Carbon accounting: integrating climate risks to financial reporting

CARBON ACCOUNTING: INTEGRATING CLIMATE RISKS TO FINANCIAL REPORTING WITH LIVIA ROSSI, STEWARDSHIP SPECIALIST AT THE PRI, CLIMATE ACTION 100+, BARBARA DAVIDSON, SENIOR ANALYST, REGULATORY AND ACCOUNTING AT CARBON TRACKER INITIATIVE AND CAROLINE ESCOTT, SENIOR INVESTMENT MANAGER – SUSTAINABLE OWNERSHIP AT RAILPEN

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Livia Rossi
Hello and welcome to the PRI podcast. My name is Livia Rossi. I’m a stewardship specialist at PRI, working at the Climate Action 100+ initiative. And I’m delighted to be your host today. Before we start, I wanted to remind you that Climate Action 100+ is an investor led initiative that coordinates collaborative engagements to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change. We are now in a critical decade for technical climate change. Some companies have started advertising and reporting the measures they’re taking to transition to a low carbon business model and address climate change. However, when looking closely at 2 companies’ financial statements, it is not always clear how, and whether they’re actually transitioning. Companies still need to step up and ensure that the practice in their financial reports reflect what they’re preaching publicly. Today, I’ll be talking about this new hot topic, climate accounting. To talk about integrating the financial impact of climate related matters into company’s financial statements, I’m joined today by Barbara Davidson. She’s a senior analyst at Carbon Tracker, who is the lead author of a report that Carbon Tracker published earlier this year ‘Flying line - the glaring absence of climate risks in financial reporting’. Barbara has a background in both audits and accounting standard setting. She will walk us through the fundamentals of climate accounting and what this report has found about companies’ practices. I’m also joined today by Caroline Scott, senior investment manager at Ray open, who provide us with investors’ perspective and expectations on this topic. Caroline has a wealth of experience working in this stewardship space and in 2020 won investment week’s investment woman of the year for small and medium firms. Welcome Barbara and Caroline. It is no secret that setting the world on a direct path to no more than 1.5 degrees warming by the end of the century will be a tremendous challenge and ensuring that finance flows are consistent with the activity pathway towards that goal is essential. As part of achieving this corporates need to ensure that their financial statements accurately report their financial position and performance by incorporating material information about climate related risks. Investors have been clearly vocalising their needs and expect for better information about these issues to companies and auditors. Barbara, some cities as a very technical topic before we get into the weeds. Could you provide us with a brief background?

Barbara Davidson
Yes. Hi, thank you, Livia. And thank you, for inviting me to speak today about this topic. So, I can see why some see this as a technical topic, but, and I’ll take a step back and talk a little bit about the perception around this and try to make it a little bit simpler for people who are not accountants. In the past, there was some sort of perception that because financial accounting requirements and audit standards, don’t explicitly mention the word climate to climate change. That climate related risks didn’t apply when companies should prepare their financial statements or when auditors were auditing them. But for that matter of financial statements of, excuse me, financial accounting standards and auditing standards, don’t mention a lot of risks that we’re looking at today. For example, they don’t mention COVID, but we’ve had to look at these risks and the effects on financial statements in the past year or two. 3 Additionally, as you mentioned in your introduction, there’s been a growing concern from the investment community about the material impacts of the energy transition on current financial reporting. So in response to the perception about the lack of mention of climate in accounting standards, as well as the concerns from investors in the past couple of years, accounting standards centers, which would be both the international accounting standards board, which said international financial reporting standards are I for S and the financial accounting standards board, which sets the US generally accepted accounting principles for US gap have both made it clear that companies management must consider the material impacts of climate related matters when preparing their financial statements today. So, it’s now clear that even though these standards do not split specifically require the consideration of climate, the consideration is still implicit in the standards. Additionally, the international audit standard setter has also made it clear that auditors need to consider material climate related matters when they’re auditing companies.

Livia Rossi
So what does this meaning practice?

