Corporate reporting and climate change
How external corporate reporting is affected by the impact of climate change
Climate change is having far-reaching impacts on the economy and it is becoming increasingly important to reflect this in corporate reporting. A ‘practical framework concept’ explains how climate change can be integrated into corporate reporting, and how this can strengthen investor confidence.
First published in EXPERT FOCUS 10 | 2020
1. THE TASK FORCE ON CLIMATE-RELATED FINANCIAL DISCLOSURES (TCFD)
Demand is growing from investors, regulators and other stakeholders that companies should consider the effects of climate change on their business. Initiatives such as Climate Action 100+ and the Institutional Investors Group on Climate Change bring together investors who call on companies to take action against climate change and expand their disclosures on climate-related information.
The Task Force on Climate-related Financial Disclosures (TCFD or the Task Force) has developed a widely accepted voluntary framework for standardised and comparable reporting of climate-related information. The Task Force was established in 2015 by the Financial Stability Board. The objective of the Task Force is to recommend disclosures that investors, lenders, insurers and other stakeholders around the world can rely on in order to adequately assess climate-related risks and opportunities. The Task Force is supported by more than 1,027 companies and organisations with a combined market capitalisation of over USD12 trillion.
The objective of the Task Force recommendations is that companies should provide a comprehensive understanding of the risks and opportunities they face from climate change in disclosures that are uniform, consistent, and comparable between companies.
The analysis of risks and opportunities of climate change and their application to known accounting and corporate reporting issues is important. Narrative reporting based on the Task Force model must be consistent with commentary in the annual report (see Figure 1).
Figure 1: Reporting according to the task force model
2. RISKS AND OPPORTUNITIES OF CLIMATE CHANGE
The first step by companies towards implementing the climate-relevant disclosure recommendations is to analyse the risks and opportunities from climate change that apply to their particular business environment.
The Task Force model recommends dividing the risks into two categories:
- Physical risks
- Transition risks
Physical risks are the risks of disruption to a business due to climate change. These may be acute, event-driven risks, such as one-off disruptions caused by extreme weather events. However, they may also relate to chronic long-term changes, such as higher average global temperatures and rising sea levels.
Transition risks arise from the transition to a low-carbon economy or due to the global commitment to limiting the rise in temperature:
- Political and legal risks: For example, governments may restrict the use of certain resources or increase taxes on CO2 emissions, which would drive up operating costs. Legal risks may come from climate-related litigation claims against governments or directly against companies.
- Technological risks: For example, new technologies may reduce demand for existing products and services. Developing new technologies is often a costly undertaking.
- Market risks: For example, consumer behaviour patterns may change, leading to higher demand for low-emission products and services. There is already evidence of this trend, for example in the food, clothing and transport sectors. Supply restrictions or limitations may increase raw material and production costs.
- Reputational risks: Stakeholders have high expectations of how companies should respond to climate-related issues.
However, the Task Force model recognises the opportunities as well as the risks associated with the transition to a low-carbon economy:
- Greater resource efficiency, for example through the development of cost-effective machinery
- Lower operating costs from the use of renewable energy
- Potential competitive advantage from early adaptation of the company’s product or service portfolio to low-carbon alternatives
- Entry into new markets can be associated with new markets and new opportunities for cooperation.
- Increased resilience to changes in the business environment by developing a supply chain that uses sustainable resources.
It is important to recognise that any company can be affected by climate change.
3. THE TCFD’S DISCLOSURE RECOMMENDATIONS
Once a company has analysed the risks and opportunities of climate change for its business, it is in a position to implement the 11 disclosure recommendations of the Task Force, which relate to the following core areas of a company’s business:
- Risk management
- Metrics and targets
Companies should disclose their governance around climate-related risks and opportunities:
- Recommended disclosure 1: Describe the board’s role in monitoring climate-related risks and opportunities.
- Recommended disclosure 2: Describe management’s role in assessing and managing climate-related risks and opportunities.
In order to implement these recommendations, various internal stakeholders and departments should be involved in developing appropriate disclosures.
The following disclosures in relation to the company’s strategy are recommended:
- Recommended disclosure 3: Describe the climate-related risks and opportunities identified by the company over the short, medium, and long term.
