Understanding ESG Ratings and How to Measure for Them

LM:Well, thank you very much, Joan. That's a very good question and it's a question that can become overwhelming for the general public and investors. And when we talk about all the different systems of reporting and mechanisms of reporting, you have to put yourself in the shoes of investors and general public that need to be informed to make their decisions, their investment decisions. And of course you have to put yourself in the shoes of the CFO of the company and the corporate social responsibility of the company to start collecting the data and putting these reports out there. And then you have to understand basically five things. The first one, what is the scope of the information? You mentioned TCFD. TCFD is Task Force for the Climate-Related Disclosure. So it's climate centric, it's climate focused. So you have other systems or standards or frameworks of disclosure that are not necessarily only focused on climate, but could be broader.

Like you mentioned CDP. CDP has climate, has water and has others, and they base on questionnaires. So it's a little different the type of scope. So the first thing that you have to think about, if I'm disclosing only climate related risks, is that what the SEC wants, maybe a TCFD is the way to go, and that's what the SEC is suggesting, is recommending. But that's the first thing, the scope of information. So it's going to be broader, could be more narrow. So that depends on what you want disclosed and to what extent, what's the scope of your disclosure. The second thing is the type of guidance. So a guidance can be in the form of a framework or a standard. TCFD is a framework. It's based on principles. It's a recommendation from a task force. TCFD is a task force on the climate-related financial disclosures.

And they made 11 recommendations based on four pillars. So that's our, it's a framework and those are recommendations. And those are principles for reporting and which is different from SASB. We mentioned SASB as well. SASB is a standard. So standards, as the name suggests, are used when you want to have a uniformity. You have a comparable way of analyzing and making your investment decisions. So you are looking at one company and you want to compare to another company. You can compare apples to apples. The information you're going to get from the same industry. Of course, if you're comparing to companies from the same industry, if they're both are reporting through SASB standards, you'll be able to compare them, which is not necessarily the case for framework.

JM:So let me just clarify that. SASB is the Sustainable Accounting Standards Board?

LM:It's standards board, exactly. So standards from the IFRS foundation. The idea of a standard is to be able to compare across different companies within a specific sector. Again, talking about specific sectors, another element that you have to think about is you are reporting scheme or you're reporting mechanism or framework has to be either industry agnostic or industry specific. So I have to think about that as well. SASB is industry specific. There are 77 industry types that you can go there and then see all the standards that are specific for that sector. And then whenever you are in that specific sector, you can compare because if you are reporting according to SASB, you are reporting according to that specific standard within that specific industry. GRI, for instance, is a sector agnostic. However, they are starting to create sector specific standards. And GRI is a standard, if you report according to GRI, it's a standard.

It's not a framework. So that's the difference. It's SASB and GRII are standards and SASB is sector specific. GRI is not, but it's getting there. So it's starting to... Or your guess was the first one. And they are starting to get more and more sectors when they're developing this sector specific. The fourth one is the target audience. So if you are creating a report for investors or general stakeholders or general public, it's different. Investors want to know very specific things about the financial health of the company and how environmental and social and governance risks will impact that specific financial statement or that specific financial indicator or cash flows or cost of capital. So however you want to see and analyze and you as an investor want to know whenever I'm investing in a company, if you can sustain future cash flows that you should talk about valuation and basic of valuation, that's where you're going to make money or not when you invest in a company.

That's that's very basic understandings that we need to think about before choosing one way to report. TCFD is a investor specific, the target is for investors. Same for SASB, it's targeting investors. And this is very correlated with the last characteristic, which is what is the method that it was used in order to assess materiality? For SASB, TCFD, is financial materiality. So if you talk about the double materiality concept, SASB and TCFD, they are very much concerned about the financial materiality, the valuation of the company. The enterprise value creation that those elements will bring to the company. And investors want to know that. That's why when you are talking about the target audience and the way that you're assessing the materiality, they're linked. If you're targeting investors, they look for financial materiality. Therefore you use a system that is linked to value creation, financial materiality.

JM:So I just want to pull out to make a point that you said that if your audience is the investor community or the public, the public is more interested in your impact on the community. They're less focused on the financial risk side. They're more focused on what does it mean for me as a consumer? What does it mean for me as a community member? And the press of course, will latch onto that. The business press and the financial press will talk about the numbers and the financial risk, but the general press and the general business press will talk more about the consumer impact and the community impact of a company. That's why a lot of the labor movement actions and stuff have been elevated. As an example, they've probably affected, and I'm sure I know they have affected the stock, but they've also really affected other aspects of the business that cause other risks, right?

