Climate risk considerations in traditional financial reporting – pressure on companies is expected to mount

In this article we reflect on the growing push by investors and regulators for companies to provide transparency in their traditional financial reporting on climate-related considerations.

The rise of climate reporting

The need for harmonised climate reporting has quickly gained support over the past couple of years. Whilst there are many frameworks that can assist market participants, the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) have definitely taken the spotlight: the framework provides guidance on reporting climate-related risks and opportunities across four main pillars – Governance, Strategy, Risk-Management and Metrics/Targets. More than 2,600 organisations have now endorsed the recommendations; an increase of over 70% since last year. TCFD supporters span 89 countries and jurisdictions and nearly all sectors of the economy, with a combined market capitalisation of over $25.1 trillion – a 99% increase since last year.

At the same time, governments have started the process to put into law the requirement for companies to make disclosures according to the framework (Including the European Union, the United Kingdom, Switzerland, New Zealand, and Hong Kong). And, it is expected that the TCFD will underpin the first Global Sustainability Reporting Standard that is set to be published by June 2022, by the newly-created International Sustainability Standards Board.

Connectivity of climate and financial reporting

Whilst these are undoubtedly welcome developments, there is a growing question about the connectivity of climate and financial reporting. Indeed, the financial reporting standards already require that material risk factors should be disclosed and accounted for in the company’s financial statements and accompanying management report. In fact, as it’s generally recognised that climate change poses material risks to many companies, the corresponding risk assessments should already form part of the financial accounts.

Existing rules and guidance

In November 2019, the International Accounting Standards Board (IASB) argued in an article that the principle-based approach of the International Financial Reporting Standards (IFRS) means that climate change and other emerging risks are addressed by existing requirements, even though such risks are not explicitly referenced. Further information released by the IASB in 2020, explicitly stated that material climate information, such as transition risks and targets, must be incorporated into financial statements under IFRS, including material assumptions and estimates.

In 2020, the International Audit and Assurance Standards Board (IAASB) published an ‘audit staff practice guide’, clarifying that climate-related issues should be considered as part of financial audits. Finally, in March 2021, the US Financial Accounting Standards Board (FASB) published a paper on the intersection of ESG matters, including climate change, and the US Generally Accepted Accounting Principles rules, pointing out that a company may consider effects of material ESG matters, similar to how it considers other changes in its business and operating environment that have a material effect on financial information.

Level of climate risk disclosures in financial statements

Despite growing regulations and industry bodies raising awareness, recent studies show that the level of disclosure of climate considerations in financial statements may not be sufficient. In September 2021, the Carbon Tracker Initiative, in partnership with the United Nations Principles for Responsible Investment (UN PRI), published the results of its review of 107 corporate financial statements highlighting that:

  • There’s little evidence of companies incorporating material climate-related matters into their financial statements – over 70% didn’t indicate that they had considered climate matters when preparing their 2020 financial statements.
  • Most climate-related assumptions and estimates aren’t visible in the financial statements – only 25% of the reviewed company reports provided disclosure of at least some of the quantitative assumptions and estimates being used in preparing the financial statements.
  • Most companies don’t tell a consistent story across their reporting – for 72% of the companies, the treatment of climate matters within their financial statements appeared to be inconsistent with their disclosures of climate-related risks in their other reporting.
  • There’s little evidence that auditors consider the effects of material climate-related financial risks or companies’ announced climate strategies – 80% of auditors provided no indication of whether or how they had considered material climate-related matters.
  • Even with considerable observable inconsistencies across company reporting (‘other information’ and financial statements), auditors rarely commented on any differences.
  • Companies don’t appear to use ‘Paris-aligned’ assumptions and estimates – while some of the companies used inputs from published climate scenarios, none appeared to use assumptions and estimates that were ‘Paris-aligned’ or provided sensitivities to this.

Overall Results:

Consideration of Climate Matters in Financial Statements and Audit Reports

Source: Carbon tracker and Consumption-based Accounting and Policy (CAP) team analysis

Investor pressure

As comprehensively summarised in the joint Carbon Tracker Initiative/UN PRI research above, investors are getting worried about the impact of climate on company financials. In 2020, the PRI, the UN Environment Programme Finance Initiative (UNEP FI), the UN-convened Net-Zero Asset Owner Alliance initiative, the Institutional Investors Group on Climate Change (IIGCC), the Investor Group on Climate Change (IGCC), the Asia Investor Group on Climate Change (AIGCC), and the Pensions and Lifetime Savings Association, along with individual investor organisations (together representing more than $100 trillion in global assets under management) urged companies and their auditors to ensure that they follow the relevant requirements to consider climate in the 2020 financials (and their audits). These investor groups and individual investor organisations also requested that companies use assumptions and estimates that are compatible with achieving the goals of the Paris Agreement.

One of the largest investor groups, CA100+, is also looking to develop a climate accounting indicator “to assess whether a company’s accounting practices and related disclosures reflect consideration of transition risk relative to a range of possible climate scenarios”.

Growing supervisory expectations

Regulators both in the UK and the EU are beginning to prioritise supervision of climate-related disclosures. The UK Financial Reporting Council (FRC) published its Climate Thematic in November 2020 in which it stated that it was generally unclear “how forward-looking assumptions and judgements applied in preparation of the financial statements were consistent with narrative discussion of climate change”.

In October 2021, the FRC published its Annual Review of Corporate Reporting, outlining its ‘top ten’ areas where reporting improvements are required. On climate, the FRC said that it expected for companies’ 2021/22 reporting to see “… material climate change policies, risks and uncertainties to be discussed in narrative reporting and appropriately considered and disclosed in the financial statements, particularly where investors may reasonably expect a significant effect on the expected life or fair value of an asset or liability”.

Finally, the FRC announced its supervisory priorities for 2021/22, with the most pressing task being a thematic review – in collaboration with the FCA – of the first batch of TCFD disclosures provided by premium listed companies, as well as reviewing the extent to which the financial statements reflect the impact of climate change.

In a similar vein, on 29 October 2021, the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, issued its annual Public Statement on European Common Enforcement Priorities for 2021 annual reports, highlighting, among others, the integration of climate-related matters into financial reports. The Statement calls out, quite explicitly, expectations around better consistency between IFRS financial statements and non-financial information as well as how climate-related matters may be addressed in financial statements under the current IFRS regime.

Recommendations to companies

Below are some steps that companies may wish to consider as they seek to align their climate and financial reporting.

  • Don’t wait for the perfect solution or guidance – start acting as soon as possible on the basis of information available already. (For example, in December 2021 EY published a guide Applying IFRS – Accounting for Climate Change to support entities in assessing the extent to which climate change affects their IFRS financial statements).        
  • Engage with your auditor and/or supervisor as early as possible to better understand expectations.
  • Engage with investors to determine which climate metrics are of most importance to them.
  • Consider setting-up a cross-functional working group to ensure a coherent and well-informed approach to climate reporting within your organisation.
  • Consider joining industry-wide discussions and forums on the subject to learn about best practice.
  • Be transparent in your approach – disclose key assumptions made when considering climate-related matters in your financial reporting, including why you consider those assumptions appropriate and what constraints you may have faced in the process of preparing financial information.
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