The International Accounting Standards Board should be commended for its latest guidance on how companies should incorporate material climate risk into their accounts. This is a vital step in ensuring that financial flows are aligned with the Paris Climate Agreement’s goals of keeping global warming well below 2°C, and aiming for 1.5°C.
Accurate accounts are key because it is the published numbers that drive decision-making in businesses. Accounts tell executives how profitable certain activities are, and thus drive capital allocation. They also generally determine bonuses that executives receive. They need to be accurate.
Climate-related impacts could be highly material (and thus impact the numbers) for a number of companies. These impacts might manifest themselves through the direct physical impacts on company plants, property or equipment, staff, suppliers, or customers, or through the policy response that alters the market dynamics in which the company operates, e.g. through taxes, emission controls, new permitting systems. As such, climate change is as much an economic concern as an environmental concern.
As with the Australian Accounting Standards Board guidance on climate-risk reporting released in April 2019, the paper highlights the relevance to impairment tests, asset lives, fair value measurement, loan-loss provisioning and provisions for contingent liabilities and assets. In other words, climate risks are potentially very material for companies’ reported assets and liabilities, and this will have an impact on profitability and also on potential dividend-paying capacity.
Critically, the paper emphasises that materiality is not merely an assessment by incumbent directors of their view of the quantitative impact, but directors must have regard to whether investors “could reasonably expect that emerging risks, including climate-related risks, could affect the amounts and disclosures reported in the financial statements”.
The letters we published today to the Big Four audit firms state explicitly that investors expect to see fossil-fuel-related companies take account of climate risks in their financial statements. In other words, these risks should be treated as material for the purposes of financial reporting.
We will be writing to individual company audit committee chairs and lead audit partners for these companies over coming weeks setting out these expectations for 2019 annual reports and accounts. We will specifically ask for assumptions to be stress-tested for Paris-alignment to ensure investors can see how resilient companies are for government policies to align with Paris.
If companies and their auditors fail to ensure Paris-aligned accounting, investors should vote against their reappointment. Governments should consider mandating Paris-aligned accounting. This should not be optional.