The ESG Advocate 015 - Should CFOs care about ESG?
In case you didn't know, I graduated with an English degree. The closest I got to Finance was Accounting 101. Still, over my 20+ year career working in technology and IT, I had to go up to the CFO, hat in hand, for many a budget request.
CEOs are saying things that Wall Street and stakeholders want to hear. Those efforts quickly fizzle without strong board sponsorship, prioritizing, incentives, and proper funding.
As a result, CFOs are the gatekeepers and custodians of a company's financial operations, but should they be the champions of ESG?
Let's get to it!
CFOs strike back!
There's been no shortage of the ESG backlash as of late, but largely it's been centered in two camps:
Conservative states and their pension funds misaligning ESG with values
Sustainability advocates who believe ESG is a distraction to change
There is a difference between managing risk (ESG) and saving the world (sustainability), but these things are conflated from all sides.
But this week, CNBC brought in a new contender to the fight. CFOs! 🔔🔨
There's an ESG backlash inside the executive ranks at top corporations — www.cnbc.com
A CNBC survey of chief financial officers finds low support for an SEC climate rule, while many CFOs approve pushback against ESG in states like Florida and Texas.
First off, your initial reaction might be 👀, but please note this information about the survey. It covered:
21 chief financial officers at major organizations between September 12-27. Council membership includes 44% of CFOs from Fortune 500 firms, and of that cohort, half from Fortune 100 firms.
21 people are driving this conversation. Still, there is much content to unpack in the read.
Regulation: It's the worst, or is it?
Point 1: "CFOs are always worried about over-regulation."
Yes, this is very much the case. Regulation of any kind is costly, yet it can reduce risk. Remember when I covered Enron's CSR report a few weeks ago? With better governance and oversight, Enron might still be around. But okay, let's put aside accounting scandals (note: sits with CFOs) and SOX audits.
Recently, the SEC put out its draft proposal for climate risk reporting for US companies. Of course, the EU also has its Corporate Sustainability Reporting Directive (CSRD), which Fortune 500 companies in the US also likely need to adhere to. These disclosures are meant to give investors better access to decision-useful information consistently.
Despite the sensational headlines, including the WSJ's "Companies Skewer SEC’s Climate-Disclosures Plan in Comment Letters," respondents were largely in favor (listen to PwC's podcast here or read KPMG's report here). There were broad acknowledgments that, like SOX, adhering to this regulation would not be easy and that maybe Scope 3 and undefined materiality requirements were a little unreasonable in the near term.
The attestation requirements are interesting and may be behind a CFO's fear. Multiple standards are at play, and companies use a mix of actual and estimated activity data to calculate emissions. On the surface, this means ESG and sustainability metrics appear not as firm as financials.
Still, financial restatements happen regularly with 'little r' restatements. This is when "the error is not material to previously-issued financial statements." Per SEC Acting Chief Accountant Paul Munter:
“little r” restatements as a percentage of total restatements rose to nearly 76% in 2020, up from approximately 35% in 2005.
It's doubtful that investors would accept numbers without some kind of attestation or audit. After all, financial statements are audited (and, as pointed out here, restated). Stakeholders do understand the complexity, and I believe they are willing to accept reasonable assurance on these numbers. It isn't an excuse for inaction, but we'll have to wait and see if the SEC will be as forgiving.
Sustainability vs. ESG
Point 2: "A critical issue for CFOs with the new SEC climate disclosure is the lack of a clear correlation between the climate data and financial statements."
This is the crux of the anti-ESG movement and climate activists' complaints. Carbon reporting, especially critical for addressing climate change, isn't necessarily as material a risk as the impacts of climate change on a company. It's quite the chicken and egg. Put another way:
...the issue is that the disclosure may not be the most useful data to provide to investors on climate risk.
This statement is 100% correct. A company's carbon emissions might be decision-useful for an impact investor, but it is not as useful (read 'material' here) for an investor looking at risk.
This is what, bafflingly, The Economist continues to get wrong about ESG, but I can see why. Even the climate draft proposals conflate it. The SEC has another draft proposal out there for fund managers regarding labeling. Even this proposal conflates it with something called "ESG Impact," which I hope they change. Here's how the draft proposal describes it.
Finally, “ESG Impact” strategies have a stated goal that seeks to achieve a specific ESG impact or impacts that generate specific ESG-related benefits. Impact strategies generally seek to target portfolio investments that drive specific and measurable environmental, social, or governance outcomes.
Drop the "ESG" here, and you might eliminate a lot of confusion.
