Like a chemical reaction, the environmental, social and governance (ESG) agenda is creating change as it spreads across the corporate landscape. It’s beginning to inform every aspect of business as organizations re-appraise their purpose and performance in the light of ESG demands. It has become the ‘hot ticket’ for 2022 and must be top of mind for chemical company executives, as for business leaders across sectors and industries.
In the wake of last year’s COP26 climate summit, the ‘E’ of ESG is at the fore. It’s a massive global priority – the future of our planet literally depends on it. The most recent report from the Intergovernmental Panel on Climate Change (IPCC) looking at mitigations to climate change didn’t pull any punches: it’s “now or never” the IPCC warned in terms of action to keep global warming below the critical 1.5 degree Celsius mark this century. To achieve this, carbon emissions must peak before 2025 and then be rapidly reduced (by more than 40 percent) by the end of the decade, before being progressively driven down to reach Net Zero by 2050. Dramatic reductions in methane and other emissions are also needed.
This is a collective challenge that faces everyone – governments, businesses, communities. It also means that scrutiny of industries and individual businesses will rise. The chemicals sector is one of those that is sure to feel increased attention, given the energy intensive nature of the industry.
However, this is not something that chemicals organizations should be over-awed by – in many aspects of ESG there is a strong story to tell. The industry has long adopted leading practices around safety processes and the protection of the environment. It has advanced systems in areas such as the recycling of wastewater. It is increasingly embedding cutting-edge technologies into processes in order to maximize safety and minimize environmental impact.
But like a host of other sectors, there’s no question that taking carbon and other gases like methane out of the footprint at the scale (and speed) needed will present a challenge. It’s one the industry can rise to, but it will be testing, nonetheless.
And of course, it’s by no means only about the E of climate change. The other parts of the ESG equation – diversity, equity & inclusion, social impacts, support for communities, strong governance and ethics, rigorous supply chain management – are key too.
The reporting challenges
There is another challenge that sits alongside all this, however, that simply can’t be ignored: ESG reporting. ‘Doing’ ESG may ultimately be the most important thing, but every business must also be able to report on it with accurate, robust and transparent information. Investors and other stakeholders need and demand it. And regulators are acting at pace to mandate it too.
In fact, arguably there has never been as much activity, at such speed, around corporate reporting requirements as is happening right now in relation to ESG. There are three sets of ESG reporting standards being developed, and they are all moving fast. In the US, the SEC released proposals in March that are out for consultation until late May. Meanwhile, the newly-formed International Sustainability Standards Board (ISSB) – a sister organization to the International Accounting Standards Board (IASB) – has put forward proposals for consultation too. While the European Union has already published a Directive on EU Sustainability Standards that is due to go through political negotiations and voting later this year.
All three sets of standards should be finalized or near-finalized by the end of this year, with effective dates most likely falling in the 2023 – 2025 range. Given the significance and scope of what these standards will be requiring, this is change at lightning speed.
The challenge will be made harder again by the fact that, while the three sets of standards can be expected to have many commonalities, there will also inevitably be some differences. And many organizations will need to report under all three in one form or another if they have an international footprint. With many chemicals businesses being truly multi-national, the sector could really feel the effects of this.
Take for example a US-headquartered chemicals business with a subsidiary in Europe and another one in Australia. The business would need to report on a consolidated basis against the SEC rules, while reporting in line with EU requirements for its European subsidiary, and potentially in accordance with the ISSB standards for its Australian business. The latter would depend on how/whether Australia chose to adopt the ISSB standards, as will be the case in every jurisdiction – adding yet another layer of complexity.
You can quickly see how demanding and time-consuming the task could become. Add to this, that the subsidiary information filed is likely to receive far more attention than is traditionally the case for financial subsidiary filings. Financial filings are largely an administrative exercise for tax/legal purposes. No one pays significant attention to them – it’s the consolidated group accounts that most users pore over. But subsidiary ESG filings could be of huge interest to a wide range of stakeholders – from regulators and investors to activists, NGOs, community groups and the public at large.
