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Financials remain woefully short on climate information

Author: ICAEW Insights

Published: 23 Nov 2021

Barbara Davidson, Senior Analyst – Regulatory and Accounting at the Carbon Tracker Initiative says that without an understanding of the impact of energy transition on company financials, the extent of capital at risk – and whether funds are being allocated to unsustainable businesses – remains largely unknown.

It is these unknowns that will reduce our chances of achieving the goals agreed in the Paris Agreement, points out Davidson.

She – along with Rob Schuwerk, Executive Director, Carbon Tracker North America – co-authored the report ‘Flying blind: the glaring absence of climate risks in financial reporting’. It reveals that over 70% of some of the world’s biggest emitters failed to disclose the financial effects of climate risk in their 2020 financial statements, and 80% of their auditors showed no evidence of assessing the impacts of climate risk during their audits. And all the while, these companies face significant financial risk from the climate crisis. Many have made net-zero pledges.

The report covers the 2020 filings and other relevant reports produced by 107 publicly-listed companies primarily in the EU/UK and in the US. This cohort of companies included 94 that are part of the Climate Action 100+ focus companies, which have significant carbon footprints and whose future actions are crucial to energy transition. Sectors included oil and gas, transportation, utilities, cement, consumer goods and services, and other industrials. Carbon Tracker partnered in this endeavour with the Climate Accounting Project, a team of experts commissioned by the Principles for Responsible Investment.

“The starting point was companies that would either have a significant impact on the energy transition or would be involved in transition,” says Davidson. “We therefore assumed their financial statements would already consider the financial effects of energy transition.”

She reminds us that in 2019 and 2020, global accounting and auditing standard-setters clarified that material climate-related risks should not be ignored in accounts or audits. “So we looked for how and whether the assumptions and estimates that management is already using could be affected by climate change. We weren't expecting companies to come up with new inputs into their financials,” she says.

“We focused on items in the accounts that would normally have an interaction with long-term estimates and assumptions. A common issue was the effect on asset impairments and asset lives, especially productive assets for energy companies and some industrials. Timing of decommissioning obligations was another important item. We often looked for a discussion of the effects on residual asset values, leased assets and receivables for transportation companies. Overall, we also looked for evidence of onerous contracts.”

She continues: “If it was unclear what might be affected, we looked at industry risk or risks that companies talked about outside their accounts. We also looked at their significant assets to see where most capital might be at risk and to understand how those might be affected by the energy transition. But fundamentally all of this should already have been in the accounts.”

“We also looked at audit reports. Auditors have to report on key (or critical) audit matters, depending on the jurisdiction. Those are matters that would be subject to significant estimates and judgements by the auditor or the company. And we all know that the uncertainty of the energy transition can lead to significant judgements and estimates” Davidson says. “Most auditors identified impairment, which uses estimates of long-term cash flows, as one of these matters. So we expected auditors to mention how they addressed the impacts of the energy transition on assumptions and estimates used. We were surprised by the results of the audit reports.”

The two teams also looked at discussions in sustainability reports and the ‘front-end’ of annual reports such as management commentaries for consistency in reporting. The report also looked at whether the companies’ accounts were ‘Paris-aligned’ – something that is not required by existing standards – as investors have requested this information in order to understand the extent of assets at risk and the resilience of investment portfolios in the face of decarbonisation.

As for the definition of Paris alignment, Carbon Tracker referenced the preferred Paris Agreement goals of achieving no more than 1.5°C warming and net zero by 2050. “Unfortunately, most companies did not even talk about the scenarios that they used. None used assumptions or estimates, such as commodity prices, which would align with these goals,” says Davidson. 

“Some investors had previously communicated that they wanted auditors to independently check and comment as to the Paris alignment of those assumptions and inputs. And they wanted the auditors to do a sensitivity analysis to those assumptions and inputs if the company did not.” While they used the IEA NZE2050 price deck for assessments, Davidson said that other scenarios also addressed these goals. 

However, she disagrees that financial statements should provide a 360° measurement of the company’s impacts on the environment. “The financial statements are not going to measure impacts on natural capital because that’s not how financial accounting works today. Instead, there are some sustainability standards that try to achieve that. But addressing the financial impacts of these issues on companies is a good way of reducing the impact on the environment. This should lead to reduced emissions by showing management that if they don’t change strategies, they will continue to invest in unprofitable activities and lose significant amounts of capital.”

Davidson believes that we don’t need new financial reporting standards to address the financial impact of climate risk. The existing standards enable management to give investors a good amount of information to understand if their capital is at risk. That’s the main point of this effort,” she says. “In 2020, investors representing over $100 trillion in AUM made clear the information that they need in financial statements (and audit reports). Investors are starting to think about how they’re going to vote. They’re going to try to remove directors from the board. They’re going to look at companies’ climate policies, whether they can vote against the accounts. If they can, they will vote out certain directors, vote out the heads of the audit committees, and they might vote against reappointment of the auditors.” 

Does Davidson believe the markets have the answer to reporting on climate-related risks or ultimately does it depend on the imposition of policy and regulation on companies to make it very unattractive to be a carbon-intensive industry?

“We all have a role to play, including policy and regulation. However, some argue that the markets have already priced in the impact of the energy transition. If that was true we shouldn’t see continued investments in loss-making activities. We need better disclosure of this information – to ensure the efficiency of the markets and to drive change. Part of this is effective engagement and conversations between investors and companies so that companies know that investors need this information to understand the financial effects of climate risk and the extent to which their capital is at risk.”

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