Companies have been promising for years to come clean about their exposure to climate risk. But 2020 may prove to be the moment that investors finally force them to do it. That, in turn, will put the onus on auditors to step up and challenge the way managers assess — or obfuscate — the impact of decarbonisation on financial accounts.
As things stand, many big investors fear that companies in energy-intensive industries are failing to recognise the potential hit to asset values posed by climate risk.
Some utilities may be failing to depreciate thermal power plants quickly enough, given that many might need to be scrapped to help meet the 2015 Paris agreement target to keep global warming well below 2 degrees centigrade.
Energy groups may also be failing to acknowledge that fossil fuel prices will almost certainly drop in the transition to a low-carbon economy if governments require their use to be accompanied by expensive carbon capture and storage. This could lead companies to leave hard-to-extract oil and gas in the ground as “stranded assets”.
A third concern is that companies are not setting aside money for contingent liabilities such as fines and litigation of the kind that forced Pacific Gas and Electric Corporation into bankruptcy after wildfires in California.
There are signs that auditors are starting to rise to the challenge. Most companies currently put their sustainability reporting in the management narrative at the front of annual reports. Much of it is unhelpful because there are so many standards and initiatives in this area that they confuse users of accounts and companies themselves, according to Hans Hoogervorst, chair of the International Accounting Standards Board.
He also argues that greenwashing — companies puffing their sustainability credentials — is rampant. The extreme example is Volkswagen, which portrayed itself as a green model while cheating on emissions tests. The big oil companies also trumpet their green efforts while continuing to invest far more in fossil fuels than in renewables. They are cheerfully assuming there will be no punitive legislation on taxing carbon dioxide emissions.
IASB recently put out an important practice note explaining that climate risks are potentially very material for reported assets and liabilities, and therefore for future corporate profits and dividends. The note specifically addresses issues such as depreciation and stranded assets that have worried institutional investors. It emphasises that it is not sufficient for directors to make a quantitative impact of climate-related risks. Auditors must also be on the alert for information that would influence a company’s investors or creditors if it is omitted, misstated or obscured.
This matters because most big investors are very anxious to minimise the risk of climate change on their performance. More than 370 investors with $35tn of assets under management have signed up to the Climate Action 100+ initiative that seeks to force the largest corporate greenhouse gas emitters to take action on climate change. And environmental, social and governance funds are growing rapidly as an asset class.
IASB has no powers to enforce its practice note and it does not apply to the US, which uses different standards. But the guidance will be influential across much of the global corporate sector and will provide a valuable lever for investors when they engage with companies.
The European Commission is adding further impetus to improving disclosure with its plan to align the bloc’s financial system with the Paris agreement’s goals. It has set out a framework for companies to provide reliable, consistent data.
Last month, the Spanish group Repsol became the first oil and gas company to set a target of net zero emissions by 2050: it will aim to capture as much carbon as it releases and sells. In doing so, it has revalued its assets on a basis compatible with the Paris agreement and taken an impairment charge of €4.8bn. This will put pressure on other big energy companies to go for net zero emissions — and Repsol’s auditor, Deloitte, faces an issue of consistency as with the accounts of other energy clients including Total and BP.
Does this mean that more realistic accounting will soon permit markets to put a more realistic price on climate risk? Only in part. There remain huge uncertainties, especially with carbon pricing. The OECD estimates that today’s carbon prices are far too low to make a material impact on global warming. Draconian policy measures may be needed to reduce emissions.
Making good judgments about the timing and potential impact of this on asset values, earnings and cash flows is extraordinarily difficult. But accounting has always been an imprecise art and where climate risk is concerned it is finally moving in a positive direction.
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