How climate change became a business issue worth reporting
Climate change has become a hot topic that is making its way into financial statements because it could affect amounts of assets and liabilities recognised in the balance sheet, but it should also be making its way into the annual report in the form of climate risk reporting.
The Paris Agreement, net zero, and the environment
Climate-change reporting has been a long time coming. A by-product of the environmental movement, it has progressed in fits and starts over the past 30 years. The most recent turning point came in 2015, when 197 countries adopted the Paris Agreement. Part of the United Nations Framework Convention on Climate Change, the agreement commits world leaders to limit global warming. The key performance indicator: keeping global average temperatures below 2 degrees Celsius above pre-industrial levels—and preferably 1.5 degrees. The current increase is about 1 degree.
But while Paris marked a breakthrough, it was more starting point than final destination. To further limit emissions, many countries have since committed to net-zero emissions by 2050. Getting to net zero means a country produces the same amount of greenhouse gases as it takes out of the atmosphere, such as by planting forests.
Countries differ on how to reduce climate change—even those like Australia that signed the Paris Agreement. Some countries have changed their approach midstream. The U.S. signed the agreement under the Obama administration and then withdrew under the Trump administration. Under the Biden administration, the U.S. re-joined Paris and is working with other countries to reach net zero by 2050. And even within Australia, there is a lot of debate on the best approach to meet emission targets by 2050.
“Climate risk is investment risk”
The governments that signed the Paris Agreement could compel businesses to help stop climate change. Yet some businesses have embraced environmental sustainability of their own accord.
Overseas, Microsoft has pledged to become carbon negative by 2030, and more than 50 companies have signed the Climate Pledge organised by Amazon, committing to reach net zero by 2040.
Perhaps it is BlackRock CEO Larry Fink who has said it best, and generated the most headlines.
“Climate risk is investment risk,” wrote Fink in his annual letter to CEOs in 2020, adding that BlackRock would exit investments that present a high-sustainability risk, such as thermal coal producers. The company would also launch new investment products that screen for fossil fuels, he said, and integrate sustainability in portfolio construction.
Why climate change is risky for business
While some companies are adopting environmental sustainability to be good corporate citizens, BlackRock’s statement makes clear that the environment is serious business. Investors are responding to a business reality: the financial results of a company may look rosy today, but they could suffer in the future if the company doesn’t protect itself.
Investors and lenders are also pushing the immediate agenda. Unless businesses embrace the need to build climate change into their strategy and planning, they will pay higher costs for capital or, in some cases, will not be able to raise capital at all. At the same time, they will create significant value for investors.
Greenwashing and the reporting solution
The financial reporting that fuels the world of financing only works because businesses have agreed on reporting standards. If money makes the investing world turn, trust lubricates its gears.
That’s why climate reporting has gained momentum. Any business holding a financial stake in another—via equity investment or loan—needs to know its risk profile. Climate is just another form of risk. The way businesses increasingly view the situation, reporting on climate should be no different than for other risks.
At the same time, reporting on the environment suffers from two obstacles: there are too many and diverse frameworks, and the frameworks are voluntary. While some companies—mainly larger ones—have adopted a framework, they may focus on metrics that portray them in a positive light. Critics call this ‘greenwashing.’
The lack of unanimity on climate reporting is quickly coming to a head. In March, one of most important financial reporting organisations in the world said it plans to move forward with the creation of a parallel body for non-financial reporting. In its announcement, the International Financial Reporting Standards Foundation cited overwhelming demand for a sustainability standards board.
ESG: Three letters to report non-financials
If it seems like the terminology around climate risk can get confusing, that’s because it can be. The business community uses a series of related terms when discussing the environment and other forms of non-financial reporting.
‘Climate risk’ speaks for itself: the risk to businesses related to climate change.
‘Sustainability’ is also misleading. By itself, the word refers to more than just the environment. For investing and reporting, sustainability comprises three discrete categories: environment; social (how the business deals with social issues, like its employees, external political trends or humanitarian issues in its supply chains), and governance. Together they are known as ESG. Environment is just one— very high-profile—source of risk.
Refere to our May 2021 Accounting News article which explains ESG in more detail.
Taskforce on Climate-Related Financial Disclosures
While no one framework has gained universal acceptance for climate reporting, more than 1500 companies worldwide have adopted the recommendations of the Taskforce on Climate-Related Financial Disclosures (TCFD). Released in 2017, the TCFD recommendations incorporate input from large banks, insurance companies, asset managers, pension funds, large non-financial companies, accounting and consulting firms, and credit rating agencies.
Some countries have already mandated reporting to align with the TCFD. In the UK, many listed companies will be required to report in accordance with the Recommendations from 2021, with new ones added in 2022 and 2023. In New Zealand, reporting will be required from around 200 financial sector organisations from 2023. While not mandatory in Australia, the ASX Corporate Governance Principles and Recommendations, Recommendation 7.4 dealing with environmental risks, encourages listed entities to consider whether they have a material exposure to climate change risk by reference to those TCFDs, and if they do to consider making the recommended disclosures.
The four areas of climate risk reporting
The TCFD recommendations focus on four areas:
- Governance - The organisation’s climate risks and opportunities, and management’s role in assessing and managing them. Different from the governance putting the ‘G,’ in ESG, this refers specifically to governance on climate risk.
- Strategy - The actual and potential impacts of climate-related risks and opportunities on the organisation’s business, strategy, and financial planning. Included is the resilience of the organisation against climate scenarios and how the company would respond.
- Risk management -
The processes used by the organisation to assess, manage, and report on climate-related risks. Included is how the organisation determines the relative significance of different risks and how leadership makes decisions about addressing the risks.
- Metrics and targets -
The key numbers used to assess, manage, and report on climate-related risks. Included could be greenhouse gas emissions, whether climate-related metrics impact remuneration, and revenue targets for products and services in a lower-carbon economy. Businesses often use specialised systems to track these metrics.
Defining climate risk
The TCFD recommendations are not just a popular choice for companies that need a framework for climate reporting right away. They also help companies with no immediate needs understand how to approach the subject.
Among the key themes to consider is the difference between physical risks and transition risks. Physical risks are the business interruptions arising directly from climate change—such as wildfires or lower agricultural yields. Transition risks come from the world’s gradual move to a lower carbon economy.
Transition risks can be wide-ranging. They include technology risks, such as the phasing out of internal combustion engines; political and legal risks, such as carbon taxes; reputational risks, such as activists, investors, or even employees demanding climate-friendly policies; and market risks, due to changing consumer lifestyles.
Climate risks inhabit short-, mid-, and long-term windows. As a result, companies may strugle to assess how much risk they add to the organisation. But those who consider climate risk strategically now will put themselves in the best position when running their business, raising money, and reporting on their progress to anyone who needs to know.
Please contact Aletta Boshoff if you require assistance with climate change reporting.
This article original appeared at: https://www.bdo.ca/en-ca/insights/assurance-accounting/climate-change-business-reporting/