ESG - A Valuer's Perspective

Financial Reporting Brief July 2021

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The development of a comprehensive corporate reporting framework has seen strong momentum in recent months at a Global and European level.

Global initiatives have centred around the efforts made by the IFRS Foundation to propose an International Sustainability Standards Board (ISSB) which it would govern in tandem with the existing International Accounting Standards Board (IASB). The proposed ISSB will take account of and build on the substantial work done by many leading global organisations in the area of sustainability and the underlying environmental, social and governance (ESG) factors over recent years.

In Europe, the EC has published a proposal for a Corporate Sustainability Reporting Directive. The proposals include a massive broadening of the scope of entities included over and above the existing European non-Financial Reporting Directive. The EC has also instructed the European Financial Reporting Advisory Group (EFRAG) to initiate work on European sustainability reporting standards.

Our Quarterly Financial Reporting Brief comments further on the above.

There is no shortage of work, and underlying opinions and perspectives, on the standardisation of ESG disclosures and reporting. It is needed as the current lack of uniformity results in widely varying disclosures, or the absence thereof. Many struggle to make sense of interconnected standards, disclosure requirements and ESG ratings.

With reporting challenges being addressed, one of the major areas requiring attention is how the underlying ESG factors, including climate change, represent fundamental considerations to inform valuation analysis.

ESG factors have become central tenets in the capital allocation process for both providers of capital (investors) and users of capital (e.g. corporations and others). The pandemic has increased the focus of both on reliability and long term sustainability.

The International Valuation Standards Council (IVSC) has in 2021 had a particular focus on valuation challenges arising from the pandemic and the importance of ESG factors to the valuation process.

IVSC Perspective

All markets have seen significant change since the beginning of 2020. While the Covid-19 pandemic is the major contributor to this, there has been burgeoning growth in awareness of ESG factors and the need for robust response not just in reporting, but also in the approach to business and asset valuation.

The IVSC has published the following perspective papers in recent months:

February: Challenges to Market Value
March: Framework to Assess ESG Value Creation
May: ESG and Business Valuation

Challenges to Market Value

The great uncertainties that pervade markets pose questions of the valuation process, including:

In the COVID-19 world, how does the valuer quantify market value given a lack of comparable information?
Where market comparable information is available, have the parties acted knowledgeably, prudently and without compulsion?
Is the pandemic market one where there are sellers under abnormal pressures and opportunistic buyers that is more aligned with a liquidation market, and how does it relate to market value?

Is market value nimble enough to react in volatile markets? Many question if market value is backward looking and therefore not as relevant when markets are in flux. The increasing difference between price and value has raised issues even in developed markets, despite the abundance of available information. There is also likely to be a greater propensity of special circumstances underlying transactions during a crisis period with regard to both information available and the specific terms under which they are transacted.

Some organisations around the world are considering a transition away from Market Value because of the difficulties such a basis of value creates during volatile periods on markets. Amongst the parties that are considering this are the European Banking Association and the Bank of England, with some focus on long term value indices.

Multiple different scenarios, exacerbated by extremely challenging conditions during the pandemic, pose new and different questions for the valuation profession. By utilising commonly accepted valuation standards and guidance to educate and communicate valuation matters, professional valuers are a vitally important resource to stakeholders.

Value Creation

The IVSC Perspective Paper ‘Value Creation Framework to Assess ESG Value Creation’ represents the IVSC’s first steps on the path towards a more systematic approach to the incorporation of ESG into business valuation and practice. Incorporation will need reliable ESG metric reporting to provide a platform that is consistent between companies, across geographies and over time.

There is a common perception that because ESG disclosures are typically non-financial in nature, they therefore do not have a financial impact. This fails to recognise that ESG factors represent a multitude of factors that need to be assessed to consider the long-term financial viability and sustainability of an enterprise. While the ESG factors may not directly impact the current period financial statements, they can be a leading indicator of financial prospects and question the robust nature and quality of a company’s asset base. Impairment of assets and asset valuations are just of the prime examples of where ESG factors may have a significant impact. ESG factors may possibly in some ways be considered as pre-financial, rather than non-financial information.

A significant factor in the escalating significance of ESG in the capital allocation process is the interest rate inherent in discounting future cash flows to present value. The further in the future the benefit, the greater the relative increase in present value from declining rates. The economic crisis that has persisted since early 2020 has brought about an unprecedented expectation for a prolonged period of low interest rates. The relative value of long-term cash flows has increased at the expense of those in the near term. In the prevailing circumstances, the ESG framework has taken on greater importance.

The same principle holds true to identify and quantify potential future liabilities through explicit forecast adjustments or scenario analysis, rather than assume such tail risks reside implicitly in the terminal assumptions.

The fundamental degradation in near-term profits resulting from the pandemic has also placed additional value on the lasting prospects of an enterprise. With the ever-increasing recognition and adoption of ESG by market participants, as well as the current market conditions that have placed additional weight on lasting value, there is a strong argument that a system needs to be developed whereby valuers could begin incorporating ESG considerations into the business valuation framework.

ESG Framework

It remains elusive for businesses and investors to quantify the potential risks, losses, benefits and rewards associated with ESG decisions. The way to tie ESG to company valuation has been the problem facing corporate leaders and their boards for some time who have a fiduciary duty to tie every decision to value creation.

A more articulate framework is necessary to ensure financial discipline and the most efficient allocation of capital. The value proposition of ESG investments must be evaluated to assess if and how such investments have resulted in value creation.

A close link exists between ESG investments and intangible asset value creation and/or maintenance. The resulting implication is that ESG returns may be better assessed by reference to intangible asset value creation. Valuation techniques that are used to value intangible assets may be used to value the impact of ESG on a company’s total value. There are several methods that can be used, with some based-on income variation including:

Multi-period Excess Earnings Method
Differential Income Method

The question of what distinguishes companies based on their ESG characteristics and what is the link between ESG information and the performance and valuation of companies is based on factors such as:

Are natural resources used efficiently?
How innovative are research and development programmes?
Are risk management and compliance standards robust?
How vulnerable is company to market shocks, increases in cost of capital and lower expected returns?

High standards in these and other related areas, and the pursuit of improvement, should result in improved valuation as a company should benefit from lower systematic (lower cost of capital) and specific risk (reduced incidence of tail risk events).

Given that ESG investments often generate non-financial (or pre-financial) information, a strategic financial framework should consider not only the impact on return metrics (e.g., profits, earnings, cash flows), but also value created. Such a framework should outline the value proposition of ESG investments, assess whether such investments have created value, and if possible, connect any value creation to the resulting financial information. A focus on value creation can help provide the critical linkage between investments in ESG resources and assets and return. If ESG investment continues to support and enhance the value created, the asset value and resulting benefit may be maintained indefinitely.

Equivalent considerations apply to liabilities that arise from ESG-related factors, including decommissioning and restoration obligations.

Conclusion

Both financial reporting and valuation expertise are key to the future development of sustainability reporting. Progress in both respects should ultimately lead to more effective communication with investors and other stakeholders which will enable improved investment selection processes and key decision making.

There is a way to go before regulators reach the point that will allow the ESG valuation impact to be fully reported on balance sheets.

Corporates need to remain aware of progress and developments, and to add their voice to address the right questions and add their support on the road to sustainability reporting.