(This article was published on 28 June 2021 and updated on 27 January 2026)
Highlights
What’s the issue?
A company needs to consider the impact of climate-related matters when calculating the recoverable amount of a non-current asset or cash-generating unit (CGU) as part of its impairment testing. Companies typically use the discounted cash flow (DCF) technique in such calculations, with the rate used to discount the cash flows being a key assumption.
Given that not only cash flows, but also the discount rate, may be affected by climate-related matters1, this raises questions such as the following.
- Where should climate-related matters be reflected – in the cash flows or in the discount rate?
- How should climate-related matters be reflected in the discount rate?
- How might double counting for climate-related matters be avoided?
Getting into more detail
The rate applied to discount the cash flows is based on the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those of the asset or CGU. In other words, the discount rate is based on a market participant’s view of the asset or CGU. This is true for both a calculation of the recoverable amount based on value in use (VIU) and on fair value less costs of disposal (FVLCD). [IAS 36.55-56, A16, IFRS 13.B14(a)]
Where should climate-related matters be reflected – in the cash flows or in the discount rate?
In valuation practice, the impact of climate-related matters is generally reflected in the cash flows rather than in the discount rate, whenever possible. However, this may not be possible when cash flow projections relate to circumstances or events outside the company’s control and there is no data or evidence to support them. [IFRS 13.61, B12]
If sufficient data is not available, or it is not possible to reliably quantify the impact of a climate-related matter on the cash flows, then adjustments to the discount rate may need to be considered.
Adjustments to the discount rate may be made if they can be supported and do not result in double counting. Methods that may be used to support such adjustments include calculating:
- an adjustment factor based on market multiples for comparable listed companies – comparable transactions may also provide some support; and
- the implied adjustments to cash flows that would be consistent with the proposed adjustment to the discount rate.
In some cases, climate-related matters may be reflected both in the cash flows and the discount rate. For example, this may be the case if climate change measures are expected to change the cash flows (by reducing revenues or by increasing costs or capital expenditure) and increase the risk or range of outcomes of these cash flows.
For more information on how climate-related matters might affect cash flow projections, see our article What’s the impact on cash flow projections used for impairment testing of non-current assets?
How should climate-related matters be reflected in the discount rate?
In our experience, the most common approach to estimating an appropriate discount rate is to use the weighted average cost of capital (WACC) formula. One of the components of the WACC is the cost of equity, which is typically calculated using the Capital Asset Pricing Model (CAPM).
Climate-related matters may affect two inputs that are used to calculate the cost of equity using the CAPM – i.e. the alpha and the beta factors. [IAS 36.A17(a), Insights 3.10.300.30].
The beta factor reflects the risk of the industry or sector in which the CGU operates, relative to the market risk as a whole (systematic risk).
The beta factor is typically estimated based on betas of comparable companies in the relevant sector or industry, even if the company subject to the impairment test is listed. If climate-related matters are significant, then they should be considered when identifying comparable companies.
Companies in the same industry can have significantly different exposures (or degrees of exposures) to climate-related matters. For example, this could be due to differences in:
- their location;
- the applicable legislation; and
- their strategies (some companies are proactive, others are not).
For example, in some jurisdictions, large public oil and gas companies are increasingly diversifying away from purely extractive activities and selling assets that emit high levels of greenhouse gases, whereas small private companies are not as likely to do so.
Beta is a medium-term measure – it is typically based on historical data over a two- to five-year period. A five-year beta may not (fully) reflect climate-related matters – for example, in markets where companies have recently started providing climate-related information. Climate-related risks that are industry-wide and significant may be reflected in the beta factor; this depends on whether the risks are priced by the market and the time span over which the beta is measured.
An alpha factor reflects a CGU-specific risk premium that may need to be added to the cost of equity when a CGU is determined to carry additional risk – i.e. risk that cannot be attributed to market risk (unsystematic risk) that would affect a market participant’s required rate of return.
