It is time for ESG Financials

Reading the FT this morning, I saw the article "Wall Street is letting Orwellian doublethink kill climate action." It was about the growing number of financial giants pulling back from climate action in the face of specious campaigns against so-called "woke capitalism." It seems that the move to a "triple bottom" line of people, profit, planet is even further away. There is nothing woke about a world warming faster than scientists expected.

Yes, investing is, and must be, about delivering financial returns. This will not change. Business health is expressed in financial results, and more is better. The question is how we measure the financial results and whether to include ESG consequences in measuring profitability. What gets measured gets managed.

Today, financial results do not include the true cost for "using the earth" and other ESG consequences. Like running a taxi company where you price for a trip including the cost of the driver and petrol yet forget about future maintenance and depreciation. With this approach, you make money today. When the cars need to be replaced in the future, your company is gone as there is no money for new taxis. Yes, the same will be true for all companies if we don’t account for the cost of ESG maintenance and depreciating the earth. So, like the taxi company, we will not be able to use what is no longer there as we did not account for such future ESG cost. It is just over a longer period. Investors expect us to account for depreciation and accrue for maintenance when we report financial results. So, they are reassured we maintain our company assets to create future results (and can buy new taxis). However, we do not account for the cost of the ESG externalities we create (and these will require future investments).

Financial accounting has evolved over time with new standards being developed. It used to be more cash-based and today it includes a more comprehensive economic value approach. For example, stock options were not part of the P/L (you just bought the stock when the option issued) and off-balance leasing arrangements were not included as liabilities in the past. So, accounting changed over time to be more substantive in providing a complete picture of the financial health of a business.

We can do the same for ESG. Include the cost for using and depreciating the earth and price for it. Without the right pricing and cost, behaviors will not change, and actions will not happen. That’s why "all you can eat" restaurants charge for the food you don’t eat. When it comes to ESG, the world feels like an "all you can eat/use" restaurant. For example, pricing the use of CO2, like adding VAT, should be the norm and costing the "use of the earth" needs a new accounting standard. Without it, financial returns will not include the true ESG cost. This will eventually catch up on all investors as it did in the taxi example. There is enough written about how out-of-pocket costing undermines the long-term sustainability of any business. Today, we use an OOP cost approach when it comes to ESG (as we do not take this cost into account).

Measuring the financial results and returns including the ESG costs will not be easy. Neither is stock option accounting or any other new accounting standard. This is where we, as finance professionals, can make a difference and develop the new ESG accounting standard. There are many task forces who can support this effort. The ESG agenda will only change if we change the calculation of profit and financial returns.

The article confirms the urgency of making such change. It simply does not add up for any investor to have outperforming financial returns in a world that moves into an unsustainable direction.

https://on.ft.com/49WpB4E

Hans