If you are a CFO, here's what you need to understand:
Some investors will want assurance that you are dealing with your most material E, S, and G issues. If you can prove that with storytelling and data, congrats! You should be considered low-risk and probably find your company in an ESG fund because you have proved you know how to run your company. Advance to Go (Collect $200).
Other investors will want you to save the world. Those thematic investors have always been there but are gaining momentum because (checks notes) climate change is undeniable, and 1-in-1000-year weather events happen weekly. Advance to Boardwalk, but watch for flooding.
Both are valid investment strategies. Yet, there's still something to consider. Even if carbon reductions, which get all the attention, aren't material, climate change almost certainly is. Best to start on those operational reductions today before we're all in trouble!
Politics! (I'm not doing this again), but...
I've covered this in the newsletter across several issues, so I'm not diving into the politics again here. Spoiler: It boils down to the misunderstanding in the previous section.
Instead, let's kick off with this interesting quote from Lauren Taylor Wolfe, Impactive Capital co-founder and managing partner.
We believe that ESG without returns is simply not sustainable. We are exclusively focused on risk-adjusted returns.
I half agree with this, but there's a small caveat. The point of ESG is to reduce risk and create new opportunities. Logically, that would mean more sustainable returns, but perhaps not explosive growth.
If you are a CFO reading this, there is a LOT of conflicting data. In an ideal world, managing ESG risks (putting ESG scores aside) would translate to growth. I'm wary of this win-win situation because this is the trap that pro-ESG pundits sometimes use to drive attention to corporate sustainability issues, but there is growing evidence it is true.
ESG's misunderstood ties to growth lie in this statement buried in the UN Global Compact's 2004 report Who Cares Wins.
We recognise that a series of barriers have in the past hindered a better integration of ESG factors. CEOs and CFOs recently interviewed by the World Economic Forum, for example, stressed that intangible aspects related to ESG issues play an increasingly important role in value creation but that analysts’ short-term focus hinders them in recognising this trend.
In other words, our short-term, quarterly reporting structure goes against long-term planning horizons. This also is likely playing on CFOs' minds.
It has been almost 20 years since that report, yet the same issues called out immediately after this statement are the ones that still exist:
Problems of definition of ESG issues
Problems of making and measuring the business case
Problems with quality and quantity of information
Problems of skills and competence
Problems of differing time horizons
Will it be another 20 years before we figure this out?
Enough fighting. Let's do something!
Point 3: “Really smart people are spending time on how to polarize it. Let’s spend time on solutions,” per Eileen Murray, former co-CEO of Bridgewater Associates.
💯
Do the work, whether it is an ESG risk or operational environmental reduction. Someone will care.
A quick opposing CFO view
Earlier, I noted constructive criticism but broad support for the SEC's draft proposal. There is more evidence out there that CFOs are paying attention to ESG. Grant Thorton conducted a CFO survey in Q3 2021 called CFOs spotlight ESG as a growing concern. While that title could be translated as pro- or anti-ESG, lucky for me, it highlights a positive CFO focus.
57% of CFOs have made it a priority to invest in environmental, social and governance (ESG) efforts since the start of 2020, with 23% saying that ESG investments are much more important for their organizations than they were prior to 2020.
Here are the issues that Grant Thorton includes in ESG:
Employee retention and development
Diversity, equity, and inclusion
Employee health and safety
Those are certainly all worthy ESG issues. I'd hope for a little more focus on climate risk, but in my experience, not many companies are focusing on that.
And here's what other concerns CFOs had:
Talent shortages
Overall employee benefits costs
Plans to return to a full-time and/or hybrid employment model
The continuing pandemic
Workforce shortages
Supply chain disruptions
Infrastructure legislation
Here's where it gets interesting. Every single one of those issues is an ESG issue! Many focus on one of the most critical stakeholders for a business, its employees.
If you are a CFO focused on any of the issues above but don't think you are considering ESG, you are! It takes only a slight pivot to drive meaningful change from this starting point.
Tweet of the Week
Imagine a future state where a CFO has presented ESG on their quarterly call:
LinkedIn Post of the Week
Lotti Hawkins on LinkedIn: #MentalHealth #ESG #ESGinvesting — www.linkedin.com
World Mental Health Day is coming up (10th Oct), this year's theme is to 'Make mental health and wellbeing for all a global priority'.
As CFOs and others struggle with ESG but require innovation with high expectations, ESG professionals find themselves in the middle of a lot of pressure.
Check out this thoughtful post on self-care from Lotti Hawkins!