Earlier this year I wrote about the importance of including the financial effects of material climate-related risks in financial statements, and highlighted an International Accounting Standards Board (IASB) paper that clarifies how International Financial Reporting Standards (IFRS Standards) address the treatment of such risks.
In September, global investor groups (representing over US$100 trillion in assets under management) published an open letter confirming that climate-related risks are indeed material to their decision-making. The investors urged companies to follow the IASB paper by including relevant, material climate risks in their IFRS financial statements.
Ideally, investors would like management to use assumptions and estimates that align with the goals of the Paris Agreement. At a minimum, management should disclose how they address relevant, material climate-related risks, even if they do not adjust their accounts as a result.
The investors also asked auditors to challenge management if such information is excluded from financial statements, and regulators to include this in their enforcement actions. Additionally, the International Auditing and Assurance Standards Board (IAASB) issued a staff audit practice alert to remind auditors how the consideration of climate risks fits in with their responsibilities.
Why is this necessary?
Economies need some time to react to climate-related risks to achieve systemic stability. It may take many years to shift to low-carbon industries, scale up the necessary technologies and train employees.
A large part of this transition is providing investors with the information they require to make appropriate and timely capital allocation decisions.
Today, investors have little visibility of the effects of climate-related risks on financial performance and position, including whether management have reflected the relevant impacts in the accounts and if they have strategies in place to address these risks.
Investors need to know if management have used sustainable assumptions when preparing their financial statements and if not, why not. Equally, information in the financial statements needs to be consistent with the climate-related discussions in the front end of annual reports.
Estimating the effects
A common example of why investors need better climate-risk information in financial statements is the extractive industry. Companies operating in this area have generally failed to allow for the impact of material climate-related issues on their operations and strategic decisions.
For example, despite the growing number of policies to reduce or eliminate the use of coal-fired power for residential electricity, many coal companies continue to assume that their assets have useful lives that extend beyond any reasonable deadlines to phase out the use of coal.
In the face of commitments to reduce CO2 emissions, companies with operations incompatible with climate goals will find it increasingly difficult to continue with business as usual
They continue to invest in new mines and use inflated prices when testing assets for impairment, while failing to explain how these actions correspond to local and global moves toward net-zero emissions.
My own attempt to recast a coal company’s assets by using sustainable assumptions resulted in an impairment loss six times the amount of the company’s already significant reported net loss. The paucity of information provided by the company meant that there was no way to confirm the reasonableness of my calculations. This highlights why investors are simply not able to accurately value companies with the degree of certainty necessary to make sustainable investment decisions.
Recently, companies such as Repsol Group, Shell and BP have started responding to investors’ requests. However, investors want to see more of this, and across all industries.
What’s next?
In the face of global commitments to reduce CO2 emissions, companies with operations that are incompatible with achieving climate goals will find it increasingly difficult to continue with business as usual.
The investor letter requested the use of sustainable assumptions and better transparency in IFRS financial statements. Companies that use assumptions and estimates that do not reflect the move to a low-carbon economy need to explain why.
Investor groups hope that the timing of the letter means that companies will include this information in their audited financial statements for 2020.
Individual investment organisations will use their powers as shareholders to enforce these requests. Accountants and auditors have a key role to play, including challenging management and engaging with investors.
Science is clear that climate change is a reality. The only uncertainty is the amount of time and carbon budget remaining to address it. The IASB and the IAASB have given us the financial reporting tools, while Covid-19 has given us the opportunity to regroup, to implement better policies and to shift our strategies and investments to low-carbon activities. Let’s not waste it.
