Sustainability as a Balance Sheet Item

The time has come for a profound transformation: sustainability accounting as a first step.

As early as March 1972, the well-known study “The Limits to Growth” of the non-profit Club of Rome examined the global interaction and negative effects on planet Earth of five factors: industrial output, population increase, agricultural production, non-renewable resource depletion - especially fossil resources - , and pollution generation.1 Since then, awareness of environmental protection and sustainability has continuously increased among politicians and the public, but without the necessary reversal for “real” transformation. On the contrary: the globalised world economy’s demand for resources is increasing linearly and continuously, while current crises and conflicts continue to aggravate supply shortages. Disrupted supply chains, impeded access to raw materials, exploding energy prices, the now obviously worsening climate crisis, and social disruption - conditions for companies are currently anything but unchallenging. However, it is not just global conditions that are affecting business. Complex regulatory initiatives concerning sustainable management, synonymously referred to as environmental (E), social (S) and governance (G) management, are putting additional pressure on companies. But is all this negative, and reason enough to do nothing? Or does this massive pressure also present opportunities through real transformation?

No longer just “nice to have”: sustainability is becoming a strategic factor for success

According to BDO USA’s Private Capital Pulse Survey from the spring of 2022, 94% of fund managers state that they assess their target companies’ ESG potential as part of their due diligence review.2 Consumers, employees, and investors are demanding more transparency of procurement channels and production processes of products. For example, those affected from raw material producing regions often report severe human rights abuses and lasting environmental damage and, irrespective of where this occurs, are increasingly turning to the public. A growing number of consumers are basing their buying decisions on whether companies comply with minimum ethical standards. Companies earn social acceptance through stakeholder loyalty as a “licence to operate.” If this licence is withdrawn, earnings and profit margins suffer, as demonstrated by the recent “greenwashing headlines.” In this environment, companies must ensure that they and their suppliers comply with the desired ESG standards - for environmental impact, e.g., of hazardous waste, and for employee and human rights.

Companies must continuously demonstrate their commitment to sustainability by selling products made using sustainable processes and materials, ensuring ethical working conditions across the entire value chain, and taking steps to contribute to their targets of diversity, equality, and integration.

New market entrants who base their business models and company mission on ESG will accelerate this change by allowing their customers to choose brands that meet these expectations, and thereby set new standards for established market players.

Water scarcity caused by climate change is a serious existential threat to companies

Historically, the environmental dimension and, specifically, discussions about greenhouse gas emissions and climate change have dominated the implementation of sustainable management in practice. As the current discussion about energy availability and savings potentials on all levels of society shows, this is not enough, since increasing (land) consumption by industry and agriculture makes it impossible to ignore issues, such as loss of biodiversity, microplastics, and waste and water management—in addition to energy. Besides the difficulty of supplying people and animals with drinking water, another hot summer like 2022 revealed further problems of our time related directly to the increasing scarcity of water: transportation routes lost due to low water levels or power supply shortages caused by a lack of cooling water needed in large quantities to operate nuclear power plants safely.

Global water consumption has risen six-fold in the last 100 years and continues to increase by approx. 1% per year.3 The OECD predicts global demand for water to increase by 55% by 2050. This is especially due to the growing demand of the processing industry (+400%), thermal power generation (+140%), and home use (+130%)4.

In 2021, water shortages caused by climate change forced the world’s largest chip maker (TSMC) to spend nearly half a billion dollars on water tankers to meet the water consumption of its chip production. Otherwise, production would have been disrupted with severe consequences for the global market - which had already experienced a loss of production due to the Covid-19 pandemic in 2020.5 The causal chains are also revealed here: lack of water which must be transported by water tankers results in further emissions of greenhouse gasses. A classic lose-lose situation.

Due to the number of vulnerabilities caused by potential shortages of water, these must also be included in classic risk management. Scenario analyses, stress tests, and corresponding adjustment measures for sustainable and consistent management are required to prevent loss of production, and cost increases.

When it comes to supply chain problems due to low water levels, chemical producer BASF prevented a stop in production in 2022 as in 2018 due to extremely low water levels of the Rhine6. Nonetheless, such scenarios are likely to reoccur in coming years. BASF is therefore planning a special cargo ship with a low hull to avoid supply chain disruptions in the event of low Rhine water levels in future summers.7 Such (sometime expensive) adjustments are becoming necessary because of the increasing water scarcity and must not be overlooked to prevent greater financial loss. They may also have transformative effects on common business practices, and enable long-term - in this case, sustainable - growth.

An adequate representation of the strategic success factors, and positive positioning towards investors and competitors requires credible and transparent reporting on how a company manages ESG challenges.