So Danielle, you're actually doing this counting and your background is so interesting. I want to get into the nitty gritty a little bit with you because you are, as I understand it, you're actually helping companies count the carbon emissions and count their environmental, figure out what their environmental and ESG imprint is. So help us figure out what do we need to report in any of the frameworks and to any of the audiences that Lorenzo outlined, what exactly do we need to report? I mean, the SEC breaks into scopes 1, 2, and 3, for example. And you can talk about that.

Danielle Barrs:When it comes to ESG. Not only don't we need to measure everything, we also shouldn't measure everything. For example, the price of gasoline is going to be more relevant to a transportation and logistics company than to a professional services company. Same goes for carbon emissions. And because ESG can be overwhelming if you're just starting out, it's important to prioritize. This is why we have materiality assessments. So number one, what's important to your company and stakeholders? Who is your audience? And two, what outside-in factors are relevant to your industry, which basically means what are the ESG related risks and opportunities that come with this changing global landscape. So you can ask, for example, a good place to start is, do you want to look at something that is industry specific, which is SASB or industry agnostic, which is something like GRI, the Global Reporting Initiative.

And it matters for which standards you want to choose. So SASB for instance, which is a standard, can help with sector specific criteria. And SASB actually has what's called SICS, S-I-C-S, which is the Sustainable Industry Classification System. And this is a tool that helps companies identify which of 77 specific sectors they fall into for the purpose of narrowing down what exactly to measure. And this also uses sustainability profiles specifically to group similar companies, which is better overall for comparability across peers. So the question that you'd have there is, which SASB industry does my company fall under? Now if you have already determined that climate change and greenhouse gas emissions are important, those are now divided into two categories. So you might ask, what are your physical risks? These are the risks associated with changes in weather and climate. So increased flooding, drought, wildfires. A question there might be, are your assets located in high risk areas for any of these things?

The second risk type is transition risks. And these are the policy and regulatory changes that result from this global transition to a low carbon economy. Questions here might be, is your company subject to reputational or legal risks? Have you set some sort of internal carbon price? To move a little further, all companies, if you have your lights on, are having some sort of scope 1 or 2 emissions because that is directly attributable to your direct emissions or your electricity. So the question to ask here would be, should your company consider scope 3, which is supply chain emissions, and what portion of your company's emissions come from scope 3?

This is important for example, if you want to report to SBTI, which is the Science-Based Targets Initiative, and this is a global organization that is a collaboration between CDP, formally the Carbon Disclosure Project, the United Nations Global Compact, the World Resources Institute, or WRI and the World Wildlife Fund. And this is the gold standard for guidance on setting GHG targets. And according to SBTI, if 40% or more of your company's total emissions are scope 3, they require a scope 3 target be set.

JM:That percentage again is what? 40%? Four zero?

DB:40% or more. Four, zero, correct.

JM:Wow.

DB:Then you need to set a scope 3 target according to SBTI. So a manufacturing company, for example, is very likely to have a large scope 3 emissions target for that reason exactly. And then last but not least, you can ask a question such as, will you be reporting to the SEC? And of course, the SEC uses the TCFD, which is the Task Force for Climate-Related Financial Disclosures. And that's important because it focuses on greenhouse gas emissions. So if you are reporting to the SEC, that is a question that you need to ask yourself. And also you would need to fall into the TCFD's framework core elements, which are governance, strategy, risk management, and metrics and targets. So these are a whole bunch of questions that you really should be asking when you're looking into this kind of thing.

JM:So Charles, help us out on the making sure these numbers are accurate part, right? Because LM set up the framework, Danielle told us the questions to ask, but now it's in the place of collecting the data. So how can a business leader decide how to capture this information so that auditors like you can verify, because the SEC will require that you validate these numbers and any investor or any lender will need to know that these are audited numbers as well. So what advice would you give to business leaders on how to capture this data in a way that if not makes it easy for auditors, at least helps auditors to verify it?

Charles Waring:So it's a great question. It really comes down to the need for the information to be in a repeatable manner. And so what that means is that the data that is being collected and ultimately reported upon is flowing through a process that is structured, is formalized, is repeatable, and from an auditor's sake, we call that re-performable. So from a standpoint of has the organization, has management developed that process to do that so that then an auditor can come in and assess, evaluate that information, that data and the process that's in place there, that is a repeatable, formalized, re-performable process.

JM:So when you say repeatable, you mean... Clarify that a little bit. Do you mean that the process of collecting the data can be repeatable or the process of validating the data can be repeated?

