The approach taken by the TCFD is emblematic of a shift in how leading investors are thinking about ESG, argues Johnston at EY. Rather than using ESG data as a “risk lens,” which paints an essentially backward-looking picture of performance against ESG key performance indicators (KPIs), investors are instead using it “as a lens to think about value creation … about how it enables an organization to deliver and sustain its business strategy and its value.”
“What we’re seeing is a shift from KPIs that talk about ESG performance – how well a company is doing in reducing its carbon footprint or at managing water scarcity, for example – to those KPIs that enable investors to understand how resilient a business is, or whether it is able to deliver its strategy,” Johnston says.
This means that companies have to take a broader view of KPIs, and look to track and disclose those that link the ESG agenda to the financial performance of the business, he continues. For example, KPIs should aim to demonstrate the value at risk from disruptions to the business from extreme weather or disrupted supply chains or pandemics, and should attempt to quantify the likely changes in demand for products and services as we shift to a more resilient low-carbon economy.
This is a challenging process in two regards, says Johnston. First, companies are “universally” grappling with how to identify the most meaningful scenarios of how ESG issues are likely to shape corporate strategy. These scenarios need to capture future regulation and physical exposures from ESG risks, as well as changes to their markets.
“Organizations need to select these scenarios based on where the risks and issues are within their business,” says Johnston.
Second, it can be challenging to translate non-financial indicators into financial metrics that companies can disclose. For example, a company may need to invest to reduce its carbon emissions to protect its operations against future carbon regulations. Alternatively, it could use that capital investment to improve the profitability of a product. “How do you compare those two capital investments?” Johnston asks. “There are ways to do so, but they require new approaches.”