Accounting for values and valuation

Early in 2020, several of the world’s largest asset managers called for companies to be more transparent about how they’re managing environmental, social, and governance (ESG) issues and other nonfinancial risks.1 Climate change was a primary catalyst for the push. After the onset of the COVID-19 pandemic, however, all companies—not just investment institutions—became much more aware of how vulnerable they are to ESG-related issues and how important the disclosure process is, says Kurt Kuehn. He is the former CFO of United Parcel Service of America (UPS) and a board member of the independent Sustainability Accounting Standards Board (SASB).

Accounting disclosures that are material, consistent, and reliable can help reassure shareholders and other key stakeholders about ESG-related risks, he says, but many of these characteristics have been lacking in typical sustainability-reporting processes, which has been frustrating for investors and corporate leaders alike. In a conversation with McKinsey’s Tim Koller and Roberta Fusaro, Kuehn explains the challenges and benefits of companies sharing information about their nonfinancial risks, as well as SASB’s evolving “industry-specific, market-informed” approach to sustainability reporting. An edited version of the conversation follows.

McKinsey: Why has it taken so long for sustainability reporting to gain traction?

Kurt Kuehn: Until very recently, companies and investors often thought of ESG reporting as a form of greenwashing—an issue more relevant for marketing and communications than an actual financial issue. Now we’re seeing more tangible effects from climate change, and companies and investors have come around. They’re witnessing firsthand how nonfinancial risks can significantly affect corporate valuations. I think they understand now that many ESG issues are really all about business opportunity and risk. The COVID-19 pandemic also opened their eyes.

McKinsey: In what way?

Kurt Kuehn: The combination of climate change and COVID-19 has been humbling for everyone. Business leaders learned how critical their human capital is and how nonfinancial events can create huge swings in corporate value in a very short period of time. Recent events have also made executives—particularly CFOs—aware of how important it is to be able to think through multiple scenarios and adapt. Annual forecasts, however perfect they might have looked in January 2020, probably weren’t all that useful for the rest of 2020 in most organizations. Meanwhile, oil and gas companies, real-estate companies, transportation companies, and others have become adept at modeling climate-related scenarios to, say, vet investments in shoreline properties or estimate the effect of carbon restrictions. Unsurprisingly, many are now realizing the broad relevance of measuring, managing, and disclosing key sustainability issues.

McKinsey: What’s the biggest reporting challenge for companies?

Kurt Kuehn: The lack of consistency. Companies often just tweak what they report every year—maybe adjust it for what looks good and what looks bad. Different industries use different metrics. Even within the same industry, companies use different thresholds for performance on ESG issues, or they focus on different types of exposure. Meanwhile, a whole cottage industry has developed around trying to interpret sustainability-related data and helping investors understand which companies are at risk from ESG issues and which are beginning to take action. Even when companies do disclose material risks, they may find that they rank high on one rating company’s ESG index and low on another. That makes it tough for investors to create fair comparisons or to get an accurate read on how companies are thinking about and managing ESG programs. Corporate leaders want simpler reporting processes. Investors want clearer data. And both have indicated that they are looking for a standard way to report and assess ESG activities and impacts for themselves.

McKinsey: How has SASB stepped in to fill this gap?

Kurt Kuehn: SASB’s mission is to provide information in a format that the financial community can use to understand prevailing ESG issues and make good long-term investment decisions. It was intentionally mirrored after FASB [Financial Accounting Standards Board] and IASB [International Accounting Standards Board]. Think about it: there are a thousand different ways to interpret a company’s financial statements. Investors who are momentum-oriented will look at one set of numbers while others who are focused on ROIC will search for a different set of numbers. In all this, we don’t expect a single interpretation of financial results. Similarly, I don’t think we can expect a single vision of sustainability. But companies, investors, and other stakeholders will still need to use a set of standardized metrics as a starting point for their analyses.

McKinsey: How is SASB’s reporting framework different from others?

Kurt Kuehn: There are two things that make SASB’s approach unique. First, SASB standards are focused on ESG issues that are likely to have material financial effects. In recent years, we’ve seen a concept emerge of double, dynamic, or nested materiality, which guides the different levels of reporting that companies undertake. At a base level, companies report on “traditional” information that is already reflected in their financial accounts. This is where IASB and FASB standards come into play. Companies also report on the subset of sustainability topics that are material to the creation of enterprise value. This is where SASB standards fall. Or they may report on matters that affect the broader economy, the environment, and society; organizations such as GRI [Global Reporting Initiative] focus on such topics [exhibit].

