Financial reporting that accurately reflects companies’ exposure to climate risks is a crucial piece of the puzzle in understanding progress towards achieving the goals of the Paris Agreement. But many companies are yet to provide substantive reporting on this issue.
COP26 saw negotiators debate between a ‘phase out’ and ‘phase down’ of coal, but the implications for assets on the balance sheet are quite similar for companies. Along with growing investments in renewables and numerous net-zero initiatives, these discussions signal that fossil fuels’ days are numbered. Current financial reporting must reflect that.
Transition policies, regulations, changes to demand and implementation of emissions reduction targets are happening today. These and other climate-related matters can significantly impact a company’s current financials, especially for assets and liabilities valued using estimated long-term cash flows. Remaining asset lives, commodity prices and/or changes to growth rates, all of which are affected by the energy transition, directly feed into asset impairments, the timing of decommissioning obligations and tax assets, to name a few.
While impacts on corporate profits and financial positions hardly make climate headlines, the reality is that changes to balance sheets drive investor engagement, voting and capital allocation decisions. Without these disclosures, global coalitions such as the Glasgow Finance Alliance for Net Zero cannot effectively allocate capital to ‘keep 1.5 degrees alive’.
Fortunately, current accounting and audit standards already require consideration of material climate matters. This is why in 2021, Carbon Tracker and the Climate Accounting Project analysed the financial reporting of 107 carbon-intensive companies for consideration of such matters.
The results of our analyses, published in the report, ‘Flying blind: The glaring absence of climate risks in financial reporting’, were disappointing. More than 70% of these companies and 80% of their auditors provided no evidence that they considered the financial impacts of climate change for the 2020 audited financial statements. Investor requests to align financial reporting with achieving the goals of the Paris Agreement went largely unanswered.
Ignoring climate-related matters can lead to overstated profits and assets, understated liabilities and investments in non-sustainable business activities. This misallocation of capital reduces our ability to achieve the goals of the Paris Agreement, yet fails to receive the attention that it deserves.
Declining oil and gas prices — a likely long-term trend associated with declining demand — might significantly reduce companies’ abilities to generate returns by using existing property, such as plants and equipment, potentially leading to impairments and stranded assets. While 77% of the audit reports we reviewed identified impairment as an audit matter, only 25% of the auditors acknowledged and assessed the impacts of the energy transition on relevant future cash flows related to such assets, much less the reasonableness of other estimates, such as the remaining useful lives of asset — some of which extended well beyond the timing of the actual regulations.
Auditors have an independent duty to scrutinise and challenge management’s significant financial estimates and judgments. They need to examine the material effects of the energy transition and disclose how they tested them. Investors expect and need this check. Accordingly, auditors need to implement consistent firm-wide policies and provide greater transparency about how they have addressed such matters. Regulators must increase their oversight and reviews of whether financial statements consider the requisite material climate-related impacts, and ensure that auditors step up as well.
Companies need to improve governance and increase transparency over these issues. Board oversight via audit committees, along with integration into risk management and control systems, are key. Finally, investors must engage with companies and auditors on these matters — and make their expectations clear — when possible.
There is a growing recognition of the role of corporate reporting in providing better climate information. The recently announced International Sustainability Standards Board is aiming to create a global, comparable set of sustainability standards, that we support. But we must not forget that vanilla financial reporting, such as that covered by the International Accounting Standards Board, already requires companies to address the financial risks flowing from sustainability challenges. Allowing companies to brandish green credentials without assessing their impact on the accounts is effectively just greenwashing, which leads to potential misstatements and puts financial markets and society at significant risk.
Barbara Davidson is a senior analyst and Rob Schuwerk is executive director for North America at think tank Carbon Tracker.
