Why is it important that climate-related risks are reflected in financial accounts? Because they are material and investors have a fiduciary duty to manage the impact of those risks on their investment returns.
Finance played an integral role at COP26, having previously been relegated to the fringes. This year, finance ministers and investors were welcomed onto the main stage and displayed the extent of the private sector’s commitment to playing its part in addressing climate change.
The issue of climate accounting was largely absent from official discussions at the conference but on the last day, Carbon Tracker (CTI) – in coordination with Ceres, IIGCC and PRI – brought this issue to the forefront at a side event hosted in the Federated Hermes fringe space. Barbara Davidson, a senior analyst at CTI, opened the event by sharing findings from their report published in September 2021 entitled: Flying Blind: The glaring absence of climate risks in financial reporting.
As part of this research, CTI, along with the Climate Accounting Project and PRI, analysed 107 publicly listed companies, most of which feature on the focus list of Climate Action 100+. The results were disappointing:
- 70% of carbon intensive companies gave no indication that they considered climate- related financial risk in financial statements and only 25% provided quantitative inputs (such as the number of years of assets’ lives)
- 80% of auditors did not provide evidence of consideration of climate in audit reports and only 25% looked at the impact of climate on impairment, despite previously saying this was important
- 72% of companies had inconsistent reporting across their financial reporting and other information (e.g. sustainability reports) and 59% of auditors provided no indication of the inconsistency that CTI found when comparing other information and financial statements
“This is a big problem. The impacts of ignoring these issues – if this is what is happening – can lead to overstated assets, overstated profits, understated liabilities, significant capital at risk, misallocation of capital and so effectively missing our chance of achieving the goals of the Paris Agreement.” – Barbara Davidson
Barbara was joined on the panel by speakers from across the financial spectrum: Anne Simpson of CalPERS, Natasha Landell-Mills of Sarasin & Partners, Nick Anderson of International Financial Reporting Standards (IFRS) and Bridget Beals of KMPG.
Panellists discussed where things currently stand on reflecting climate-related risk in financial accounts and what needs to happen to make this an imperative. A number of key themes emerged:
Producing accounts based on BAU scenarios is misleading. Investors need to see climate risk reflected in company reports’ scenarios and assumptions in order to accurately assess risk and capital allocation. Balance sheets should not be drawn up on future assumptions that reflect past demand or do not accurately reflect major structural shifts underway. Inaccurate accounting was likened to reading the label on a tin of beans, buying the tin and opening it to find out it’s not what you expected.
Net zero commitments must be backed up by net zero aligned accounts. 1.5°C aligned numbers are needed to get 1.5°C aligned capital allocation. Net zero aligned commitments should be paired with net zero aligned accounts – there’s no reason they shouldn’t match up.
The necessary accounting standards exist but they are not being enforced or implemented by companies or auditors. The standards produced by the IFRS are voluntarily adopted in 145 countries. But the IFRS only has the mandate to set the standards; enforcement is the responsibility of regulators in each individual country. It is therefore up to them to step up and enforce existing rules and up to policymakers to make net zero accounts mandatory. ESMA, a collection of regulators, recently published enforcement priorities and there are some very strong words in there, saying companies need to be thinking seriously about reflecting the size and magnitude of risk.
The 2008 financial crisis should act as a lesson and forewarning of misaligned accounts: Parallels were drawn between mythical accounting numbers that contributed to the 2008 financial crash as they did not accurately reflect the risk facing companies and accounting numbers today that don’t reflect material climate risk. There were calls for executive compensation to be linked to long-term goals so that company internal incentives are aligned with Paris (1.5°C), and further calls for bonuses to be paid out only where accounting is aligned with net zero and not where numbers do not consider climate-related risk.
Investors should use the power of their audit-related vote at AGMs: The auditor works for the shareholders. Investors need to scrutinise their performance when it comes to judging if material climate risks are accurately reflected in the accounts. There was a prediction of more votes against misaligned accounts next year, and even if this only happens at a few high-profile companies, it could generate a ripple effect.
Covid has changed risk assessment: The last 24 months have seen three key areas of understanding evolve: physical risk, transition risk and the systemic nature of those risks. Climate science and modelling is improving all the time, particularly around tipping points and feedback loops. Humans will always underestimate systemic risk but Covid has been an important line in the sand here on increasing understanding and modelling risk through economies.
Everyone has a role to play in ensuring net zero aligned accounts: Companies clearly need to provide better disclosure about what they have and haven’t done in financial reporting and improve climate governance. Boards and audit committees need to ensure climate is considered in their risk management systems and audit committees need to discuss these issues with their auditors. Auditors need to provide better transparency on their handling of these issues, if they are considering them or not, and give signals of what they are doing internally and how they are working with companies and audit committees to achieve integration of climate matters. Regulators need to start identifying if companies are including material climate-related issues and their financial impacts in financial reporting and increase their enforcement oversight of these issues. Investors need to make expectations clear, engage with management and look at the impact of CTI’s report and capital allocation decisions.
New accounting indicator in Climate Action 100+ Benchmark is an important practical tool: Climate Action 100+ is using the force of the total AUM its signatory base is responsible for – 600+ investors responsible for USD 60T in AUM – to ensure 167 companies on its focus list develop sustainable business strategies and report on them. Climate accounting is critical to this transparency and accountability and this is why a new indicator on climate accounting and audit has been added to the Net-Zero Company Benchmark. The next iteration of company assessments will be published in March 2022. This is a practical tool for investors, companies and auditors and will help to set the stage for investors to fulfil their fiduciary duty when they are voting on audit committees or the re-appointment of the auditor.
For more information on the Benchmark’s climate accounting and audit indicator, see here.
You can watch the full COP26 panel discussion here.
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Notes
In June 2021, Ceres published a report entitled Lifting the Veil: Investor Expectations for Paris-Aligned Financial Reporting by Oil and Gas Companies. The report found that many U.S. oil and gas companies had neither set targets nor fully acknowledged the financial implications of the energy transition.
In November 2020, IIGCC published a report on Investor Expectations for Paris-aligned Accounts, setting out five clear steps companies should take in preparing ‘Paris-aligned’ company accounts. It also outlined expectations for auditors to call out where accounts are ignoring material climate risks and making it clear they should say when accounts are not ‘Paris-aligned’.