Emerging reporting standards and frameworks address different environmental, social, and governance use cases.

Second, the SASB framework is industry specific. The board developed a matrix of potentially material factors for business leaders in 11 industries and 77 subsectors. These areas of focus were developed in a multiyear effort that included input from investors and companies. We had high-level support from an investor advisory group that now represents 55 of the largest investment companies in the world. We asked, “What ESG issues do you think would be most relevant in a given industry, and which topics would you like companies to talk more about?” At the end of the day, this is still a voluntary process, but investors told us they look at four factors: Is the company at least aware of nonfinancial risks? Does the company actually have a plan to mitigate these risks? Does it have targets for performance and a way to measure performance against risks? And, most important, is the company making progress against plan?

When business leaders are asked to fill out surveys or issue annual overviews, the SASB framework outlines a core set of data to share with the markets to address their concerns. The industry-specific approach appeals to me personally, as a former CFO, because it’s very tangible and practical.

McKinsey: Can you provide an example?

Kurt Kuehn: Take the social issue of animal rights. It may be a major economic issue in some industries, such as poultry or food production, where demand may be significantly affected if there’s a perception that animals are being mistreated. But it may be less of an issue in other industries, such as consulting or mining. SASB’s discipline is to say, if you are in poultry, that issue could be material and should be included in your ESG reporting. For the other 70 industries out of the 77 we identified, animal rights may be a heartrending issue but is less likely to cause financial impact and so would not necessarily be reported.

Or think about the industry I grew up in—transportation. The biggest material ESG risks there might include carbon footprint, labor policies, and human relations—thinking about the effects of the gig economy. The CFO and other senior leaders in these companies could enhance their ESG reporting by focusing on those factors, and without much extra work, they’d likely address investors’ key questions and concerns.

McKinsey: How have companies responded to SASB standards?

Kurt Kuehn: Since we launched the framework in November 2018, we’ve seen increased interest in reporting standards across the globe, especially in Europe. Currently, more than 600 US and non-US companies are reporting with SASB metrics. More recently, we announced plans to join forces with another organization, the International Integrated Reporting Council [IIRC] so we can better harmonize global corporate reporting standards. We expect to work with other groups as well.

We’re seeing companies use SASB standards to report on ESG in different ways—it could be as small as a four-page insert tucked inside a sustainability report, with maybe a page on metrics, a page on trends, and the rest setting some context. What’s clear is that the barriers to investor-grade sustainability reporting are coming down. And we’re seeing some enlightened CFOs and CEOs trying to educate investors about how ESG factors could affect the financial performance of their companies. Rather than simply reporting out the numbers as a bit of PR, they are contextualizing them as part of corporate strategy.

Five ways that ESG creates value

Five ways that ESG creates value

McKinsey: What is the CFO’s role in sustainability disclosure?

Kurt Kuehn: The CFO must be involved to ensure that there is some level of credibility, that the reporting process has been sufficiently documented, and that the numbers could be replicated if needed. Companies need to make sure they are not being too naive when it comes to projecting potential risks and opportunities from ESG. Initiatives that have a strong environmental or social benefit over the long term usually come with some costs in the short term. Right now, for instance, alternative vehicles cost more to produce and often don’t create returns as high as those for traditional vehicles. So the CFO can help manage expectations about what’s important to the community versus what’s important to the company—focusing the company’s best efforts on addressing ESG issues in ways that aren’t too detrimental to financial health.

At UPS, for instance, we set a goal of using a certain proportion of biofuels in our airplanes; then I found out about all the hoops we were jumping through to incorporate biofuels at $12 a gallon when, for that same amount of money, we could be putting up low-carbon vehicles, electric vehicles, and so on. We redirected our focus toward doing just that. Just wanting to do good isn’t the only factor; companies have to do it in a way that makes sense for the company and leverages the right resources.

McKinsey: What’s your advice to companies that are not doing any ESG reporting currently?

Kurt Kuehn: There are lots of good reasons to report on ESG factors—among them, your community, your reputation, and your employees’ morale. But the real reason is, investors care a lot, probably more than you realize, and not just the socially conscious funds. As McKinsey has pointed out in its own research, there is an important question of value creation or destruction—it’s getting harder to ignore the effects of ESG on, say, a power company in California that is managing increased loads because of successive heat waves, or a beverage manufacturer that faces potential water shortages. Companies and investors need to be able to think through different alternatives, and the more tangible they can be, the better the decisions they’ll make.

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