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Janet Ranganathan Headshot

Minding the Sustainability GAAP

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Limited transparency around corporate sustainability risks can lead to investments that are bad for the environment, and investors' bottom lines.

Yesterday BP abandoned its hope of bidding on a potentially lucrative exploration license in Greenland. The implication is that its tarnished reputation is undermining its ability to compete for projects. Across the Atlantic, the Tennessee Valley Authority has lost nearly $50 million in power generation during this summer's heatwave, because the Tennessee river is too hot for the nuclear plants' cooling towers to function.

What do these two stories have in common? They are both examples of how environmental degradation can hit home for companies. The global environmental crisis, including climate change, water scarcity and ecosystem degradation, isn't just a problem for "greens." It also creates significant financial risks for companies and their investors.

Environmental Risks Alter Balance Sheets

Such risks vary from sector to sector but include: potential liability for environmental accidents; the physical impacts of climate change on supply chains; and growing water scarcity in many parts of the world.

BP's recent crisis generated by the mammoth Gulf of Mexico oil spill is an extreme example of environmental risk. It turned the company's anticipated net income of $5.6 billion for the second quarter of 2010 into a record $17.1 billion loss.

But in a resource-constrained and warming world, there are many other risks that may significantly alter the balance sheet. For example, research suggests that consumer goods companies could face a loss of earnings if they do not respond to environmental pressures in their supply chains, including physical climate change impacts and public policy responses to them. Specifically, the World Resources Institute (WRI) report Rattling the Supply Chains indicates that such businesses could face a 13-31 percent reduction in earnings before interest and taxes as soon as 2013, rising to 19-47 percent in 2018.

Certain sectors will be heavily impacted by specific risks in vulnerable countries or regions. For example, 79% of planned new power plant capacity in India will be built in water scarce or stressed areas. Since thermal and hydroelectric power plants depend heavily on water for cooling and energy generation, uncertain water supply creates significant risks for domestic power companies.

A Gap in Financial Accounting Standards

Worldwide, current financial accounting standards and generally accepted accounting principles (known as GAAP) fail explicitly to address such risks, which often derive from unsustainable business strategies. They can also miss the opportunities that such challenges create. Superior environmental performance by corporations can translate into lower costs from improved energy and resource efficiency and higher revenues from product innovation and enhanced brand recognition. General Electric's Ecomagination™ product line is one compelling case in point.

Corporate sustainability reports can help fill information gaps on some risks. But sustainability reporting standards, such as the Global Reporting Initiative, remain largely voluntary, and as a result, their uptake is limited. Another recent WRI report Undisclosed Risk, for example, found that developing markets have particularly lagged behind in producing corporate sustainability reports. What's more, stand alone reports all but guarantee that sustainability remains at the periphery rather than the mainstream of financial and investment decisions. A 2008 KPMG International Survey of Corporate Social Responsibility, for example, found that only three percent of annual financial reports had corporate responsibility information fully integrated into them.

The failure to integrate sustainability as a strategic business issue in annual financial reports means that businesses and investors continue to make investments that are bad for the environment, society and ultimately their own bottom line. As a result, environmental trends continue on a downward trajectory, creating even greater risks for companies, especially those that have not embraced sustainable business strategies.

Towards Integrated Reporting

A solution may finally be on its way. A coalition of businesses, regulators, accountants, securities exchanges and not-for-profit groups recently launched an International Integrated Reporting Committee initiative to "create a globally accepted framework for accounting for sustainability." Jointly convened by HRH Prince Charles's UK-based Accounting for Sustainability Project and the Global Reporting Initiative, the committee includes participants from the International Accounting Standards Board, U.S. Financial Accounting Standards Board, International Organisation of Securities Commissions, the Big Four auditors - Price Waterhouse Coopers, Deloitte, Ernst & Young and KPMG - and NGOs including the World Resources Institute. The committee intends to present a framework, which brings together financial, environmental, social and governance information in a single "integrated" reporting format, at the G20 intergovernmental summit in France in 2011. The G20 already backs the formation of a single set of reporting standards, and G20 support for broader rules will be crucial to their introduction.

Moving sustainability from the periphery to mainstream investment is an essential next step in preparing the corporate sector to deal with environmental risks. The move won't be easy. But given worsening environmental trends and the fact that today's investment decisions will either sustain or degrade the earth's environment, integrated reporting is both sorely needed and long overdue.

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