A significant workload
While there are differences between the three sets of proposed standards, the guiding principles and end-goals are the same: ESG information and metrics should be gathered, calculated, assured and reported with the same rigor and level of technical detail as financial information is today. Proposed standards are also generally built from or inspired by the framework of the Taskforce on Climate-Related Financial Disclosures (TCFD), which some organizations have already begun to report some information in line with. The four pillars of the TCFD – Governance, Strategy, Risk Management, Metrics and Targets – are the same pillars underpinning the SEC’s proposals.
To meet the requirements, organizations will need to develop new processes, controls and data streams – and ensure that they stand up to the scrutiny of an auditor’s lens in assuring them.
Make no mistake that significant work will be required. A lot of the information and controls that will be needed sit outside the traditional reporting and oversight process – it may not be captured by existing ERP systems for example. Many organizations, understandably enough, are currently relying on manual and/or unstructured sources such as spreadsheets and emails to gather ESG data. But where data is collated in this way, there is a high risk of both error and incompleteness. Better systems and processes will be required. There will also need to be close collaboration between sustainability teams and finance and controller teams to reconcile any tensions between the ambition for reporting and what can actually be reported on.
Resources could become a huge challenge, too. As ESG becomes a reporting matter, it is likely to become the responsibility of the finance and controllership functions, but they are already under significant pressure to manage the existing reporting workload – these new requirements will likely add considerably to the demands and may also require some specialized skillsets. Expect a war for talent as businesses look to recruit the talent needed. Arrangements with some third-party service providers around the provision or analysis of specific data sets and information may also be necessary.
Get started now – and don’t forget assurance
All these factors could lead to a perfect storm: enhanced and complex regulatory requirements, with pressure on resources, and limited time. This just underlines that it’s important to get started on the journey now – not in a year or two years’ time.
Businesses should start mapping out what systems, processes, policies and controls they will need to gather and aggregate the information required. Not forgetting that most of this information will need to be externally assured too. As the assurance requirements grow over time (moving from ‘limited assurance’ in the early stages to more detailed ‘reasonable assurance’), organizations will need to make sure they have sufficiently robust processes and controls to stand up to those independent certification standards.
And it’s not just a case of submitting your data for assurance when you reach the first reporting cycle – that’s too late, and too fraught with risk in the event that the assurer identifies gaps or deficiencies that there is no time to rectify. It will be necessary to make sure your data is ready to be assured first, by going through a precondition assurance exercise.
Under the microscope: SEC proposals
So what kind of information will chemical businesses and others need to report? Taking the SEC proposals as an example, they would require domestic or foreign registrants to include certain climate-related information in registration documentation and periodic reports, including:
- Climate-related risks and their actual or likely material impacts on the business, strategy and outlook
- Governance and risk management processes related to these risks
- Greenhouse gas (GHG) emissions
- Certain climate-related financial statement metrics and related disclosures in a note to the audited financial statements
- Information about climate-related targets and goals
The proposals surprised some observers by the depth of some of their accounting requirements. For example, they would require that some ESG-related information be reported within the financial statements themselves. This is in contrast to the ISSB’s proposed rules that would see ESG disclosures sitting outside the financial statements.
The proposed financial statement disclosures fall into three broad categories: financial impact metrics, expenditure metrics, and financial estimates and assumptions. The aim is to disclose the financial impact of climate-related conditions and events (e.g., severe weather) and transition activities on the consolidated financial statements.