CW:So it's a good clarifying point here. What it is is that the process that management uses to collect the data and to then report upon it is a repeatable process. So said differently, the sustainability officer, if that person is just aggregating and doing calculations of the data on the back of a napkin, that is not a repeatable formal process. It needs to follow a well-defined process that has formality in the documentation and those really constitute internal controls that then an organization can demonstrate that that information is being structured, presented, and reported on in a repeatable manner. So that information on a quarter over quarter or a month over month process is consistent, calculated, aggregated, and reported upon in that repeatable manner. So that's what I mean from a repeatable process.

JM:LM, you come from an investment industry background and so you talk about putting your feet in the shoes of the audience that you're going after. So if somebody's going after the investor or the investment community, or even a lender, right? Somebody who wants to look at audited financial statements, what are the actual elements that they would want to see in that to reflect your climate risk or your risk of exposure to climate change or how you're having an impact? What exactly would they want to see? I mean, do they want to see how many miles you are from the, how much exposure you have to sea level rise? I mean, how granular do they want you to get?

LM:That's a very good question, Joan. Putting myself in the shoes of an investor or a capital provider, that could be a bank, could be a private equity fund, could be a VC, or an investor, could be an institutional investor or a retail investor or any kind of investors, an asset manager. So regardless of the investor type and the segment of the investor, if I put myself in their shoes, we want to see replicable sustainable future cash flows and how these cash flows will be discounted using a cost of capital rate that is going to give us the valuation of that company. And I want to know if this company can sustain those cash flows and how much this company is discounting in terms of how much the market is perceiving this company, the risk of this company, the risk exposure of this company, which is linked to the cost of capital.

So that's what, as an investor I want to see. So how do I do that and how do I start asking the CFO of the company, can you give me this information that will lead me to this conclusion? So where it resides, it resides in identifying and assessing the exposure of that company to those climate-related risks. So then to Danielle's point, there are two, could be physical risks, could be transition risks. And your question related to the location of an asset could be a very important information for a real estate investor, someone investing in real estate. I need to know the location, the location of that asset. If it's too close to a hurricane prone location or a flood location, I need to know. And I also need to know if this is an investment of short term or long-term investment.

If it's a long-term investment, I want to know what is the situation, what is the exposure of this asset in the future? So I need to know also the projections. I need to know scenarios. I would like to know this kind of information. And according to the SEC, these companies should follow the TCFD. And the TCFD is a good framework to enable companies to identify and assess those climate-related risks and also provide a mechanism to identify opportunities to mitigate those risks that are linked to physical and transition mitigants. If the location is near a flood prone zone, think about insurance, think about building your real estate with materials that are more resistant to floods, to hurricanes or whatnot. So that's exactly the kind of mentality that an investor will like to see. Are you identifying your risks and assessing them?

Do you know the risks that you are you're taking, that you're exposed to? And can you link those to your value drivers of your company or your business? Can you make this connection? And are you managing these risks properly in terms of governance? You have the board aware of those climate related risks, your management, are they aware of these type of risks? Are you integrating these risks and opportunities into your decision-making process for budget, for strategy for... And how you are disclosing those? And the SEC is asking them to put them in [inaudible 00:21:39] and make them publicly available for investors using the TCFD framework.

JM:So let me just get into one little nugget of what you said because we're living in a time where we have entire communities being wiped out by floods and hurricanes. So I also saw that Babcock Ranch in Florida is a new development that was essentially unscathed from Hurricane Ian recently, whereas adjacent Fort Myers was practically wiped out and their insurance claims went crazy. So would an investor look more kindly on a company that is in, if they're both in a hurricane prone area, but one company has more insurance, but the other company has more solar panels but it's more expensive and they're spending more money on that, which is considered less risky? And how does that show up?

LM:Yeah, so the insurance, I need to understand the structure of the insurance and then the insurer and how the insurance is doing all the insurance and retrocession, that's another story. So as an investor, I need to understand that too. So in the moment of an event, will I be able to go there and recover my money from that insurance company? I need to understand the contracts, I need to understand how in the event of a loss, how this loss is recovered. So that's a very good question, a very interesting one. Sometimes it goes unspoken, but that's a very important question that we need to understand the contracts of the insurance companies and how likely am I to get my money back in the event of a loss? That's a big chunk of the question. But the second question, in terms of the exposure for a real estate, it is important of course for you to go to renewable energy and have a more efficient energy.

But in this case, for physical risk, I would go for an investment that is concerned about what kind of materials that are in place or the kind of mitigants that the builder is... And me as a capital provider can also finance that as well. So I need to understand the mitigants, the opportunities that are there in order to mitigate that specific risk. Of course, solar panels are very important for transition risk. They are going to be key for, of course, solar panels, you have to think about the cost and then the viability, et cetera. But however, for physical risk, they might not be as effective to manage that risk or to mitigate that risk. So we have to think about what is the source of the risk or the type of the risk that you're facing and the impact in your business, and what are the opportunities that you have, specific opportunities, that will mitigate that risk. That's why it's important to understand what are the risks and identify them and identify the nature of those risks. Cause those will be linked to how you're going to mitigate them.

