with taxes used as the main financial instrument employed to address the crisis. However, climate implies risk, and a large portion of infrastructure assets are likely to become stranded as the crisis worsens. We need multiple avenues to involve the private sector in mitigation strategies, all of which must be based on up-to-date information. This is essential for ongoing capital allocation and participation in capital markets. Building a sustainable financial centre is a core component of addressing the uncertainty of how climate risks will play out. The work that Reichlin, on behalf of the IFRS, is undertaking on sustainability reporting builds on the earlier recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) around voluntary consistent and compatible disclosure on climate-related risk. The TCFD recommendations generated significant success in terms of the number of companies who chose to adopt them, and for the creative methodologies designed to address the uncertainty around climate risk.
However, the landscape remains undefined and chaotic, with different standards, authorities and regulations involved – which can leave the door open for greenwashing. By designing global, mandatory standards as part of a sustainable financial system, audit and measurement process can be more effectively implemented. Responses to public consultation by the IFRS were overwhelmingly in support of them taking a leadership role in expanding the scope of sustainability reporting for three main reasons: 1) Governance – the IFRS is uniquely positioned to incorporate the input of regulators and the private sector; 2) Reputation – the IFRS operates due process and standard setting globally; and 3) Integration – sustainable standards will need to interrelate with current financial standards, which the IFRS already oversees.
International implementation remains a complex challenge, and will build on the adoption of a commonly agreed core
Progress to date has been made around the basics – metrics, GHG accounting and governance. However, progress remains to be seen in the area of forward looking strategy or strategic resilience – which goes to the heart of what is different about climate-related risk. Carney discussed how the challenge to companies is not only the physical risk arising from climate, but also their exposure to transition risk as governments mobilise to implement policy. These changes – including the EU moratorium on new combustion vehicles post 2030 – materially impact the economic activities of companies in this space, and regulations would require disclosure of how resilient companies are to changing scenarios. Despite a growing appetite, particularly by the providers of capital for more consistent discourse, implementation remains purely voluntary and is therefore limited in scope. Comprehensive coverage is required across geographies and forms of disclosure provided, particularly on forward looking components.
In order to satiate the need for consistency, the IFRS is developing a ‘building-block’ framework in which a set of standards would be applied globally, with more ambitious jurisdictions retaining the option to adopt additional regulations. The core set of standards would centre on global capital markets, while the additions could address divergent more localised legal and political agendas. In establishing this, the IFRS has structured their engagement within jurisdictions and organisations to ensure broad consensus and support, while building reliance in their governance process. Although this framework will initially centre on climate as a matter of urgency, Reichlin envisions that this will one day cover all aspects of sustainability, such as social and diversity issues. The responses to the IFRS consultation advocated for this more holistic approach, but recognised the complexity in enforcing these. While the IFRS has deep experience in enforcing financial aspects, through auditing and assurance, there will be a growing role for their security regulators to play here. The Sustainability Standards Board is on the path to implementing disclosure in the ~140 countries where the IFRS standards are applied, but rely on authorities like The International Organization of Securities Commissions (IOSCO) for support and enforceability.
The definition of value creation is expanding to include social and ethical considerations, influencing the push for sustainability standards
Papaioannou asked how we might be able to blend climate risks with traditional accounting practices. Carney spoke of the tension today between those elements that can affect enterprise value of a company, and those that may affect social and environmental outcomes without necessarily affecting EV. Traditional financial reporting is backward looking in assessing results, disclosing impairment to date on existing assets. Until now, it has not given consideration to the material economic shifts expected as a result of changing climate legislation. The factors that may not affect EV today will become incredibly material in the future, so the question becomes how to best empower stakeholders, management and capital providers on these issues to understand when and how materiality arises.
This relies more on supervision than regulation, although some countries – China is one example – have raised the possibility of capital regulation changes in this space. By placing more emphasis on proper climate-related financial disclosure, risk management and supervision, providers of capital can strengthen their commitments to net zero investments.
This is but one signal of how the definition of capitalism in the neo-classical sense is dynamically shifting. Shareholder primacy is the core tenet of this definition – but is now too limited to give us a basis for policy in a solely financial sense, according to Reichlin. The idea of corporate purpose and responsibility has emerged as another lever of value creation, which has far-reaching legal, managerial and economic implications. New accounting standards for climate-related disclosure must also relate to this broader definition of value creation and consider longer-term effects. Investors are increasingly looking to purpose, expanding the previously narrow definition of shareholder primacy.
Carney also raised Friedman’s caveat on the statement that the business of companies is purely profit – which is that this assumes prevailing social norms persist. An exclusive focus on short term returns can act to undercut social prosperity and the functioning of the market in instances where short and long term goals are not aligned. Where society places emphasis on an issue, as it is now with climate, the market can play a significant role in achieving the solution to that issue with adequate information. There is also increasing evidence that companies with a specified purpose drive greater alignment across their suppliers, employees, communities and even customers in achieving this purpose. This can increase efficiencies, productivity and prosperity, leading to financial and social value creation. Although these measures of purpose or social responsibility cannot always be pulled into the price or EV of a company, these carry weight when we consider sustainable value and different individuals, societies and stakeholders will value these aspects differently – again supporting the building block approach of the IFRS to allow for jurisdictional ‘add-ons’. This highlights the limitations of the assumption that price is equal to value, as price does not reflect subjective value. If we can break this core assumption, we can engage in a richer, more productive way of assessing prosperity.
Sustainability standards will benefit both advanced and developing economies by driving investment across a company’s supply chain
In designing sustainability standards, the IFRS has created an advisory group to represent the concerns of emerging markets and other constituencies harder hit by additional disclosure requirements. To this point, involvement of emerging markets has been driven by the World Bank, so implementing a permanent structure in governance to voice their perspective is integral to establishing mandatory standards applicable to all. Although some tailoring is almost always required in implementing international standards across jurisdictions, the proposed building block approach would ensure that the core is nested in all countries and remains as consistent as possible. Any difference would then be additive, not detractive. Moreover, the financial architecture being created intends to maximise capital flows across economies in addressing climate mitigation through increasing transparency on climate effects up and down the supply chain. For a company operating in an advanced economy, this may mean having greater insight on Scope 3 emissions, as well supply chain activities in developing economies, creating incentive to reduce emissions across all parts of the business. Establishing this connectivity and co-investment across the supply chain also reinforces the use case for voluntary carbon offset markets. Although not in place currently, these have the potential to be a €50-100B market annually, of which 75-90% of offsets supply will come from the developing world, and ~90% of demand will come from companies in advanced economies. This again opens up the potential for large capital flows – but without well-defined, supervised disclosure standards in place, these markets will not see growth to the scale required to achieve carbon targets.
The “past is not prologue” when it comes to climate-related risks, and the international financial community is mobilising rapidly around these risks
In summary, both Carney and Reichlin emphasised the enormity of the change taking place and urged listeners to do their homework on the scale of the shift that is underway. By fundamentally amending financial reporting standards through the implementation of new disclosure standards for sustainability, regulators and investors alike recognise the insurmountable impact that climate will have on the ways we assign value. Climate mitigation has become a driving force for large-scale systems shift in even the most traditional of institutions – finance – and will continue to be in the growing push to achieve future carbon targets.
Climate standards and enterprise value was co-hosted by the Wheeler Institute for Business and Development at the London Business School and the European Corporate Governance Institute.
Victoria Henderson (MBA 2021) has three years’ experience in management consulting at Bain & Company, and a background in Law and Politics. She is an intern for the Wheeler Institute, contributing to the creation of content that amplifies the role of business in improving lives.