A snapshot of the key requirement is as follows:
Financial statement disclosures would include:
- Financial impact metrics, line item basis
- Expenditure metrics, disaggregated
- Financial estimates and assumptions
- Financial statement audit and audit of internal controls over new information
Other disclosures would include:
- Governance and risk management processes
- Physical and transition risks, actual or likely impacts
- Targets, goals and any transition plan
- Scenario analysis, if used
- Carbon offsets or renewable energy credits (RECs)
- Internal carbon pricing, if established
Greenhouse Gas (GHG) emissions disclosures would include:
- Scopes 1 and 2, with limited assurance for accelerated filers and large accelerated filers, moving to reasonable assurance after two years
- Scope 3, if material or part of goals/targets under a phased transition
- Domestic and foreign filers
- Registration statements
- Periodic reporting
- Scope 3 safe harbor; smaller reporting companies exempt
- Phased transition possibly starting fiscal 2023; limited assurance one year later
All disclosures in the financial statements would be subject to audit and would also be in the scope of the organization’s internal control over financial reporting.
Scoping it out: Scopes 1-3
Another area that has generated widespread discussion and debate is the SEC’s proposals relating to Scope 1, 2 and 3 emissions. To quickly summarize, Scope 1 emissions are direct GHG emissions from an organization’s operations; Scope 2 are indirect emissions from the generation of purchased or acquired electricity, steam, heat or cooling; while Scope 3 emissions are all those that occur in the upstream and downstream activities of an organization’s value chain (essentially, the carbon footprint of a business’ supply chain).
The SEC proposed that Scope 1 and 2 emissions should be separately disclosed, initially subject to limited assurance and then to reasonable assurance by 2026 or 2027 depending on the size of the organization. So far, so uncontentious. The real debating point had been about what the SEC would put forward for Scope 3 – and in our opinion they found a good middle ground. Their proposal is that Scope 3 emissions will need to be disclosed if they are material (which for nearly every organization of any size they will be) but that these disclosures would be subject to ‘safe harbor’ protections and would not need to be externally assured.
Effectively this means that organizations will have a responsibility to make a ‘good faith’ effort to gather and quantify their Scope 3 emissions, but the company and its directors may be protected from certain forms of liability in the event that the information is subsequently found to be wrong. This creates a softer landing and, in our view, strikes a good balance for the early years of reporting at least.
It is not yet clear how the Scope 1-3 rules will turn out in the other two standards. Current indications are that the EU and ISSB rules will both require Scope 3 emissions to be disclosed, and the EU rules may require them to be assured, while the ISSB standards may leave this up to individual jurisdictions to determine. But this is a fast-evolving area. Between the time of writing this and publishing it, things may have moved on!
Climate change and related issues are highly emotive and there are many and varied parties with a stake in the topic who passionately care. This means that defining and agreeing the rules around ESG reporting is quite different from the process for ‘normal’ accounting and reporting standards. It makes the possible outcomes harder to call. In the meantime, corporate find themselves caught in the crosshairs of a massive global issue. Businesses need to focus on the facts, keep track of concrete developments, and start work in earnest to map out the route ahead. One thing is certain – delaying will not help. The sooner you get started, the smoother the ride should be, even if there will inevitably be some hurdles and bumps along the way.
How KPMG can help
The KPMG ESG strategy has become a central focal point for member firms. ESG is the ‘watermark’ that should run through every aspect of our work, whether that’s Audit, Tax or Advisory. To meet the challenge, KPMG firms will spend more than US $1.5 billion over the next three years to address ESG issues and enable us to support our clients in meeting their ESG aspirations.
To deliver on this, KPMG firms have a clear ESG strategy framework that consists of three pillars.
For non-audit clients, KPMG professionals stand ready to help and support on:
- Transformation – helping our clients transform their businesses in the ESG journey including decarbonization.
- Reporting – helping and advising clients around collecting, measuring and then reporting on their progress.
For audit clients, (subject to final regulatory rules) a key role in the third pillar is anticipated to be:
- Assurance – providing robust independent assurance over ESG disclosures as well as precondition assurance to give entities the confidence that they’re ready.
Using KPMG professionals experience and deep expertise in supporting chemicals businesses around the world, KPMG firms are well placed to help players in the industry with ESG issues.
Please don’t hesitate to get in touch to discuss any issue or query arising from this article – we would be delighted to help.