Discount rate

Under the expected cash flow (ECF) approach (see Cash flow projections: Question 4), the uncertainty about the future cash flows is considered in estimating the cash flows and the probabilities attached to them. If this is the case, then the cost of equity would not include a risk premium for this uncertainty.

In contrast, under the traditional approach, an adjustment is made for any cash flow uncertainty not captured in the single cash flow projection. This adjustment is made to the WACC through the alpha factor in the cost of equity.

Therefore, the WACC used under the ECF approach is usually lower than under the traditional approach. The diagram below highlights the differences between the ECF approach and the traditional approach.

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). It is typically estimated based on comparable companies’ betas in the relevant sector or industry. If climate-related matters are significant, then they are considered when identifying comparable companies.

Companies in the same industry can have significantly different exposures to climate-related matters. This could be due to differences in their location, the applicable legislation and the companies’ strategies – some companies are proactive, others are not. This needs to be considered when identifying comparable companies. 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; small private companies are less likely to do so.

If climate-related matters are industry-wide (rather than CGU-specific) and significant, then they may be reflected in the beta factor. This will depend on whether climate-related matters are priced by the market and the time span of the beta factor. Beta factor is a medium-term measure – it is typically based on historical data over a two- to five-year period. A five-year beta factor may not reflect climate-related matters – e.g. in markets where companies have only recently started providing climate-related information. 

For the interaction of the beta factor with the alpha factor, see Question 3.

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 that cannot be attributed to market risk (unsystematic risk).

If a CGU is exposed to a particular climate-related risk or has a distinctive climate-related strategy that differs significantly from those of the comparable companies identified, then – after reflecting the impact in the cash flows – climate-related matters may need to be reflected in the alpha factor if the discount rate does not reflect the return required by a market participant.

If it is not possible to find an appropriate beta factor of comparable companies with a similar climate-related risk, then reflecting the risk through the alpha factor is appropriate if it can be supported. Such adjustments are carefully considered to avoid double counting of risks that are already reflected in the cash flow projections or in other components of the WACC, and need to be supported by sufficient data.

For example, if the company is significantly exposed to physical risks (e.g. storms and/or flooding) to which the group of comparable companies is not, and these risks can be reflected in the cash flow projections, then:

• the cash flow projections need to be adjusted to reflect these risks; and
• the discount rate needs to reflect these risks to arrive at the rate of return required by a market participant to the extent that any adjustments to the alpha factor can be supported. Climate-related risks may change the expected cash flows by introducing or increasing the likelihood and severity of possible negative outcomes. The increase in risk from the existence of a wider range of possible negative outcomes may increase the return investors require for investing in the company and bearing such risks.

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. To avoid double counting, a company needs to consider whether climate-related matters have been reflected elsewhere before adjusting 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 matters due to the influx of hybrid and electric vehicle competitors. The industry beta factor may at least partly reflect this. If climate-related matters are reflected in the industry beta factor, then 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 – e.g. 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.