NFRD, CSRD, ESRS, LkSG, EU Taxonomy: stricter regulations promise greater transparency

Since 2014, the EU Non-Financial Reporting Directive (NFRD) has required public interest entities (PIEs) to prepare non-financial statements in addition to standard financial reports. As part of the further development of the ambitious European Green Deal which aims to fundamentally transform the European economy and achieve “net zero” greenhouse gas emissions by 20508, the European Commission revised the current Directive into the Corporate Sustainability Reporting Directive (CSRD)9. As part of the plan for implementing the revised CSRD, the number of addressees was expanded. This will especially require large non-capital market-oriented companies to prepare sustainability reports. In Germany alone, the number of companies who must disclose such reports will increase from 500 to nearly 15,000. External audits with limited assurance will also be required for the first time. The European Financial Reporting Advisory Group (EFRAG) established by the European Commission developed the European Sustainability Reporting Standards (ESRS)10 to offer guidelines for proper sustainability reporting in accordance with the CSRD.

Furthermore, the German Supply Chain Act (LkSG)11 requires companies to manage and report on respect for human rights in their supply chains as of 2023. At first glance, these regulatory measures seem to only affect a small number of German companies: the first step started beginning of 2023 “only” applies to companies with more than 3,000 employees. However, all direct suppliers of such companies must suddenly position themselves to fulfil the increased legal requirements of their customers.

Also in the context of “sustainable finance.” the number of regulations, in addition to voluntary recommendations, is increasing. In 2018, the European Commission published its “Action Plan: Financing Sustainable Growth”2 which contains targets and measures for sustainable economic growth. Since 1 January 2022, an important tool has been the so-called EU Taxonomy13, a regulation that introduces sustainable economic criteria, and features corresponding reporting obligations. Investments and activities may be classified as “green” based on these criteria. The aims are: increasing transparency, preventing “greenwashing,” and redirecting capital to sustainable economic activity. The EU Taxonomy defines six environmental objectives (climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, pollution prevention and control, prevention and restoration of biodiversity and ecosystems). Sustainable activities for these objectives are then defined using technical screening criteria (TSC). As of 1 January 2023 - i.e., for fiscal year 2022 -, companies must review whether economic activities previously classified as Taxonomy-eligible are aligned and satisfy the TSC. And this closes the circle to the reporting obligations of human rights due diligence, which are as "minimum safeguards" an essential factor in assessing taxonomy alignment.

Financial companies dependent on data from the real economy will be subjected to Taxonomy requirements one year later (2024), i.e., as of fiscal year 2023. Taxonomy reporting obligations are linked to the general reporting obligations - currently applicable to large capital market-oriented companies, and to a significantly larger number of companies in the future.

Holistic approach: sustainability strategies must be part of the overall corporate strategy

Given the dynamic nature of ESG regulation, which poses a major challenge, especially for the many future first-time reporters, it is important develop a roadmap for sustainability integration. As we have seen so far, the objective must be to incorporate sustainable management into all areas of corporate action. No subject can be viewed in isolation, and issues not yet at the top of the agenda could be there tomorrow. 18 months ago, who would have thought that our society would be facing an energy crisis?

A holistic approach requires a sustainability strategy, ideally, integrated into the overall corporate strategy. The first step in developing a sustainability strategy is a materiality assessment.

Materiality assessments identify the ESG factors that are most affected by the company (inside-out) and those that may affect the the position of the company, its risks and opportunities (outside-in). These assessments should also consider perspectives of internal and external “key stakeholders.”

This will reveal not only the main factors to be reported, but also approaches for integrating sustainability into the strategy, governance, and risk management (e.g., for energy and water) -to sustainably position the company for the future.

Holistic sustainability management and effective sustainability governance require defined objectives and KPIs, in addition to compliance with regulations. Structures for (preferably automated) data collection may provide a solid basis for determining such KPIs and integrating the results into the governance process.

Controls and audit reports must also be introduced to fulfil future reporting obligations under the CSRD. This also applies to the monitoring obligations of the supervisory board and audit committee. Auditable systems and processes are necessary to enable external auditors to examine the content and, especially, preparation of reports.

Reporting obligations as an opportunity for long-term business success

When focusing on the upcoming audit obligations for sustainability reporting, these may at first be seen as an additional financial and personnel burden. However, such audits may also be understood as supporting functions to introduce more robust processes and establish and improve control mechanisms. Seen this way, audits act as a “sounding board,” and help ensure quality so that transformative ESG factors receive the same importance as data quality and reliability for financial information. Financial results are also affected by sustainability: whether in relation to commodity prices for energy or water, high personnel costs caused by illness and fluctuations, or increasing profits through better sales of innovative solutions.

“Business as usual” is no longer enough. Customers and the public have become highly sensitive to sustainability - ecologically and socially - and have extensive information about causal relationships. In this environment, companies still have the opportunity to develop innovative best practices, and boldly push forward to secure a competitive advantage - that will soon be the minimum standard for all.