As more governments around the world set ambitious net-zero emissions targets, the importance of climate disclosure has never been more crucial for business. Coupled with investor-driven pressure to disclose material climate-related issues, the need for corporate leadership to present reports with clarity and transparency is essential.

The recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) have brought visibility to these financial and investment risks, driving the uptake of climate-related narrative reporting in the ‘front half’ of company statements. But the omission of climate-related information within financial reporting (the ‘back half’) is glaring.

A 2020 Climate Disclosure Standards Board (CDSB) review of non-financial reporting by 50 of the largest companies in Europe found that 100% of them provided some narrative on climate-related matters, while only 10% referred to climate-related matters in their financial reporting. Similarly, independent thinktank Carbon Tracker reviewed 107 publicly listed carbon-intensive firms in its 2021 report, Flying Blind: The glaring absence of climate risks in financial reporting, revealing that 70% had failed to disclose climate risk in their financials.

Defining ‘material’ risks?

Companies need to indicate clearly how they have incorporated material climate-related risks into their financial statements. But what is ‘material’ under existing standards?<

Materiality can be described as a concept to guide the application of professional judgement for the purpose of determining acceptable levels of disclosure in mainstream reports, thereby informing decision-making by the users of those reports.

An article published by the International Accounting Standards Board in 2019, complemented by educational material issued by the IFRS Foundation in 2020, clarified that although the IFRS Standards do not explicitly refer to climate-related risks, these must be reflected in financial reporting where considered material. Significantly, it is explained that investor expectations may make some risks ‘material’ and therefore meriting disclosure in the financial statements, regardless of their numerical impact.<

This is evident when considering the impairment of assets, for example. Under IAS 36 Impairment of Assets, companies shall “assess at the end of each reporting period whether there is any indication that an asset may be impaired. If such an indication exists, the entity shall estimate the recoverable amount of the asset.” It is plausible that a company in an industry likely to be affected by climate-related risks determines that climate risk does not have a quantitatively material impact on its impairment testing.

However, considering investor sentiment on the importance of climate-related risks to their investment decisions, and reasonable expectations that the recoverable amount of the company’s assets could be affected by such risks (based on reporting by other companies in that industry), the company may conclude that it needs to disclose information to explain why the carrying amounts of its assets are not exposed to climate-related risks. This may provide material information to investors, even though the carrying amounts in the financial statements are not exposed to those risks.

The IFRS Foundation’s educational material also explains that a company is required to consider whether to provide additional disclosures when compliance with the specific requirements of IFRS is insufficient to enable investors to understand impacts on the company’s financial position and performance. In addition, the TCFD cautions organisations against prematurely concluding that climate-related risks and opportunities are not material based on perceptions of the longer-term nature of some climate-related risks.

Investors have made it clear that climate-related risks are material to their investment decision-making, for both allocation of capital and stewardship (see the 2020 open letter by investor groups representing assets more than $103trn). As primary users of financial reports, they expect companies to reflect material climate-related matters (alongside other natural capital) in their financial statements and to provide additional disclosure on judgements and assumptions used in relation to climate issues.

Challenging as it may be, companies can no longer avoid considering, quantifying and reporting on material climate-related matters.

Global consistence

With leading regulators – the US Securities and Exchange Commission, the EU and the G7 – showing interest and support for expanding mandatory disclosure laws, will we also see regulators mandating integration into financial statements in the coming years? The fact is, today, if you are an IFRS preparer, it is already mandatory. With clear investor demand for consistency and integration, the appetite to put sustainability risks into monetary terms is growing. When we see narrative reporting in the front half varying from the financial statements in the back half it erodes confidence. Regulators will need to increase supervision and enforcement on disclosures in financial reporting as there is still a lack of consistency in this information.

The TCFD recommendations are becoming the de facto standard for reporting worldwide. An important part of the recommendations is the monetary inclusion of climate risks into financial statements and this is where companies have been failing in – or avoiding – their disclosures. Organisational net-zero target reporting, without the accompanying financials in the back end, only contributes to ambiguity. If information is material, then it must be reflected in the financial statements.

The United Nations Framework Convention on Climate Change reports that 70% of global GDP is covered by net-zero targets and yet the bulk of corporate reporting remains aligned to a 3° – or perhaps 4° – trajectory.

The IFRS Foundation’s International Sustainability Standards Board (ISSB) should play a role in filling this gap in reporting. A globally consistent set of sustainability standards based on enterprise value materiality has been welcomed and has received broad support from the G7 finance ministers, the G20, global regulators in the form of the International Organisation of Securities Commissions, investors, corporates and other standard-setting organisations.

Through extensive global stakeholder engagement and 576 comment letters submitted, the IFRS Foundation’s Trustees saw broad demand for the ISSB to play a role in creating a globally consistent sustainability reporting landscape. Indeed, part of the appeal of the ISSB being housed under the IFRS Foundation, alongside the IASB, is that it should lead to complete, coherent and consistent reporting of sustainability matters, including climate, by companies.

Challenges of monetisation

Climate change is inherently uncertain, be it the extent or timing of physical or transitional risks on a company, which creates difficulties in quantifying and managing such climate-related risks and, in turn, how these are reported.

Challenging as it may be, this is something that can no longer be avoided. A range of forward-looking information is already embedded in financial reporting in areas such as fair value accounting, impairment testing, the measurement of provisions and the recognition of contingent liabilities. Such information is a collection of judgements and estimates, based on the best data available to preparers. Climate risk is another matter that should be considered, like any other material risk to a business. To a degree, preparation of financial reports will always include a level of uncertainty and in this sense the consideration of climate-related risks is not fundamentally different.

Companies should disclose the significant assumptions, judgements and estimates likely to be impacted by climate-related matters, enabling investors to review and analyse this information. Critically, assumptions should be consistent with (or not contradict) the narrative reporting by a company, both internally (even if not publicly available) and externally.

This is no easy task for companies. As part of CDSB’s mission to advance the integration of decision-useful environmental and natural capital information into the annual report, we produced guidance in 2020 on Accounting for climate. The aim of the guidance is to support preparers in understanding why material climate-related matters need to be reflected in financial statements and how they can begin to do so, complementing the existing position of the IFRS Foundation and the IASB.

Reflecting climate risk in financial reporting is receiving more attention than ever from investors, regulators, auditors and others, and it’s time for companies to step up.

About the author
Sundip Jadeja, Technical Manager, Climate Disclosure Standards Board