To assess whether the alpha factor could be affected, a company considers circumstances in which an alpha factor may need to be included for the WACC to reflect the rate of return required by a market participant. For example the following circumstances may be considered:
| Circumstance | Potential effect on the alpha factor |
| The CGU has a distinctive climate-related strategy which is significantly different from those of the comparable companies and not reflected in the calculated beta | The impact of the company’s strategy is reflected in the expected cash flows. Nevertheless, the WACC may also be affected. A market participant may require a higher return if the company’s strategy is not expected to significantly reduce the impact of industry-wide climate-related physical or transition risks, unlike the strategies of industry peers. If this is not reflected in the beta then an alpha factor may need to be added. |
| The industry beta does not sufficiently reflect the return required for bearing the industry-wide climate-related risks | A market participant may require a higher return if the industry beta is calculated based on historical data from markets where companies have only recently started providing climate-related information. |
| The CGU is significantly exposed to physical risks (e.g. storms or flooding) which the comparable companies are not | Although these risks are reflected in the cash flow projections, a market participant may require a higher return as compensation for bearing the higher uncertainty associated with the significantly increased likelihood and severity of possible negative outcomes. Propose replacing wording with the table from the How To for ease of readability |
In the examples above, an adjustment to the WACC through the alpha factor is appropriate if it can be supported. Such adjustments need to be carefully considered to avoid double counting of risks.
How might double counting for climate-related matters be avoided?
To avoid double counting, a company needs to consider whether climate-related matters have been reflected elsewhere before adjusting the discount rate. A proposed adjustment to the discount rate for climate-related matters could already be reflected, directly or indirectly:
- in the cash flows; or
- in other components of the discount rate. [IAS 36.A15, IFRS 13.B14(b)]
Significant climate-related matters that are industry-wide may be reflected in the beta factor. For example, the automotive industry is significantly impacted by climate-related risks and opportunities due to the influx of hybrid and electric vehicle competitors. Therefore, the industry beta may reflect this. If climate-related matters are reflected in the industry beta factor, then including or adjusting the alpha factor for the same climate-related matters would result in double counting.
Another example is when the alpha factor contains a premium for size risk. This premium considers smaller companies to be more risky than larger ones – for example, because they are less likely to have the resources and expertise to mitigate climate-related risks or to take advantage of climate-related opportunities. As such, size premiums may implicitly account for some climate-related matters.
Disclosures
IAS 36 Impairment of Assets specifically requires companies to disclose the discount rate used to estimate the recoverable amount (both VIU and FVLCD) when:
- an impairment loss has been recognised or reversed for an individual asset or CGU; or
- the impairment test is for a CGU (or group of CGUs) with a significant carrying amount of goodwill or intangible assets with indefinite useful lives. [IAS 36.130(f)(iii), (g), IAS 36.134(d)(v), e(v)]
Generally, the discount rate is a key assumption when estimating the recoverable amount under the DCF technique. Therefore, the following IAS 36 disclosure requirements related to key assumptions also apply when estimating the recoverable amount of a CGU (or group of CGUs) with a significant carrying amount of goodwill or intangible assets with indefinite useful lives:
- a description of management’s approach to determining the value assigned to the discount rate [IAS 36.134(d)(ii), (e)(ii)]; and
- sensitivity disclosures if a reasonably possible change in the discount rate would result in the CGU’s carrying amount exceeding its recoverable amount. [IAS 36.134(f)].
In other cases, disclosure of key assumptions is encouraged. [IAS 36.132]
Regulatory expectations
Climate-related information is a key area of focus for many regulators. For example, the European regulator ESMA2 has published a report on climate-related disclosures with examples of disclosures of the impact of climate-related matters on impairment of non-current assets together with explanations of why such disclosures may be useful to users of financial statements. ESMA expects companies to consider these examples when assessing and disclosing the degree to which climate-related matters play a role in the preparation of the financial statements. For example, the report states that issuers should consider disclosing how climate-related matters were considered in the estimation of discount rates.
For more guidance on disclosures and regulatory expectations see Have you disclosed the impacts of climate-related matters clearly?
Actions for management to take now
- Have you taken climate-related matters into account, to the extent necessary, when screening for comparable companies in the sector to estimate the beta?
- Have you supported any adjustments to the discount rate?
- Have you double counted any climate-related risks?
- Have you provided the required disclosures related to the discount rate used?
References to ‘Insights’ mean our publication Insights into IFRS®
1 Read our article to find out more about how climate-related risks and opportunities may impact a company’s strategy, financial reporting and sustainability reporting.
2 The European Securities and Markets Authority
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