This article was first published in the February 2014 International edition of Accounting and Business magazine.
The approach assumes the future will repeat the past, not allowing for declining demand for fossil fuel products.
There is growing attention focused on the threat posed to future economic stability by the risk of carbon assets being ‘stranded’ by the imposition of carbon budgets designed to limit climate change. Assessment of such risks is likely to become an increasingly important element of investors’ capital allocation decisions.
The Generation Foundation, which is dedicated to supporting sustainable capitalism, makes a strong case for investor action in its October 2013 white paper, Stranded Carbon Assets: Why and How Carbon Risks Should be Incorporated in Investment Analysis. It warns that failure to account properly for the risk inherent in carbon-intensive assets will cause the ‘carbon bubble’ to grow until the artificially high valuation levels can no longer be sustained. It encourages investors to take steps such as engaging company boards on their plans for mitigating and disclosing carbon risks, and divesting fossil fuel-intensive assets in order to reduce or eliminate carbon-related risks.
The need for investors to become more ‘climate-literate’ is also highlighted in a recent report by ACCA and Carbon Tracker, Carbon avoidance? Accounting for the emissions hidden in reserves. It finds that extraction sector companies typically do not disclose material information on carbon risk despite the multiple standards and regulations covering financial statements, industry reserves reporting, listings rules and greenhouse gas (GHG) emissions reporting. Existing reporting frameworks therefore need to be enhanced and aligned to require companies to provide the information and commentary that investors need.
A review of the financial statements of companies in the extraction sector shows how substantially their current disclosures vary in terms of the quality and quantity of information they provide on GHG emissions and climate change. Some are experimenting with integrated reporting and beginning to link current and future company performance with sustainability issues, but the implications for the reporting and valuing of reserves are not being pursued. Current strategies laid out in annual reports talk of growth that is incompatible with emissions limits and there often seems to be a lack of balance in the consideration of future corporate viability. Even companies that claim to support action on global warming do not always articulate how their business model is adapting to the changes required in the energy sector.
Accounting action required
Reserves accounting is a key area needing improvement. Although fossil fuel reserves are often recognised in financial accounts, this is typically on the basis of associated costs rather than current value. The approach assumes the future will repeat the past, not allowing for declining demand for fossil fuel products.
Impairment tests are applied in the attempt to identify where the expected value of an asset may not be realised, with ‘reasonable assumptions’ being applied. However, the expectation that demand for energy-intensive energy sources will be sustained appears increasingly unreasonable. The assumption of impairment therefore needs to include prudent analysis of factors such as national and global policies to limit climate change, and trends in technology that support environmentally friendly energy generation.
Financial reporting standard setters could take action to address these weaknesses. The International Accounting Standards Board (IASB) could, for example, issue guidance to interpret existing standards so that preparers of reports and accounts consider the need to include information on the carbon viability of reserves. They could also investigate how the use of fair value accounting could reflect the potential impact of carbon-constrained markets on the value placed on reserves.
Achieving the necessary change isn’t the sole responsibility of financial reporting standard setters. The potential also exists to strengthen oil, gas and mining industry standards, under which reserves are primarily assessed on geological and economic viability. Other factors such as environmental considerations may also be taken into account, but the key issue of emissions limits affecting the market for products is not explicitly included as yet.
There are weaknesses in the carbon reporting requirements of stock market regulators and listing authorities. They could require disclosure in annual reports and prospectuses of the emissions potential of reserves, and the assumptions made about future emissions in determining corporate strategy.
There is scope to improve GHG reporting standards, too. GHG metrics, for example, need to deal with material, forward-looking issues around the stocks of carbon being built up, as well as the annual flows of GHG emissions from industrial activity. The continued development of integrated reporting could also improve the linkage between carbon risk, business strategy and corporate performance.
Companies must play their part in meeting investors’ carbon-risk information needs, not just focusing on achieving basic compliance with standards and reporting requirements, but going beyond the minimum through understanding investor needs. For example, information that shows reserves and resources converted into potential carbon dioxide emissions would help investors understand future risks. So would sensitivity analysis of reserves levels in different price or demand scenarios. Investors would also benefit from companies providing clear discussion of the implications of such data when explaining their capital expenditure strategy and the risks to the business model.
Senior executives within industry, particularly accountancy professionals, are encouraged to work in tandem with all the standard setters and other key parties shaping the reporting frameworks that support financial markets. An integrated effort is required to ensure that reporting requirements – whether financial, listings-based, industry-linked or GHG-focused – fully meet market needs. The ultimate aim must be to provide investors with information to help them assess carbon risks before determining capital allocations.
Take the carbon lead
‘The accountancy profession can and should take the lead in ensuring the carbon in reserves can be assessed and reported on. Accounting rules and treatments should be reviewed to support greater transparency and understanding of asset values.
‘One approach is to state coal or oil reserves at current values. This can help companies and investors to respond better to climate change uncertainty. Integrated reporting should complement accounting standards by providing companies with a structure to highlight relevant and forward-looking information, particularly on climate risk.’
Warren Allen is president of the International Federation of Accountants (IFAC)
Rachel Jackson is ACCA head of sustainability