As countries slowly emerge from their Covid-19 lockdowns, there is a push for recovery policies that will build long-term resilience to climate change while boosting economies.
‘Build back better’ discussions recall the UN’s Sustainable Development Goals and the promises made under the Paris Agreement. Public and private funding are fundamental to meeting these objectives. Now more than ever it is crucial that capital is carefully and appropriately allocated to economic activities that will move us forward and avoid carbon-intensive lock-ins.
To identify sustainable investments, investors need to understand both the current and the long-term effects of climate-related risks on companies. Unfortunately, company disclosures continue to come up short in these areas.
Investor organisations such as the Principles for Responsible Investment, the Institutional Investors Group on Climate Change, the Net-Zero Asset Owner Alliance and Climate Action 100+ (many of which include large asset managers such as BlackRock, Allianz Global Investors and Legal & General Investment Management) have stressed the need for better climate-related corporate information in order to effectively allocate capital. This is especially important for investments in carbon-intensive sectors, including (but not limited to) energy supply, transportation and industrial activities.
Climate-related disclosures to date have focused on companies’ long-term strategies and resilience. Guidance related to this important narrative reporting is provided by sustainability standard-setters, and initiatives such as the Financial Stability Board’s Task Force on Climate-related Financial Disclosures. At present, such ‘non-financial’ information is typically found outside of the financial statements; investors also need to understand the effects of material climate-related risks on companies’ current financial positions and performance.
Accounting standard-setters, such as the International Accounting Standards Board (IASB), develop such financial reporting requirements. IFRS Standards are principles-based accounting standards and so do not explicitly mention climate-related risks. However, the IASB has also issued guidance – in the form of IFRS Practice Statement 2: Making Materiality Judgements – to help management gauge the importance of issues to investors. Additionally, investors have indicated that climate-related risks are crucial to their decision-making.
Despite this, climate-related information is rarely discussed in financial statements. When it is included, it is frequently inconsistent with companies’ non-financial narratives. But a recent article, IFRS Standards and climate-related disclosures, by IASB board member Nick Anderson, may help address this deficiency by clarifying how material climate-related risks can fit into the preparation of IFRS-based financial statements.
Materiality
Materiality is a key component in determining what should be disclosed in financial statements (including the accompanying notes). Under IFRS Standards, information is material, and therefore included in financial statements, if it could ‘reasonably be expected’ to influence decisions that investors make when using those financial statements. The IASB article clarifies how climate-related risks may be relevant when applying specific IFRS requirements, such as those related to impairment, fair value measurement, provisions and contingencies.
The market’s ability to react to climate-related risks could be the difference between stability and recession
The article provides a further reminder that IAS 1, Presentation of Financial Statements, requires management to explain the assumptions used if that information is material to investors and is important to a further understanding of financial statements. This may apply even if IFRS Standards do not specifically require such information, or if management did not adjust their financial statements as a result. In other words, complying with IFRS Standards means disclosing material, relevant climate-related risks to investors.
Materiality can be qualitative or quantitative, or both; omitting the effects of a risk can in itself be material. For example, if a company operates in a carbon-intensive industry and its peers have recorded asset impairments as a result of climate-related measures, such as upcoming regulations to phase out fossil fuels or limit carbon emissions, then investors in that company want to understand how such measures affect it. Did management factor in the effects of these policies when valuing assets and liabilities? If not, why not?
Disclosing this information enables management to explain their internal processes and stewardship to investors. Disclosure could also help management and auditors demonstrate they are listening to stakeholder concerns (such as those discussed in the UK’s Brydon review of the audit industry).
Lawsuits and shareholder resolutions seeking better climate-related information from companies are becoming more common. Complaints include failure to disclose crucial climate-related risks that management knew would affect their businesses.
Greater transparency saves time and money for everyone involved. It gives investors insight into stewardship including whether management is, in their view, responding to climate risks appropriately. This enables investors to engage with management more effectively so they can evaluate companies’ long-term sustainability and potential for future value creation. Insufficient disclosure prevents investors from effectively comparing their own valuations to companies’ reported information and from making informed decisions such as determining viable investment opportunities.
The treatment of material climate-related risks can affect a company’s current financial position and performance. For example, investments in carbon-intensive assets will likely face early obsolescence as a result of climate regulations and renewable energy policies; investing in ‘stranded assets’ could reduce cashflows and profitability, and diminish a company’s ability to respond to new regulations or technologies. An asset’s useful life can impact reported profitability – depreciating a coal mine over 10 years instead of 30, for example, may significantly reduce profit margins.
The falling cost of renewables means that previously profitable energy contracts could lose money; disruption to supply chains caused by climate-related events could mean business failures. Accordingly, investors need to know whether and how reported numbers reflect these and other risks, or why management chose to exclude such information from their assumptions and estimates. When aggregated, the market’s ability to react to this information could mean the difference between financial stability and a global recession – or worse.
Positive progress
Material climate-related risks can no longer be ignored in financial reporting. Investors anticipate that the recent IASB article will help improve transparency by acting as a tool that will enable auditors, enforcement bodies and stakeholders to obtain the information they need to further challenge management’s assumptions and estimates, especially for carbon-intensive industries.
As the world faces its new normal, the ability to obtain better climate-related information will be crucial in determining whether we can achieve global temperature goals and move forward positively.
