Climate-related disclosures and investor focus
Climate change is impacting both society and companies alike. Corporations are responding to its impact, and one of the reasons is that investors are demanding actions. Investors need to know how a company is considering the impact of climate change on its business model, risk strategy, and also the effect on its financial statements. Investors want to understand the future challenges that the company faces, and what the company’s plans are to deal with these challenges.
The Paris Agreement (United Nations) is a legally binding international treaty on climate change which will require a significant reallocation of company resources if the agreed goals are to be met. Therefore, companies could be exposed to a wide range of risks and opportunities as they aim to meet these goals. Companies will need to disclose the financial implications of climate-related challenges that face them.
An increasing number of companies are providing narrative reporting on climate-related issues. Where minimum legal requirements are being met, investors are calling for additional disclosure to inform their decision making. Some companies have set strategic goals such as ‘net zero’ (or carbon neutral), but it is often unclear from their reporting how progress towards these goals will be achieved, monitored or assured. Climate-related narrative reporting requirements and expectations cover both the potential impact on the future of a business and the company’s impact on the environment.
As the demand for climate-related disclosure by investors and other stakeholders increases, many companies are developing their climate governance in line with reporting frameworks, principally ‘The Task Force on Climate-related Financial Disclosures’ (TFCD).
Some of the information that investors may require is set out below:
- the arrangements in place and strategy for assessing and considering climate-related issues
- the metrics used to monitor climate-related goals and targets
- the opportunities and risks concerning climate-related issues which are most relevant and material to the company’s business model and strategy
- the potential effects on the company’s profitability, net assets, products, customers, suppliers etc of different climate scenarios
- are the risks and opportunities reflected in the financial statements, for example the effect of assumptions used in impairment testing, depreciation rates, decommissioning etc
- the assessment of the company’s viability over the longer-term taking into account climate-related issues
- the viability of the company’s business and business model.
Climate change and International Financial Reporting Standards (IFRS® standards)
There is no single IFRS standard which addresses climate change. However, IFRS standards provide a framework for incorporating the risks of climate change into companies’ financial reporting. Companies must consider climate-related matters when the effect is material on the financial statements.
IAS® 1, Presentation of Financial Statements
IAS 1 requires disclosure of information not specifically required by IFRS standards and not presented elsewhere in the financial statements, but that is relevant to an understanding of the financial statements. In addition, IAS 1 requires a company to consider whether any material information is missing from its financial statements such as the impact of climate-related matters on the company’s financial position and performance.
Disclosure of assumptions about climate-related matters may be required, where assumptions have been affected by climate change. For example, estimates of future cash flows for impairment testing purposes or the calculation of decommissioning obligations. The disclosure may include the nature of the assumptions or the sensitivity of the calculations.
In addition, IAS 1 requires disclosure of the judgements that have a significant effect on the amounts recognised in the financial statements.
IAS 1 requires management to assess a company’s ability to continue as a going concern. Climate-related matters may create material uncertainties that cast significant doubt upon a company’s ability to continue as a going concern. IAS 1 requires disclosure of those uncertainties.
IAS 2, Inventory
Climate-related matters may cause a company’s inventories to become obsolete, or the value to decline or costs of completion to increase. IAS 2 requires inventories to be valued at the lower of cost and net realisable value (NRV). NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. Estimates of NRV will be based on the most reliable evidence available of the amount which the inventories are expected to realise.
IAS 12, Income Taxes
IAS 12 requires companies to recognise deferred tax assets for deductible temporary differences and unused tax losses and credits, to the extent it is probable that future taxable profit will be available against which those amounts can be utilised. Climate-related matters may affect a company’s estimate of future taxable profits which may result in potential deferred tax assets not being recognised or the derecognition of already recognised deferred tax assets.
IAS 16, Property, Plant and Equipment
IAS 16 requires companies to review the residual value and the useful life of an asset at least at each financial year end and, if expectations differ from previous estimates, any change should be accounted for prospectively as a change in estimate. Climate-related matters may affect the estimated residual value and expected useful lives of assets because of obsolescence or legal restrictions on their use.
IAS 36, Impairment of Assets
Climate-related matters may give rise to an indication that assets are impaired. A decline in demand for products that are not environmentally friendly could indicate impairment of that product or the manufacturing unit making the product. An adverse change in the business environment of a company is an indication of impairment.
In assessing value in use, a company is required to calculate cash flow projections based upon reasonable and supportable assumptions that are the best estimate of the future economic conditions. Thus, companies will need to consider whether climate-related matters affect those assumptions.
Companies are required to disclosure the events, circumstances and assumptions that led to the recognition of an impairment loss, which could include climate-related events.
IAS 37, Provisions, Contingent Liabilities and Contingent Assets
Climate-related matters may affect the recognition, measurement and disclosure of liabilities related to such things as penalties imposed by governments for not meeting climate-related targets or causing environmental damage. In addition, contracts may become onerous due to a change in inventory purchasing strategy or redesign of products.
Companies should disclose major assumptions about any future events that have affected a provision or contingent liability.
IFRS 9, Financial Instruments
Climate-related matters may affect a lender’s exposure to credit losses, caused by environmental disasters or regulatory change, and also a borrower’s ability to meet its debt obligations to the lender. Climate-related matters may, therefore, affect the calculation of expected credit losses if there is an impact on the different potential future economic scenarios or the assessment of a significant increase in credit risk.
The classification and measurement of loans may be affected as lenders may include terms linking contractual cash flows to an entity’s achievement of climate-related targets. The lender would need to assess whether the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding. Additionally, climate-related targets may create an embedded derivative that needs to be separated from the host contract.
Climate change may reduce the probability of a hedged forecast transaction occurring or affect its timing. In this case, the hedge accounting relationship may need to be terminated or there may be hedge ineffectiveness. Similarly, a reduction in the volume of highly probable forecast transactions may lead to partial termination under IFRS 9.
IFRS 13, Fair Value Measurement (FVM)
When making the critical assessments and judgements for measuring fair value, the entity should consider what conditions and the corresponding assumptions were known or knowable to market participants. The impact of climate change on FVM would depend on the evaluation of whether the climate change would have impacted market participants’ valuation assumptions at the reporting date.
The information such as climate-related legislation available to the market at the reporting date may be relevant in making this evaluation. This would include any corroborative or contrary evidence such as the timing and trajectory of observable market price movements of related assets in the relevant markets, as well as information from other sources of market data up to the reporting date.
Depending on the facts and circumstances of each case, disclosure may be needed to enable users to understand whether or not climate change has been considered for the purpose of FVM. Users should understand the basis for selecting the assumptions and inputs that were used in the FVM and the related sensitivities.
The above examples from IFRS standards are not exclusive but are indicative of the far-reaching impact climate change will have on business reporting. This area of business reporting is evolving as the investor, and wider stakeholder, demand for both financial and non-financial disclosures increases generally.
Written by a member of the Strategic Business Reporting examining team