JM:Yeah, I appreciate that. Before we close out with Danielle, Charles, how do you record mitigating risk in your financial statements? How do you capture that data? Because it's almost like proving a negative?

CW:Right. Well, I think that anything within the financials when you're considering, especially in this space, anything that would affect an estimate or assumption, that needs to be documented and considered and evaluated. So if there's certain assumptions or estimates that are in place, what is that process and how has management documented those assumptions, those risks that are put in place. Because ultimately as the auditor, that's what we would go to management for, to evaluate and gain insights on what they've done, any assumptions that are baked in. And then we would look to determine is that a sound assumption and rationale and the data that's provided, does that support the conclusion that we would agree with?

JM:So Danielle, we could talk about this stuff for hours. So what I want to do is I want to wrap up with this and you're great at this, give us, you did this wonderful list of questions that business leaders should ask in the beginning. So is that the place to start? And then where do they go from there? So they've answered these questions, they're looking at the prioritizing and what they should not measure, I love that, and the different frameworks, but what's next after that? Because what I want to get into, how to figure out where your carbon emissions are coming from, for example, other than just your electric bill, where do they go from after those questions and how do they decide?

DB:This all goes back to two things, right? What's important to your company and stakeholders and what outside factors are relevant to your industry? What's important to your stakeholders really comes down to what is your greater purpose here. So a great way to start out is to gather folks together and determine what your mission statement is going to be. What is the overall goal here? Why do you want to look at ESG? Why do you want to look at sustainability and your mission statement should you choose to develop one, should be ESG specific, but it should also align with your company's values. So really figuring out what those values are as a company is going to be critical here for starting out in determining which direction you want to take this, and this is before you even get into data collection. Again, it can be overwhelming.

And so those materiality assessments first and foremost are going to be great resources for prioritizing. And things like SASB can be really great resources to help for this sector specific reporting. And then organizations like the GRI, the Global Reporting Initiative, can help for sector agnostic determinations. So really figuring out which bucket you fall into is going to be really important starting out. And then we really get back to the three pillars of ESG, which we sort of group together as this one umbrella term, but it's so important to understand what is beneath those pillars. And so environmental considerations really come down to things like energy efficiency, renewable energy integration, waste management, water management, and that's where things like your carbon emissions are going to come in. So what is the carbon intensity of your company? If you're a manufacturing company, that's going to be a little bit higher than let's say if you are a professional services company. And so figuring that out is going to be really important.

And that is even before, as you said, you get into figuring out where to get that. And so how do you reach out to your utility? What are the questions that you need to ask in order to get the data that you need? Maybe if you want to look at employee travel, what is the travel program that you use and how you get that information to look at your scope 3 emissions or employee travel considerations. And then we go into the social pillar, which looks at things like DE&I, which is diversity, equity and inclusion, labor standards, employee health and wellness, privacy and data security. And then governance, you get into bribery and corruption, executive compensation, accountability is a big one. And so really drilling down into those pillars and finding what it means for your company is going to be critical here before starting out so that you know exactly what you do need to collect and you can develop a plan of action for moving forward.

I mentioned accountability. That's going to be a really important step here as well. And so it's crucial that operations, finance and your ESG team are working very closely together on this. And then clearly state who is responsible for each aspect of your mission. And then once you do get into data collection, I would recommend looking at a very good data management software and there are many of those on the market. But ensuring that your ESG metrics align with your financial information and keep both of those things close at hand is going to be really important. And then ideally, integrating those as much as possible. So all of those things are a really great place to start.

LM:I love that. So what you're saying is if you go through these steps, you can use these frameworks to then drill down and they will give you marching orders in effect of what you need to collect. And I would add to the accountability piece, transparency, right? I mean, that's what this is all about.

DB:Absolutely.

JM:It's transparency. Accountability is you hold people accountable by having to be transparent, right? So I mean, I could talk to you guys for about four hours about this stuff, alas, we don't have that much time. The good news is we have more episodes to do of ESG in Focus. So I'm really glad to get to those.

If you have not listened to any of the previous episodes, please tune in to the previous episodes of ESG in Focus and we get into a little more detail on different aspects of what we're talking about today. So I just want to say thank you so much to Danielle Barrs, LM, and Charles Waring of EisnerAmper. If you have any questions, if we've sparked any questions in your head or you're saying, oh, I need this help, please, please reach out to Danielle, Charles and LM through the EisnerAmper website, eisneramper.com. Thank you for joining us. I'm Joan Michelson, see you next time.

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