The Materiality of Environmental Risk to Australia's Finance Sector
Ernst & Young
Environment Australia, May 2003
ISBN 0 642 54906 04
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About the paper
This scoping paper has been prepared by Ernst & Young for the Commonwealth Department of Environment and Heritage (Environment Australia) in a bid to raise awareness and contribute to the current level of debate on the materiality or significance of environmental risk to Australia's finance sector.
The paper extends upon excisting international literature as well as conclusions from recent local research including Towards Sustainable Finance: A Roadmap to the Finance Services Industry (Monash Sustainability Enterprises 2000) and The Role of Australia's Financial Sector in Sustainability (PWC 2001). This research suggests that issues of materiality or potential significance of environmental risk is not particularly well understood within Australia's finance community when compared with contemporary approaches in the USA, UK and Europe.
Approach to the engagement
Ernst & Young's approach to this engagement has been to consult with a representative cross section of the Australian finance sector.
Our approach aimed to draw out whether environmental risks, on a broad scale, are benchmarked against industry thresholds and whether such risks trigger management responses in the sector.
Our analysis focused on:
- The level of understanding, or perception of the key environmental issues, that the Australian finance sector considers to be material (short, medium and long-term) on corporate or financial performance.
- The adequacy of Australia's regulatory, disclosure and accounting requirements in dealing with environmental risk and performance issues against those of comparable jurisdictions (UK, Europe, USA).
Observations, key issues and conclusions
Observations and key issues identified in this paper are:
- An apparent lag in the Australian finance sector's approach to assessing environmental risks when compared with contemporary approaches internationally.
- A growing recognition within the sector of the need to encapsulate environmental risks in mainstream investment decision-making to ensure a balanced commercial view of the entire risk / investment profile.
- The emergence of contemporary environmental issues and the influence they have on the sector's perception of materiality in the medium to long term.
- The issue of public reporting of environmental risks and performance and whether this is best served by a voluntary or mandated disclosure framework.
- The issue of current accounting standards and whether they are appropriate in triggering disclosure of material environmental risks.
- Across the sector there is high variability in tolerance and appetite for environmental risk. The significance or materiality applied to environmental risks is also highly variable and dependent on a range of factors such as the subjectivity of excisting disclosure requirements, the overall length of investment timeframes and access and availability to analytical tools for assessing environmental risks in a financial context.
In researching and discussing these issues with key finance sector participants the following conclusions are drawn:
- The consultation revealed a notable absence of known examples in Australia where finance sector participants are aware of having suffered substantial financial losses due to environmental exposures. This is considered one of the main reasons why the debate on materiality or significance of environmental risk to Australia's finance sector is not as advanced as the UK, Europe and USA.
- The Australian finance sector has responded to increased public scrutiny of environmental performance by seeking to raise sectoral awareness of environmental risks. Segments of the finance community are beginning, albeit only recently, to engage in environmental risk analysis as it impacts on lending, capital raising and institutional investment.
- The sector's awareness of environmental risks is diversifying into strategic environmental risks that may materialise over a medium-to long-term time horizon. Examples include business risks and market opportunities associated with climate change and emissions trading.
- Environmental risks are however, still considered highly subjective in comparison to mainstream areas such as tax, regulatory, credit and operational risks. These risks are far better understood, considered significantly more important in an investment or deal context, and are backed by many more years of precedents, previous economic modelling and market impact analysis.
- The sector tends to rely heavily on subjective sources for information on environmental risks. This raises a possibility that finance sector participants may be receiving biased or a comparatively poor standard of information upon which to base assessments of environmental risks. It may also indicate an overall market absence of high quality environmental data that articulates potential economic or financial exposures from environmental risks.
- A subjective information base may be restricting the sector's ability to accurately assess or realise the full impact of environmental issues on investment decision-making. The level of understanding of how to deal with environmental risks and the sector's perceptions of what represents quality information might be more sophisticated if the sector was able to readily access relevant expertise and more robust and independently verified environmental data.
- A possible disconnect has emerged between the sector's increased awareness of environmental issues and its overall understanding of how it factors environmental risks into investment decision making. This could be resulting in an oversight of significant environmental risks in transactions as well as missed opportunities for leveraging upside commercial gains from environmental benefits, initiatives and projects.
- Across the sector the materiality or sensitivity to environmental risks is not uniform. Tolerance levels for environmental risks in some investment scenarios, such as investment banking, are exceedingly high while in other areas, such as screened funds, the tolerance levels are quite low. In circumstances where environmental risks are found to be proportionally high, the consultation revealed that finance sector participants might still accept these risks in return for significant financial gains from the investment.
- The excisting, largely voluntary approach to public disclosure of corporate environmental risks in Australia has raised concerns among finance sector participants in terms of the subjectivity under which risks are being reported. Some participants consider it likely that under a voluntary framework, companies could be accumulating environmental liabilities within their operational portfolios but not have adequate information systems to identify and assess the environmental risks or associated financial impacts. Known rising costs associated with environmental management in the corporate sector are typically being hidden in administrative (overhead) costs or co-mingled within various cost centres. Such scenarios are likely to have an impact on the accurate reporting and disclosure of environmental risks. The failure to disclose these risks in external reports could have wider long-term implications for the finance sector should these liabilities be allowed to accumulate into large aggregate financial exposures. The sector considers that this issue is likely to trigger a move to more mandated disclosure of environmental risks in the future.
- The current market approach, based on feedback from regulators, suggests that letting the market decide the appropriate level of disclosure is the most appropriate way of allowing opinion to be based on a blend of community, market and corporate expectations. This suggests that environmental disclosure standards will typically become more robust as the market increases its awareness and understanding of environmental issues. As the issue gains more significance in the marketplace, the regulators will adjust regulations accordingly. This is exemplified in the recent Financial Services Reform (FSR) and review of ASX listing rules in response to market concerns over corporate governance issues.
- Applying materiality in the accounting sense to environmental risks is complex. Inconsistency in determining materiality thresholds prevails across the finance community leading to widespread opinion on how significant environmental risks are to the sector in Australia. The valuation of environmental resources and services, and the associated valuation of costs connected with their damage, sits within the difficult and highly controversial discipline of environmental economics. The application of Accounting Standards to determining materiality of environmental risk is one that companies would undertake with caution.
- There is widespread recognition across the Australian finance sector that environmental risks are likely to become more material in the next three to five years based primarily upon tightening regulation, increased litigation and increased community and shareholder expectations of corporate environmental social and ethical performance. Key areas considered to be of importance and relevance to finance sector participants include contamination and pollution issues, carbon risk and climate change, unsustainable resource management practices and an escalating requirement for companies to manage environmental issues to preserve and / or enhance corporate governance, branding and reputation.
- The outcomes of the consultation and the findings of other recent international research suggest that the finance sector's high level interest in carbon risk and climate change issues will continue to develop as both a risk and commercial leveraging opportunity for finance sector participants in the medium to long term.
- The consultation revealed a growing recognition that finance institutions may be subjected to shareholder and stakeholder activism triggered by the involvement of an institution in environmentally contentious project financing schemes or lending to businesses that have poor environmental performance records. With corporate branding being increasingly recognised as a substantial part of the real worth of a company, the finance sector recognises that the disenfranchisement of such stakeholder groups will put the future brand and reputation of the institution at significant risk. A more open dialogue between financial institutions and the community are considered a necessary next step in proactively managing the needs and expectations of these stakeholder groups and, ultimately, protecting the value of the institution.
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