More businesses are revising their business models, reorganizing their internal corporate structures and investing significant time and resources into sustainability and environmental practices — from offsetting carbon emissions to implementing water-saving initiatives. As businesses establish environmental, social and governance (ESG) metrics, the finance and valuation function has a profound role to play.
This shift to ESG reporting is driven by stakeholder groups — community members, customers, suppliers, employees and others — who hold businesses accountable for their environmental and social impact. The collection of and reporting on ESG data should therefore allow a company to track trends and communicate its ESG activities to the public and investors and thereby increase transparency.
Before reporting can even begin, ESG implementation strategies need to be quantified and translated into value that is measurable in financial terms — and there’s “a gap between ESG ideas and the actual quantifiable impacts on value,” said Howard Mah-Lee, ABV, CFA, CAIA, Senior Manager — Fair Value Measurements at the Association of International Certified Professional Accountants®, representing AICPA® & CIMA®.
That gap becomes a chasm and valuation becomes trickier without globally recognized standards and a long-standing business mindset where businesses focus on issues pertinent to their immediate stakeholder groups, rather than the broader ESG picture — that is, if they’re looking at the ESG picture at all.
“That’s the issue that the valuation industry is facing right now,” said Mah-Lee. “How can we translate the measurement aspects of ESG into quantifiable, monetary terms?”
Transition from micro to macro
ESG is nothing new. For decades, governments have enacted many laws and regulations regarding pollution, worker safety and protections, wages and more. If for instance a factory faced a lawsuit for polluting a lake, said Mah-Lee, accounting and finance experts, along with legal and valuation specialists, could work out some monetary form of damages — how much the residents by the lake would be owed.
The current ESG movement is no longer about the effect one business has on the resources within its community or its immediate stakeholders, but instead takes a broader, more future-forward approach. “Now the question is, how do we take the models we’ve been using up to this point and magnify these analytical frameworks beyond a single factory, to now include what hall factories are doing?” Mah-Lee questioned.
And this is the hurdle of valuation practitioners, according to Mah-Lee: How can we apply existing financial measurement and valuation models using a global approach to ESG?
Some publications address how to measure ESG metrics on a global scale, such as the two-degree warming of the planet; however, Mah-Lee said, these make it harder to identify the impact of a single company. “If there are a million companies and a million factories in the world that contributed to the warming of the planet, how do you confirm, codify and divide that up between all contributors when assessing the value of one?”
The next necessary phase is to get all companies onto one globally recognized reporting standard, “even if it’s not in numbers,” said Mah-Lee.
ESG in practice
The development and adoption of a recognized standard will take time, but action within the finance and reporting function needs to start now.
The U.S. Securities and Exchange Commission (SEC) put out a call to action in May 2022 to encourage more companies to improve their ESG financial disclosures. The intent was to drive transparency with investors and increase the release of consistent and comparable reports.
However, the SEC has not yet provided specific details or concrete guidance on the steps that should be taken to accomplish this. “There are growing calls for increased disclosure,” Mah-Lee said, “but we also need overarching standards in this area to minimize ambiguity about how we all get there.”
In the meantime, Mah-Lee said that companies can and should still attempt ESG reporting the best they can — tracking their overall carbon emissions, detailing the diversity of candidates in hiring initiatives and whatever additional metrics and performance indicators they can pinpoint. These are all things companies can track without specifics from the SEC, said Mah-Lee.
Some companies are going beyond ESG reporting and shifting toward “‛ESG in practice’ and how it actually affects the bottom line of companies,” added Mah-Lee.
McDonald’s offers its employees tuition assistance, and theme park Dollywood partnered with select universities to offer staff free college. Starbucks supports its global network of coffee farmers and offers training programs on sustainable farming. ESG could also include having a remote workforce and scaling down office space.
“All of these types of efforts are ESG in practice, and how they are then measurable by improved productivity, decreased attrition, etc. These are initiatives which can be quantified, and thus serve as inputs in valuation models,” Mah-Lee said.
However, which ESG measures a company chooses to implement will be unique to them — it’s not a one-size-fits-all approach — and measures can converge over time into industry best practices.
ESG’s uneven playing field
ESG is a long game, and Mah-Lee compares it similarly to advertising: “How do you put out an ad today, and how do you measure the impact of more sales? And can you attribute the sales directly back to the ads put out, or was it something else? And when does this happen, two days later or two weeks later? And do people still have mental retention of the ad two years later? When exactly do all the good things accruing from ESG fully manifest into a measurable, positive change in economic value?”
The creation of reporting and financial standards will attempt to level the ESG playing field and hopefully provide the guidance that valuation practitioners need to remove the ambiguity surrounding quantifying ESG initiatives. “Even within a firm, from client engagement A to client engagement B, there is no standard on how to approach ESG,” Mah-Lee said.
He added that there appears to be anecdotal evidence to suggest that valuation provider firms are still addressing this area only if a client is interested in, and requests to see how ESG shows up in their valuation. The practitioners then provide high-level analysis in lose, long-game terms, or apply company-specific adjustments to cashflows or discount rates based on professional judgement.
Many companies, according to Mah-Lee, are also looking at ESG on a micro-scale — turning off the lights to save energy or hiring more diverse candidates — and not on the bigger picture of ESG in practice. And added Mah-Lee, companies can still make a good return when they adopt a complete ESG mindset.
And that’s why valuation experts are so important: They can help companies connect dots from aspiration to implementation and learn the financial incentives behind ESG.
To learn more about the various approaches within the industry, join us at the AICPA & CIMA Forensic & Valuation Services Conference (Nov. 14–16). This hybrid conference, hosted at The Wynn in Las Vegas, will be led by expert speakers who will go in depth on the expanding role of the accounting and finance profession and how ESG data can be reflected in business valuations and financial reporting.
Conference attendees will also gain insights on other topics, including how to conduct large-scale investigations during a pandemic, stop fraud with the restructuring of internal controls and learn more about financial disputes involving bankruptcy. The three-day conference kicks off on Nov. 14. Join us in Las Vegas or online. Register by Sept. 30 to catch early bird savings.