- Recommended disclosure 4: Describe the impact of climate-related risks and opportunities on business, strategy and financial planning. As climate-related risks and opportunities are to some extent outside the company’s control, this risk assessment needs to be tailored to the company’s value chain and business model.
- Recommended disclosure 5: Describe the resilience of the organisation’s strategy, taking into consideration different climate-related scenarios. Companies should analyse the many uncertainties and apply a long-term horizon in their planning.
3.3 Risk management
Investors often lack reliable information on how climate-related risks are factored into the company-wide risk assessment process. The Task Force therefore recommends that companies disclose the processes they use for identifying and assessing (Recommendation 6) and for managing (Recommendation 7) climate-related risks. In addition, companies should disclose how these processes are integrated into their general risk management framework (Recommendation 8).
3.4 Metrics and targets
Companies should disclose the metrics and targets they use to assess and manage climate-related risks and opportunities:
- Recommended disclosure 9: Disclose the metrics used by the company to assess climate-related risks and opportunities in line with its strategy and risk management process.
- Recommended disclosure 10: Discloseure of greenhouse gas emissions and the related risks.
- Recommended disclosure 11: Describe the targets used by the company to manage climate-related risks and opportunities, and provide a comparison of performance against these targets.
To help companies put these 11 disclosure recommendations into practice, the Task Force has developed the TCFD Implementation Guide. It has also issued a Good Practice Handbook, which provides an overview of disclosures by users and examples of best practice. The disclosure recommendations and real-life examples are intended to help companies communicate with investors about climate reporting.
4. THE IMPACT OF CLIMATE CHANGE ON ANNUAL ACCOUNTING
The framework concept of the Task Force aims to achieve uniform and comparable disclosures of climate-related information. The disclosure of the assumptions made by a company in assessing the risks and opportunities in governance, strategy, risk management and metrics/targets should be tailored to the information requirements of investors. The Task Force model emphasises that climate-related risks and opportunities may affect a company’s income and expenses, cash flows, assets and liabilities, and financing. Additional disclosures or notes to the accounts may therefore be needed; these can vary substantially, depending on the company and its business. There may also be legal disclosure requirements to include further information in annual reports. For example, companies in Switzerland are required to produce a management report under Article 961c of the Code of Obligations (CO), and this may explain the impact of climate change on the business if it is considered significant.
4.1 Dealing with uncertainties
There is considerable uncertainty over assumptions about how far global temperatures will rise and what impact various climate change scenarios would have on business operations. In keeping with demands for transparency from investors and supervisory authorities, the Task Force recommends that the disclosure of these assumptions in the annual report should be clear, balanced and understandable. They must also be justifiable and consistent with the following areas:
- Strategy, risk management and disclosure of the business model
- Commitments the company has made to investors and other stakeholders
Government commitments on agreements that affect the company, such as the Paris Agreement which seeks to limit the average rise in global temperatures to below 2°C.
4.2 Going concern status
When preparing the annual report, companies are required to assess their ability to continue as a going concern. This assessment must take into account all available information at the time of the annual financial statements or their approval, and this should include all climate-related information that might affect, e.g. budgets and forecasts.
4.3 Measurement of non-financial assets
Climate-induced changes may indicate that an asset ceases to be available, becomes commercially obsolete or needs to be replaced sooner than previously expected. Such factors affect the useful life of an asset under IFRS. If an asset is measured at fair value using the income approach, climate-related uncertainties may, for example, lead to changes in estimates of cash flows or to changes in the assessment of risks associated with achieving these cash flows. Increased costs of resources, production, insurance and compliance with new guidelines or laws may also need to be taken into consideration. The risks associated with climate change may also result in a risk premium in the discount rate. For assets that are measured at fair value using the market approach, companies must check whether an adjustment to the prices or transactions quoted by a comparable company may be necessary in order to reflect a higher or lower risk from climate change.
