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New reporting standard seeks to drive environmental change

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The largest companies may still behave as if climate change and accounting exist in different worlds, but a new draft financial reporting standard looks to ensure these companies meet their net-zero carbon objectives.

31st Mar 2022
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Climate change is now accepted by almost everyone as being something that is happening, and happening as a consequence of human activity.

There is also near-universal acceptance that we have an obligation to address it. However, that would be hard to tell from the accounts of the largest companies in the world. Almost none of them as yet provide any clear indication of the impact climate change has on their current operations, or on those they will undertake in the future.

To date the reporting of the profits or losses and assets and liabilities of these companies has been almost totally unchanged and unchallenged as a consequence of the biggest single issue on this planet. It is as if climate change and accounting existed in entirely different worlds.

To address this issue the Corporate Accountability Network, working with the University of Sheffield and colleagues at the Copenhagen Business School, has created a new draft financial reporting standard on accounting for environmental change.

How would the proposed standard work?

The new draft financial reporting standard recognises that there have been multiple demands made for multinational corporations to publish data on their climate emissions and to report how public interest entities (PIEs) propose to eliminate them. The standard recognises the importance of this activity.

What it also notes is that as yet no standard setter, including the new International Sustainability Standards Board that has been established by the International Financial Reporting Standard after its endorsement at COP26 in 2021, has any intention of transferring any resulting financial data arising on this issue into the actual accounts of PIEs.

The Corporate Accountability Network believes this failure to require PIEs to report the financial implications of climate change on them (as well as the financial impact of their activities on the environment) means that current accounting standards are failing to supply the basic level of information that the users of financial statements should expect from any major corporation.

In the absence of this data, it is not possible for an investor to determine which of the companies whose shares they might acquire have the lowest likely cost of managing their transition to a net-zero economy. This in turn provides them with the best opportunity of being a going concern in the long term.

How the standard would eliminate emissions

The draft financial reporting standard requires that a PIE reports the cost of eliminating greenhouse gas emissions from its business processes. For this it takes into account those emissions that are described as being in scopes one, two and three by the Greenhouse Gas Protocols:

  • scope one emissions are those actually created by the business when undertaking its activities.
  • scope two emissions are those created in the generation or production of the bought-in energy that it uses.
  • scope three emissions are those resulting from the use of the products or services that it supplies within its customer chain.

Critically, all three are within the scope of the draft financial reporting standard precisely because the objective is to estimate the cost of eliminating the externalities that the business creates by conducting its activities.

Where the draft standard differs from most in this area is that it does not seek to put a price on these emissions. Instead, it addresses an issue that is entirely under the control of the management of the organisation, which is how much it will cost them to eliminate these emissions from their business processes. This, after all, is the goal that investors and society want to know can be achieved.

How the standard differs

The standard also differs from other proposals in one other fundamental way. It requires that a provision for this cost be made in the accounts, in full, at the time that the standard is adopted. The logic is that this cost is that of closing the existing carbon-based business of the reporting entity. 

In addition, if the reporting entity wishes to be considered a going concern the standard requires it to create a reserve for the cost of the replacement assets that it will require to ensure it can continue to trade. This too has to be provided on the accounts until the sums in question are spent. The intention is to provide an indication as to the funding required so that they can remain in business, which is vital information for those considering allocating capital.

It is only if a reporting entity can meet this combined test of being able to cover the cost of eliminating carbon from its systems and the cost of replacing its existing means of production with processes that can be net-zero compliant that it can be considered to be a going concern under the tests of solvency that the draft standard proposes.  

By necessary implication, the concept of carbon insolvency is recognised within the standard, requiring that a company that cannot see its way to becoming net-zero compliant must as a consequence wind up its affairs before the time that a country requires that this standard be met.

The consequences of this approach are radical. Reporting is necessarily to a user group much wider than the investors in the reporting entity. The definition of materiality changes as a result and is not measured just at the balance sheet date, but over the future period in which net-zero carbon objectives must be met. This is a concept described as dynamic materiality.

Vitally for those undertaking investment appraisals, the availability of reserves within any reporting entity for the purposes of distribution to shareholders is also necessarily changed and is defined to meet the new tests of solvency.

Frank financial appraisal

The standard is, as a consequence, challenging, which is why it has been put out for consultation.

At present business is discussing its net zero carbon compliance without ever properly reflecting this issue on its balance sheet. So what this proposal suggests is that the time has come for some frank financial appraisal of which companies are going to make it into the era when net-zero carbon compliance is going to be a condition of being a going concern.

Given that a great many investors are in the financial market for the long term nothing seems more important in accounting than this right now and that makes this proposal something that will inevitably be debated as the necessary accounting for this issue is determined.

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