This article was first published in edition 8 (January 2014) of Accountancy Futures, ACCA's research and insight journal.
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, which focuses on the extraction sector. It finds that companies typically do not disclose material information on carbon risk. This is despite the existence of 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 so that companies are required 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
From the financial reporting perspective, 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 accounting 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.
Unmask the risk
The accountancy profession must take the lead in ensuring that the carbon risk in fossil fuel reserves is reported on, says IFAC president Warren Allen
The ‘carbon bubble’ that is associated with what may ultimately prove to be unburnable carbon in fossil fuel reserves leads to a reporting challenge for fossil fuel companies and a valuation challenge for the stock exchanges they are listed on. For these companies, it is not only the scale of operational emissions that is the strategic challenge, but the emissions associated with burning their fossil fuel reserves. We need to consider how better to understand and reflect the potential carbon footprints of reserves with the existing approach to reporting and disclosure.
From an accounting perspective, the historical link between emissions and revenues has not been considered in predicting cashflows or valuing assets. Making the implicit carbon in financial statements more transparent can help investors assess their exposure to fossil fuels and carbon risk, and invest in companies preparing for a low-carbon future.
Higher-quality business reporting and disclosure are needed to reflect the climate change uncertainties facing companies better. This information is required by both companies and their investors in order to take appropriate action. To start improving the current situation, companies need to commit to material climate change-related disclosures. To understand the potential environmental impact of carbon stocks, companies must measure uncalculated stores of greenhouse gas (GHG) emissions within their fossil fuel reserves and account for them. As more climate change-related regulation appears, and the world’s energy mix changes, reporting frameworks, accounting standards and assurance will also need to encourage companies to reflect how they are adapting.
The accountancy profession can and should take the lead in ensuring the carbon in reserves can be assessed and reported on. Where necessary, 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 respond better to climate change uncertainty. Improving this area of disclosure can only be in the public interest.
Integrated reporting is a significant initiative involving the global accounting profession. It should complement accounting standards by providing companies with a structure to highlight relevant and forward-looking information, particularly on climate risk and uncertainty, making it more accessible and understandable, and connected to the company’s strategy and business model.
Warren Allen became president of the International Federation of Accountants (IFAC) in 2012 after serving as deputy president for two years. He was a partner at EY in New Zealand.
James Leaton RESEARCH DIRECTOR, CARBON TRACKER
‘Our research has demonstrated that the coal, oil and gas resources which listed companies have an interest in exceed the emissions that can be released to achieve climate change targets. This was confirmed by the International Energy Agency in its World Energy Outlook series.
‘There is a growing patchwork of regulation, technological advances and pricing shifts which are changing our energy mix. A transition to low-carbon energy is already occurring in some markets, resulting in the coal sector declining in the US and Australia, for example. We need to ensure that the financial markets and the accounting standards they use are ready to pick up these signals, to avoid a sudden adjustment at a later date.
‘Investors are starting to voice their concern. A group of 70 institutional investors with over $3 trillion in assets have started engaging with 45 companies with exposure to carbon asset risks to get them to stress-test their assets against a range of price and demand scenarios. This will help investors understand whether the business models of these companies are compatible with a low-carbon future. Corporate disclosure needs to evolve to reflect these new kind of risks, continue to meet the needs of shareholders, and deliver orderly markets.’
Rachel Jackson is ACCA’s head of sustainability. She is the staff expert on ACCA’s Global Forum for Sustainability, and represents ACCA on committees and working groups.