Accountants and Climate Change
“A low-carbon transition is underway and will change how economies operate creating both uncertainty and significant opportunities. Politicians, regulators, and institutional investors, and asset managers are all maneuvering towards a world with net-zero emissions. The International Federation of Accountant’s Point of View on climate action outlines the enormous influence on IFAC’s 180 member organizations and on over 3.5 million professional accountants yield in driving climate change transition and adaptation. Read on…”
1 The Imperative for Climate-Literate Accountants
As Mark Carney, COP26 Finance Adviser and UN Special Envoy, put it at the 2020 IFAC and ACCA Climate Week event, the accountancy profession is essential in achieving a low-carbon transition. The contribution of an individual accountant will of course depend on their role but there are few roles that accountants undertake which do not require thinking about climate impacts and their financial consequences.
The transition to a below 2-degree Celsius net-zero world really needs climate-literate accountants who can:
- Advise their clients and employers on the risks, liability and reputational damage arising from corporate activity that negatively contributes to climate change;
- Support the strategic, operational and financial assessment of climate change and steering an organization toward the opportunities that decarbonization brings; and
- Provide investors the information they need to understand the current and prospective impact of climate-related matters on an organization and its financial position and prospects.
2 Understanding Net-Zero Emissions and Global Commitments
Net-zero emissions will be achieved when all anthropogenic GHG emissions are counterbalanced by removing GHGs from the atmosphere by carbon removal. The net-zero premise is that emissions from human activities based on fossil fuels are reduced to as close to zero as possible, and remaining emissions are balanced with an equivalent amount of carbon removal. In scenarios limiting global warming to 1.5 degrees Celsius, GHG emissions need to reach net-zero between 2063-2068 (and carbon dioxide much sooner by around mid-century). Although not all countries need to reach net-zero at the same time, the likelihood of attaining the Paris Agreement and a 1.5 degrees Celsius warming scenario depends on high emitting countries acting sooner.
Net-zero emissions commitments are a clear signal of the intent to achieving the International Climate “Paris Agreement”. About 60% of global emissions are now subject to such targets. Undoubtedly, there is significant work to be done to meet such long-term ambitions not least companies putting in place clear strategies and robust short- and medium-term targets, and ensuring where possible future investments are clearly aligned. Climate Action 100+ has put in place a net-zero company benchmark to help track business alignment with the Paris Agreement.
Pioneering Net-Zero Targets across Governments and Corporates
Governments and businesses are setting net-zero emissions targets with about 120 governments and a fifth of the world’s 2,000 biggest listed companies having made net-zero commitments. In India, which is on a trajectory to meet its current Paris climate commitments, Indian Railways has committed to achieve net-zero emissions by 2030 in addition to various large companies:
- Reliance Industries: Net carbon zero by 2035;
- Mahindra Group: Carbon neutral by 2040;
- Wipro: Net-zero GHG emissions by 2040.
More than 40 asset managers including Vanguard and BlackRock, signed up to the Net Zero Asset Managers Initiative pledging to make their portfolios net-zero by 2050 or earlier. The CEO of BlackRock, Larry Fink’s annual letter calls on all companies “to disclose a plan for how their business model will be compatible with a net-zero economy”.
The significant threat of climate-related stranded assets is also driving central banks and financial supervisors to assess their role in ensuring the resiliency of the financial system and solvency of financial institutions. Capital markets have started to make decisions about the transition to renewable and sustainable energy with the cost of capital for fossil fuel options increasing. Financial capital is seeking solutions to reduce GHG emissions.
World Resources Institute (WRI): 10 Key Solutions Needed to Reduce Greenhouse Gas Emissions
3 Valuations, Accounting Estimates, and the Need for Quantification
A major challenge for investors and the capital markets is that climate risk disclosure globally is inadequate. For climate risk to be fully reflected in company valuations every company, every bank, every insurer and investor needs to disclose their climate-related risks on a standardized basis. Company valuations in a 2-degree Celsius or lower world will likely be very different given the potentially significant implications on future cash flows.
Climate change can only be fully taken into account in valuations when companies have incorporated climate-related risks in their financial position and performance. As climate is increasingly integrated into corporate decision making and reporting, valuations will better reflect the actual and potential climate impacts.
Quantifying and Monetizing Climate Impacts
A significant challenge in climate-risk assessments and disclosures is that climate impacts are not quantified and monetized. Quantification helps to drive medium and long-term planning, and is where accountants involved in financial planning and analysis, can significantly contribute by providing financial-related information about profits and valuations that reflect climate-related risks and events. Without quantification of climate risks and opportunities, companies will find it hard to compare climate change against their wider enterprise risks, and investors are unable to make informed decisions about the allocation of their capital.
