It is essential that businesses understand how sustainability will impact their future financial position, as reflected in their income statement, cashflow statement and balance sheet. The financial impact is driven by the risks and opportunities to which a business is exposed and the decisions it makes to manage those risks and opportunities.
Four major categories are identified by the TCFD (Task Force on Climate-Related Financial Disclosures) – revenues, expenditures, assets and liabilities, and capital and financing – through which climate-related risks and opportunities may affect a business’s financial position.
Sustainability not only generates risks, it also creates opportunities
Two types of risk
Sustainability-related risks fall into two categories: transition risks and physical risks.
Transition risks arise as a result of a shift to a low-carbon economy, and are grouped into four categories: policy and legal, technology, market, and reputational.
The first, policy and legal, includes increased requirements for emissions reporting and higher compliance costs. Technology includes the cost to transition to lower-emission technologies, the capital expenditure required for technology development, and revenues lost because of a reduction in demand for certain products. Market risks include those that stem from changing consumer behaviour – reduced demand for certain goods and services, or an increase in the cost of goods and services. And finally, reputational risk includes the stigma attached to certain high-carbon sectors or businesses that are perceived to detract from the transition to a more sustainable economy.
Physical risks are incurred as a result of the increased frequency and severity of climate-related weather events. Examples include flooding and storms that lead to disruption of business production, transport issues, supply change stoppages or greater capital costs incurred by repairing or replacing damaged plant, property or equipment.
It is important that businesses are aware that sustainability not only generates risks but also creates opportunities. Potential efficiencies can be gained in energy, water and waste management, which reduce operational costs. Annual savings are made when businesses shift their energy consumption towards low-emission sources.
The move to a more sustainable economy will reveal benefits and opportunities generated by creating new and innovative green products. This will offer opportunities for businesses to attract new customers while retaining existing ones. Development of new products may permit entry into new markets – an opportunity for a business to diversify its activities.
These risks and opportunities have an effect on the financial statements of a business.
Both transitional and physical risk could impact the demand for a business’s products. Businesses should consider this impact on their current products and identify any opportunities for creating new and innovative green products. The banking sector, for example, has seen a huge demand for products such as green bonds and sustainable linked loans.
Expenditure required to transition to a more sustainable business needs to be considered. Businesses may alter the design of a product to make it more energy-efficient, potentially resulting in an increase in raw material costs, say, or higher water charges for a business that is heavily reliant on water in its production process.
When pricing policies, insurers will need to consider the likelihood of acute and more frequent climate-related events such as storms, fires and floods, which could result in higher premium costs for businesses. There is, however, potential for resource and distribution process efficiencies, thereby reducing operating costs.
Capital and financing
Sustainability risks and opportunities can alter the debt and equity structure of a business by raising debt levels to compensate for lower operating cashflows or to fund new capital expenditure or research and development. A business may require capital investment to shift to using green energy such as solar power or wind power. The startup costs for such initiatives can require substantial capital investment upfront. Capital markets are now steering their capital into green investments and avoiding certain carbon-heavy sectors.
Assets and liabilities
Assets measured at fair value could be severely impacted – for example, physical climate events such as floods and storms could affect the value of biological assets such as agricultural products. Given the climate-related risk uncertainties, these factors are likely to affect the market price.
The risk of inventory obsolescence is also higher as a result of changes in selling prices due to a shift in demand towards greener products. Businesses must also determine whether provisions for fines/penalties resulting from climate-related issues should be recognised.
Once businesses have identified the potential risks, they should consider how material these risks are to their financial statements. Likewise, they need to understand the impact of sustainability in order to seize opportunities that may be open to them.
Visit ACCA’s ‘Rethinking sustainable business’ hub to find out more about the issues relating to sustainability, the impact on organisations and the part you can play.