Net-Zero in the Front, Zero in the Back Net-Zero in the Front, Zero in the Back

Despite the immense social and economic challenges faced by UK businesses since the start of the COVID pandemic, the proportion of companies who have committed to developing and achieving ‘net zero’ carbon emissions or other ‘science-based’ targets continues to grow. 

Focusing on a sample of 100 UK private and listed annual reports released from September 2020 onwards, we found that 2/3 of companies in 2020/21 had committed to such targets, up from around half in 2019/20.

This sounds encouraging.  However, the same survey identified that only 1/4 of companies made any reference to climate change or climate risk in the back half of their annual report. If climate change/climate risk was mentioned in the financial statements, it was most commonly included in impairment disclosures and accounting policies, and references were generally brief and rarely included any quantification. 

As we have explored in previous blogs, the FRC has given notice that they will challenge businesses who discuss climate as a risk and/ or opportunity in the front-end disclosures, but do not provide adequate disclosure in the financial statements. We explore below what might be causing these reporting gaps and the steps that businesses can take to close them ahead of the next reporting cycle. 

Amongst preparers of financial statements, there has traditionally been a tendency to focus on short-term financial returns and a perception that information is only material if it impacts the current year balance sheet or P&L.  This is despite the fact that the concept of materiality under IFRS is neither a short-term nor quantitative only concept.  Information is material if it could reasonably be expected to effect investors’ economic decisions. 

There is also a perception from many that climate change will only create business risks or opportunities over the medium- or long-term. This leads to a lack of consideration of climate factors and ultimately a lack of disclosure, because preparers falsely assume that climate sits outside the realm of financial reporting.

Yet climate impacts are already being felt by businesses today. According to the World Economic Forum’s Global Risks Report 2021, extreme weather events represent a ‘clear and present danger’ for the global economy, representing the third most significant risk for businesses in the short-term.

Flooding in central Europe in August 2021, which attribution scientists calculate was made up to 9 times more likely by human-induced climate change, caused approximately €6.5 billion of damage.

In January 2019, US utilities firm Pacific Gas & Electric (PG&E) filed for bankruptcy after facing an estimated $30 billion in liabilities linked to wildfires, with the firm widely recognised as ‘the first climate bankruptcy’.

Preparers of financial statements need to stop viewing climate as a uniquely long-term risk and bring considerations into current risk assessments and financial planning. 

We are additionally seeing a lack of climate expertise amongst business leaders and key decision-makers within organisations. A recent survey of board rooms found that only 7% of board members have experience in climate change. It is therefore no surprise that boards do not feel comfortable making key business judgements around climate, or fail to challenge the finance team on a lack of climate considerations in the financial statements.  They falsely assume that making commitments on tackling climate change (however ambitious these may be) is sufficient to meet investor demands around climate. 

We also find that preparers of financial statements are commonly uncertain about how and where to include climate matters in financial statements.  Where do you start?

Finance teams are increasingly being asked to take responsibility for aspects of non-financial reporting, including climate change and wider environmental issues.  However, as they have not traditionally owned this reporting, this can lead to an unclear division of responsibility and ultimately a lack of ownership. 

Given the inherent uncertainties involved in predicting the future, many climate estimates are uncertain. Much climate-related financial analysis is nascent, without established methodologies or data providers. Given the general lack of climate expertise and experience amongst finance teams, there may also be a tendency to use climate data assumptions which are not recent, credible or have not received the same rigour and challenge as data sources used for financial assumptions.

Due to the lack of certainty around future global decarbonisation pathways, the Task Force on Climate-related Financial Disclosures (TCFD) recommends the use of climate scenario analysis for businesses to consider a range of plausible future outcomes and the impacts that those outcomes might have on their organisation. In other words, scenarios are hypothetical constructs; they are neither forecasts nor predictions, nor are they sensitivity analyses.

This requires a new way of thinking. Whist traditional financial reporting requires businesses to base financial reporting on one future scenario which they view as the most likely, climate scenarios are not intended to represent a full description of the most probable future outcome. Financial statement preparers must become comfortable with the idea that climate scenarios simply represent different plausible outcomes which may materialise in the future.

Although preparers may be concerned about messaging to their investors, there is an even greater risk that organisational inaction can result in a business falling behind its peers, the market and rapidly evolving stakeholder expectations on climate, losing its status as an attractive investment opportunity.

To combat a disproportionate impact on short-term financial returns, businesses should develop a holistic understanding of the environment in which they operate, considering short-, medium- and long-term risks and opportunities to ensure sustainable long-term financial returns.

The World Economic Forum’s Global Risks Report 2021 found climate action failure to be the second most significant global risk by likelihood and impact, with extreme weather events as the most significant global risk by likelihood. Given the severity of climate risk, corporates and financial institutions must embed climate considerations throughout their businesses and can no longer afford to overlook impacts within financial statements.

Furthermore, taking account of uncertain future events enhances preparedness and business resilience. Given the significant economic impacts felt throughout the world as a result of the COVID-19 pandemic over the last 18 months, our societies have realised the importance of strengthening and enhancing business resilience, and this is becoming an area of focus for many businesses.

Whilst there is currently a lack of climate expertise amongst board members, several methods can be used to enhance understanding of the urgency and severity of climate risk. Firstly, organisations can engage with their peers and others in industry groups. Within these groups, individuals and organisations can participate in knowledge sharing, exchanging insights on best practice climate reporting.

Secondly, they can also seek to implement climate training across their organisation.

There is a great deal of existing guidance available on the disclosure of climate-related financial impacts. The TCFD provides guidance on implementing its recommendations, with new guidance expected to be released in Autumn 2021 on reporting the material impacts of climate risks and opportunities on financial performance and position. The Climate Disclosure Standards Board (CDSB) also offers guidance on integrating climate-related matters into financial reporting.

Whilst the specific details of future climate change outcomes are inherently uncertain, it should be remembered that traditional financial statement disclosures already require corporates and financial institutions to make subjective judgements about uncertain future events.

Within organisations, finance teams regularly deal with and provide disclosure on estimates and uncertainty, for example in going concern assessments, valuations, or impairment testing. The lessons learned through these processes can be applied to climate information to bring rigour and challenge to inputs, assumptions and scenarios.

For climate scenario analysis, most preparers employ third-party experts for modelling as they do not have the expertise internally. Moreover, several businesses have developed partnerships with academic or scientific institutions on climate.

Lack of internal expertise should therefore not act as a barrier to the integration of climate into financial reporting.

The first thing to do is to make a start on disclosing climate-related financial impacts. Whilst climate change reporting is undoubtedly a new and complex challenge for many, there are existing resources available to help preparers to make a start, including guidance from the TCFD and CDSB referenced above.

To make a start with quantification, financial information on climate can be used internally to drive strategic decision-making before being disclosed externally to the market. Organisations may wish to start by generating a Climate Value at Risk (CVaR) metric or broad ranges of potential impacts on financial position and performance.

Preparers who are just starting to disclose should not let the perfect be the enemy of the good, recognising that best practice will continually evolve over time as standards converge and market expectations mature. As mandatory TCFD disclosures come into effect, we expect to see continuous iterative improvements in climate-related financial disclosures from the market, and broader understanding of how to disclose effectively in the financial statements.

Our teams are at the forefront of climate reporting, supporting clients in both quantifying the effects of climate physical and transition risks and opportunities on their business, and also making clear and effective disclosures across the annual report. 

Find out more about our market-leading climate quantification tool Climate IQ.

Alternatively, talk to our climate risk and reporting experts: Helena Watson and Simon Weaver.