Effective climate risk reporting also requires significantly better disclosure around key accounting estimates and judgements in assessing and reporting on financial position and performance. Investors and regulators, and subsequently auditors, have started to ask questions of companies, particularly those with large carbon footprints, challenging their assumptions and risk disclosures in their financial reporting. Reflecting climate risk in financial reporting is ultimately the same as dealing with other risks. Climate risk may well lead to asset impairment, and provisions and contingent liabilities. Property, plant and equipment can have useful economic lives spanning long periods with significant assumptions about future cash flows taken into perpetuity. Climate-related financial risk and opportunity both largely arise from the need to retire and replace carbon-intensive assets on an expedited basis.
“Capital markets have started to make decisions about the transition to renewable and sustainable energy with the cost of capital for fossil fuel options increasing. Financial capital is seeking solutions to reduce GHG emissions.”
With climate being a significant financial concern and threat to business resilience and long-term value creation, accountants need to provide actionable information and insights on its opportunities, risks and potential financial impacts.
4 Four Key Areas of Focus for Accountants in Becoming Climate-Literate
1. Know Your Emissions
Emissions arise from products, services, and fixed assets. Both absolute emissions reduction and carbon intensity provide a benchmark for targeted decarbonization actions. Establishing a reliable carbon footprint (or GHG emissions inventory) for an organization, or for a product, can be a complex but critical task to measure the energy consumption of activities and the emissions associated with the business model.
This requires understanding the absolute emissions across value chains (i.e., beyond Scope 1 direct emissions and Scope 2 electricity indirect emissions). Collecting robust data of Scope 3 or other indirect emissions is challenging but important to understand emissions in the supply chain, how customers use products, and the significant risks and opportunities related to operation licensing. Consequently, more companies are working with customers and suppliers to help address emissions in the consumption and supply parts of the value chain.
Setting key performance indicators (KPIs) that improve performance and link to incentives is critical. For example, an airline might reduce emissions per passenger mile traveled, but higher passenger numbers could still increase overall emissions. Accountants need to ensure GHG management plans are in place to prioritize carbon reduction projects and quantify cost savings, carbon savings, and implementation costs.
Accountants need to address the emissions data quality challenge through implementing an effective system of internal control over such data and ensuring it is subject to investor-grade assurance.
2. Integrate Climate Information into Strategy and Risk Management
Comprehensive understanding of climate risk assessments and scenario modeling supports robust analysis of opportunities and risks of different transition pathways and reveals the resilience of strategies and business models to physical and transition climate risks. Scenario analysis to prepare The Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD) recommendations for disclosure will likely include significant assumptions and estimates about the future. Many of these will be important for financial planning and financial statement preparation to underpin balance sheet items.
Scenario analysis and risk assessments help quantify potential financial impacts on revenues, expenditures, assets, and liabilities under various climate scenarios. The adaptive capacity of business models in different scenarios is highlighted by the extent to which weather events and increasing carbon costs impact expected cash flows and asset valuations.
Climate risks must be embedded in strategic decisions such as capital investment. Existing assets including buildings, machinery, equipment, and vehicles are stores of future emissions which will continue over their remaining use. Asset impairment and replacement costs, and appraisal of new assets, is a fundamental part of achieving net-zero.
3. Understand Your Decarbonization Options
This includes options for permanent carbon reduction and removal. Businesses with a decarbonization strategy and plan can respond and adapt to different approaches to achieving net-zero emissions. Investments in low-carbon solutions can often appear economically unviable because of high up-front capital costs. So measuring economic returns, and other potential benefits over longer periods become important. Investments in R&D include resource and energy efficiency, migration to circular business models, avoiding use or production of virgin materials (e.g., using bio-based raw materials like mycelium leather), and diversification into other energy forms.
A credible transition plan is needed to access finance for low-carbon investments and products, such as electric fleets or renewable energy generation. Mobilizing equity or debt finance to support new technologies and processes is usually critical. Options for green finance have significantly increased over recent years through green bonds such as the bond and sukuk issuances used at Standard Chartered, and sustainability-linked loans.
4. Tell the Story
Communicating how your company is becoming net-zero compatible will be part of any finance leader’s conversations with boards, investors and other stakeholders––explaining risks and opportunities, targets and KPIs, prioritization of capital investment, and financial impacts, including how climate change relates to accounting estimates and judgements used in the preparation of financial statements and reports. For climate reporting to move beyond a marketing exercise to one providing information that boards and investors need to enable decarbonization, accountants need to be part of the equation and rise to the occasion.