Companies are setting increasingly bold environmental goals and ambitious commitments to reduce carbon emissions. Yet these important promises are rarely mirrored in their financial statements, making it difficult for investors and other stakeholders to see the relationship between a company’s financial and sustainability performance. This could change if new sustainable accounting standards come to fruition and regulators act on growing investor pressure to introduce mandatory climate disclosure. Reporting the physical, transition and regulatory risk of climate change would go to the heart of companies’ risk management and governance processes and calls for hands-on treasury and finance expertise.
The IFRS Foundation, the body that oversees the work of the International Accounting Standards Board, IASB, in setting financial reporting requirements for most companies in the world outside the US (where these requirements are set by the Financial Accounting Standards Board) is on track to launch a Sustainability Standards Board, SSB, at the UN’s COP26 climate summit in November. All being well, the new standards will give investors and other stakeholders as clear a view of corporate sustainability as they currently do financial performance in one, integrated report.
Moreover, the different and acronym-heavy measurements and reporting standards surrounding ESG will be replaced with a standard norm. “The idea is that all the different standards will converge into the SSB and take standards forward into the future,” explains Emily Kreps, Global Director of Capital Markets at CDP, a global non-profit that uses investor pressure to cajole companies to disclose around environmental performance.
Elsewhere, Gary Gensler, Chair of the SEC in the US, recently spoke up in favour of the regulator forcing greater clarity and consistency in corporate climate disclosure, flagging new policies towards the end of the year. Earlier in June, the G7 agreed to force companies to report climate issues in line with the global Task Force on Climate-related Financial Disclosure, created in 2015 by the Financial Stability Board to develop broad but consistent climate-related financial risk disclosures for use by companies worldwide.
Carbon intensive industries
The need for financial statements to mirror the reality of climate change is important for all companies but particularly carbon intensive industries, says Barbara Davidson, a Senior Analyst at the Carbon Tracker Initiative, an independent financial think tank which analyses the impact of the climate transition on the capital markets. Her team combed through the sustainability and audit reports, proxy and annual financial statements of companies in the oil and gas, transport and utility sectors to see the extent to which climate-related risks and corporate climate pledges flowed through into financial statements to reflect changes like falls in product demand or commodity prices as the climate emergency grows.
Their findings are worrying. Despite COVID laying bare the impact of falling oil prices on oil companies’ profitability, few oil majors reflected lower oil prices, declining demand in line with IEA scenarios, or regulatory fuel on the fire shortening the lives of assets in their expected future cash flows. “Faced with declining prices as a result of climate change, oil and gas companies will not be able to recover the value of their assets from expected future cash flows,” predicts Davidson. “The costs of running these assets will also go up with efforts to reduce emissions and rising carbon prices.”
It’s not just most oil groups inaccurately reflecting the resilience of their assets to climate change in their financial statements. A decline in demand for a myriad of products that emit greenhouse gases could hit all kinds of manufacturing plants making the products. In the transport sector, companies have made bold statements around electrification but the impact on the company of meeting these promises from increased costs, investment and the impact on margins is rarely accounted for.
As for utilities, companies need to accurately account for continued product demand in a low carbon world, and put the cost of changing their offering, the impact of regulation, access to renewable energy and costly new infrastructure into their financial reporting. “Do they have long-term agreements in place to purchase fossil fuels, and if so, how will regulation impact those agreements?” asks Davidson. “When we look at most companies’ financial statements, we don’t know if they have actually considered climate issues when assessing asset impairments.” Elsewhere, she says few companies appeared to consider the costs and impact of their Paris commitments to reduce emissions in their financials.
The role of treasury
The task requires all hands to the pump. Finance and treasury teams need to understand how changes in corporate strategy and the impact of regulation will translate into the estimates they use to prepare their financial statements. Moreover, finance teams sitting in the heart of a business are in pole position to source information and act on it. “You can’t have procurement making decisions on energy sourcing and not involve finance teams,” explains Kreps. And because accounting for these issues will impact the operations of many companies, it requires governance and risk management expertise too. Teams made up of people from different business lines rather than keeping the process siloed in sustainability works best.
Treasury also has a central role explaining to investors how they are addressing the issue. Even if integrating the impact of climate change into financial statements is still early stage, treasury and finance need to show investors their sensitivity to the job in hand. Next comes board oversight to ensure the process is mainstreamed into the company, filtering into internal processes. “One of the first questions we always ask is if there is management level oversight, and where the team gathering the data sits,” says Kreps.
Auditors also play a role, challenging companies on how they are considering these issues and if financial statements are materially updated to reflect climate change. Calls for auditors to do more are growing louder. Many companies file their statements outside the US but list on the US stock exchange in a dual listing that follows two different audit standards. While the risks remain the same, US audit reports often exclude reference to any climate-related considerations. “It means the US market gets less information,” says Davidson. “If US investors are only reading the US filings and US audit reports for these companies, they may receive less information than their overseas counterparts.” A key challenge for auditors is that the timeframes that companies use for calculating expected cashflows do not always cover their timeframe for emissions reductions.
A good place to start is disclosing to CDP, says Kreps. The process gives companies an understanding of the types of questions and information they will need to begin to source, builds capacity and educates. “What we provide gives companies a way to prepare for the regulatory environment we anticipate coming.”
Evaluating, understanding and ultimately gathering the metrics companies will need is daunting. “They are not easy metrics to measure,” she says. “It is a significant shift for companies to track, collect and estimate this forward-looking component. It is not like traditional financial disclosure where finance teams can assume how a business line or company will perform in the future – it is much more difficult to do this with environmental metrics.”
But she insists the tools and methodologies are available, like the Science-Based Target Initiatives which have industry specific methodologies to help companies think about calculating their climate impact and modelling. Elsewhere, the PCAF (Partnership for Carbon Accounting Financials) helps financial institutions report their greenhouse gas emissions. “It takes time to adopt these different standards and understand them. The plane is being built as it’s being flown, and this is disconcerting and challenging for treasury teams.”
One potential catalyst for change could come from linking executive pay to meeting climate targets instead of using current metrics linked to profits. This in turn would make climate accounting and reporting processes central. “The more that compensation remains linked to profits which exclude climate targets, the harder it will be to shift practices,” says Davidson, who notes that only “a handful” of companies currently link compensation to meeting emissions reduction targets.
IFRS standards may not be mandatory, and they are also likely to be location and industry specific. “A standard that is relevant to the EU could be different for a resource intensive economy like South Africa so there will need to be nuances,” says Kreps. And although new standards will be unveiled at COP26, the reality will be a long, drawn-out introduction. IFRS accounting standards, and the generally accepted accounting principles, or GAAP, took almost 30 years for consensus. The process will be iterative and evolve over time, with the first mandatory disclosure looking very different from the third iteration. Still, the most important thing is for companies to get started on integrating climate impacts into their financial reporting. “Start now because the reality is the planet doesn’t have the time,” concludes Kreps.