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How to use financial channels to embed sustainability into core company operations

Natalie Runyon  Director / ESG content & Advisory Services / Thomson Reuters Institute

· 6 minute read

Natalie Runyon  Director / ESG content & Advisory Services / Thomson Reuters Institute

· 6 minute read

Using financial, capital project and enterprise risk management workflows can cut through internal operational silos that reduce the effectiveness of corporate sustainability strategies

Organizations are currently allocating 43% more funds towards sustainability reporting than they are investing in actual sustainability innovations, according to a recent corporate report.

This indicates that numerous organizations are treating sustainability primarily as a matter of compliance and disclosure, rather than as an opportunity for fundamental change. However, companies that integrate sustainability into their entire operations tend to experience more favorable outcomes, both in terms of sustainability and financial performance.

Indeed, companies that do so have a 52% greater likelihood of surpassing their competitors in terms of profitability and exhibit a 16% higher rate of revenue growth, according to the report. Moreover, 53% of businesses that incorporate sustainability practices acknowledge that the tangible business benefits are a crucial factor in justifying their investments in sustainability. To achieve this, companies need to start with their financial and risk workflows throughout their enterprise.

Some of the ways in which they can do this include:

Insert sustainability into capital project (capex) requests — Typical capex forms include cost-benefit information and a return-on-investment financial analysis — which often includes the payback period, internal rate of return, and net-present value of future cash flows associated with the project. To make sustainability part of the company’s DNA, options to amend the form should include adding an explanation of how the project helps to fulfill the company’s purpose, vision, and values. This can also describe how the project aligns with the company’s long-term strategic focus and improves environmental and social impacts while listing how risks can be avoided by undertaking the project, according to the CFO Leadership Network’s CAPEX Essential Guide.

Identify the financial channels of product inputs with sustainability attributes — The new European Union’s Corporate Sustainability Reporting Directive (CSRD) requires companies submit information for material impacts, risks, and opportunities. To ultimately understand how to integrate sustainability into the DNA of companies, understanding how sustainability can drive performance and enterprise value is essential. Otherwise, executives will continue to perceive that environmental, social & governance (ESG) and sustainability initiatives actually slow company growth, erodes hard-earned profits, and diminishes shareholder returns — when much of the research suggests the opposite is true.

Leveraging financial channels to show value

Traditional financial channels — such as revenue, expenses, assets, liabilities, and cost of capital — help to determine the value of a company. And sustainability issues can impact all of these.
For example, automobile manufacturers use rare earth elements and other critical materials as value-creating inputs to produce their vehicles. As the demand for smart electric and hybrid passenger automobiles increases, so does that of the electronic components that power the smart parts of vehicles.

Rare earth elements that are used in smart vehicles products include cobalt, lithium, and copper, with the first two used in the electric vehicle batteries, and copper used in the wiring. The largest source of cobalt is in the Democratic Republic of the Congo (DRC) with numerous reports of child labor and dangerous working conditions in the country’s cobalt mines. In addition, DRC is also one of the top five sources of copper mining. Lithium mining and copper mining also produce environmental and social concerns, including environmental health hazards, child and forced labor, fair wages, workplace safety, and community displacement are among the top concerns.

Forward-thinking companies are just now incorporating decision-making processes on an enterprise level into their enterprise risk management governance and processes.

— Bruno Sarda, Partner at EY

It’s important to note that the reliance on rare earth elements for smart cars and other technologies has raised concerns about the environmental impact of mining and processing these minerals, as well as the supply chain risks, since a large proportion of the world’s rare earth production is concentrated in a few countries. Efforts are ongoing to find alternatives to rare earth materials and to develop recycling methods to recover these elements from end-of-life products.

In this example, we can see that those financial channels impacted across the value chain for smart vehicle manufacturing include:

      • The revenue line item in the income statement will be impacted by the sales of electric and hybrid vehicles.
      • The expense line item within income statements will be impacted by the cost of goods sold. Manufacturers source their raw and processed production inputs, including rare earth elements, from all over the world, and these aforementioned environmental and social issues occur in the value chain. Risky operations can cause supply disruptions and price volatility that can negatively impact a company’s expenses.
      • Salaries and benefits of employees dedicated to supply chain management and compliance will hit the employee-related line item in the income statement.
      • Research and development costs may show up in the income statement as the company looks for innovative ways to reduce its dependence on rare earth minerals. Likewise, any innovation breakthroughs or new intellectual property will show up as intangible assets on the balance sheet.
      • Companies with inadequate risk management practices with exposure to supply chain interruptions and unpredictable price fluctuations, tend to see an effect on their risk profile, which in turn influences their cost of capital. As illustrated in the example, such impacts on the cost of capital are typically shown through adjustments to the discount rate. Due to sustainability-related risks like these, investors or lenders will demand a higher return on their capital investments if the company fails to adequately manage these risks.

Although not directly a financial channel, companies are finding that integrating ESG considerations into their enterprise risk management workflows is another way to weave those specific principles into the very fabric of an organization’s culture and operations. In fact, forward-thinking companies are just now incorporating decision-making processes on an enterprise level into their enterprise risk management governance and processes, according to Bruno Sarda, Partner in Climate Change & Sustainability Services at EY. This process involves carrying out assessments to determine the significance of ESG issues and examining the major risk trends affecting the broader world. Considering that organizations have limited resources to manage every risk they face, it is critical to rank these risks by importance and assess their potential impact to ensure effective prioritization.

Today, many companies are operating as if sustainability is just a compliance and reporting issue, rather than an avenue for substantial transformation. Indeed, organizations that embed sustainability across their business operations are more likely to outperform their peers in profitability and revenue growth. Thus, for businesses to truly capitalize on these opportunities, its own financial and risk workflows are critical places to begin.

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