4.4 Measurement of financial assets
Climate-related events such as floods and hurricanes can lead to business disruption or to a need for impairment charges on assets, thus affecting the creditworthiness of companies as borrowers. Political and regulatory changes introduced to combat climate change could also have a detrimental effect on creditworthiness in the affected sectors and countries. When making an assessment of expected payment defaults, a large number of possible negative future scenarios arise, affecting both the probability of borrowers remaining solvent and the scale of losses for the lender in the event of default.
The effects on trade receivables from companies outside the financial sector may be less severe. Because of the short-term nature of receivables, the economic framework and the borrowers’ solvency will probably not change significantly during the period in which the receivables are outstanding.
4.5 Provisions, contingent liabilities and onerous contracts
The speed and scale of climate change, and also political and regulatory measures by governments in response, could affect the recognition, measurement and disclosure of provisions, contingent liabilities and onerous contracts in the following ways.
- The need to create additional provisions for new or existing obligations that are now considered probable. These could relate, for example, to fines for environmentally damaging activities or for non-fulfilment of climate targets.
- An asset might be decommissioned earlier, so that cash outflows for obligations connected to the decommissioning occur sooner than planned.
- New contingent liabilities for potential obligations or existing contingent liabilities that were previously judged to be unlikely may now have to be disclosed.
- The cash flows and discount rates used in measuring the provisions must reflect the risks and uncertainties of climate change.
- If the cost of fulfilling a contract increases or the benefit from contract performance decreases, they may become onerous contracts.
4.6 Pension obligations
Under IAS 19 “Employee Benefits”, all material financial risks must be taken into account when assessing pension obligations. This includes how the financing of a pension fund might change due to climate change risks and affect payments of employer contributions. The demographic assumptions and the performance of an investment portfolio may vary under different climate change scenarios, affecting the measurement of the assets and liabilities of pension schemes. Furthermore, given the potential for higher volatility, it is more likely that those responsible for investment in pension funds will try to rebalance their portfolios and adjust their investment and hedging strategies with a view to minimising risks. In any event, the information in the financial statements should explain the risks associated with defined benefit plans.
4.7 Recoverability of deferred tax assets
In determining the recoverability of deferred tax assets, the assumptions applied in forecasting future taxable profits should be consistent with the assumptions underlying other profit forecasts used in preparing the financial statements. These assumptions could be significantly affected by climate change.
4.8 New levies or taxes
New levies or taxes may be introduced to promote the transition to a low-carbon economy. Levies must be recorded in accordance with IFRIC 21 “Levies” if the obligation is governed by law. All income tax effects must be reported in accordance with IAS 12 “Income Taxes”. Caution should be exercised in distinguishing between a levy and an income tax and in applying IFRIC 21 or IAS 12.
4.9 Incentive schemes
Companies may introduce management incentive schemes to promote the transition to a low-carbon economy. Such programmes may fall under the scope of either IAS 19 “Employee Benefits” or IFRS 2 “Share-based Payment”, depending on the nature of the benefit. These incentive schemes should normally be treated like any other estimate or actuarial assumption for employee benefits under IAS 19, or as a performance-related condition for share-based payments under IFRS 2.
4.10 Disclosure of significant assumptions and estimates
If the assumptions about the effects of climate change are associated with a significant risk, meaning that a possible change in the assumptions could result in a material adjustment to assets or liabilities within the next financial year, a disclosure on the nature of the assumptions must be made under IAS 1 “Presentation of Financial Statements”. In addition, sufficient information should be disclosed to enable readers of the financial statements to understand the sensitivity of assets and liabilities to potential changes in the assumptions.
A detailed analysis of climate-related risks and opportunities, and the implementation of the Task Force disclosure recommendations on governance, strategy, risk management and metrics/targets, provide a basis for detailed disclosures in the financial statements of information for stakeholders.
The disclosure recommendations are ambitious and should be seen as best practice. Reporting on climate-related risks and opportunities is expected to evolve over time, and the Task Force model will also adapt to these changes. Note that individual items in the annual financial statements may also be affected directly, for example through changes in cash flows, asset and liability valuations, and income and expenditure. Metrics can also be affected, and disclosures may need to be provided in the management report. We therefore recommend that climate-related disclosures should be subject to internal controls and processes that are similar to the controls on financial reporting, requiring regular review by management and the Board of Directors.