Barbara Davidson
So many items in the financial statements are already valued using long term assumptions or estimates, for example, asset impairments, expected credit losses, or the remaining period over which a company may use an asset such as the assets estimated remaining useful life, all require companies to make estimates about future activities. Climate related transition risks will significantly affect these and other assumptions and estimates that companies use such as long-term commodity prices, carbon prices, or growth rates that companies might use for determining the long term cash flows that they have to use again for recoverable amounts and impairment testing, or they may affect the remaining useful asset lives and residual asset values used for determining depreciation and amortisation. So, to give you an example, if there is a decline in demand for, or the planned phase out of a company’s products, such as cars that run on internal combustion engines, this may mean that a car company has to reassess the time over which it can continue to use its existing manufacturing equipment or the values of the cars. In fact, that it, it has used as collateral for receivables or finance receivables. Another example could be the replacement of fossil fuels for power by less expensive, renewable energy sources. This will affect the ability of oil and gas companies to use their productive assets and to make a profit using those assets. Regulations to reduce emissions will affect the cost of producing carbon intensive products, such as cement and steel. Other examples of financial statement impacts could include, like I said before, increases in expected credit losses, inventory obsolescence, where the value inventory will no longer be sold for the amounts a company thought it could be, and they won’t be able to recover their costs, accelerated decommissioning obligations. 4 If oil and gas companies have to stop producing earlier than they thought they would, or long-term contracts, which could become onerous if there are shifting prices or demand. And Livia Rossi So, does management need to integrate new types of assumptions and into the financial statements to consider the financial impacts of the energy transition?

Barbara Davidson
No, in fact, it’s quite the opposite. So, what we’re saying is that management should already be considering the financial impacts of the energy transition on the information that they’re using today. So they’re already using the, these assumptions and estimates that I, that I just described when they prepare their financial today. We’re not asking them to come up with new types of assumptions or estimates.

Livia Rossi
That’s really interesting. And as we said, investors have been vocalising their expectations to companies and their auditors about this subject. Can you provide us with a more general overview of what, what they asked for?

Barbara Davidson
Yes, so just to give you a quick context in the light of the clarifications that the accounting and audit standards centers that have made that I mentioned just before. Investors have now felt more confident in asking management and their auditors to ensure that the management and auditors are considering climate related matters when they’re preparing and auditing the financial statements. And so an example of this is as you know, it was in 2020, the second half of 2020, where large investor organisations, including the Principles for Responsible Investment and the, IIGCC as well as individual investors together representing over a 100 trillion in assets under management, published letters, emphasising the need for companies and auditors to consider the effects of material, climate related risks and financial statements. They also ask companies when they sent these letters or publish these letters to include sustainable assumptions and estimates when they prepare their financial statements or to provide a sensitivity of the relevant financial statement items when they are preparing their financials. So, when we reference sustainable assumptions and estimates, we’re often also referring to them as Paris aligned inputs, which means using assumptions and estimates that would achieve net zero by 2050, as well as no more than 1.5 degrees warming. Livia Rossi Caroline, turning to you now as an investor, can you speak about how better transparency and disclosure could help achieve the goals of the Paris agreement? 5

Caroline Escott
Yes, of course. So better transparency in this space helps investors like Railpen, understand the extent what management has considered the effects of the goals of the Paris agreement in their financial statements. And so, the extent to which their invested capital is at risk as a result of the energy transition, and this helps us understand a number of things. So firstly, whether the companies in which we’re invested are considering the effects of the energy transition on their current business strategy. And if so, to what extent or conversely, where the management believes that they can continue with business as usual. And if so, why, and it’s this transparency, which helps us, other investors, other stakeholders, pressure company boards, to refocus business strategies and invest in the new technologies and undertake other activities which require to shift their business focus in response to the energy transition. It also means that investors can engage or can vote or can allocate capital much more efficiently and effectively, and understanding the quantitative information that management has used to prepare their financial statements means that investors can also make more accurate adjustments to our own valuations. Finally, it really does help us gauge if companies are greenwashing or whether in fact, they truly understand the implications of climate change for their business model and approach. And of course, all of this also helps us of investors and other stakeholders, generally pressure governments and regulators to enforce change in order to achieve the goals of the Paris agreement and alongside sustainable finance and investments and innovation. It’s this public policy pressure that is key to supporting a shift to a Paris aligned trajectory.

Livia Rossi
Thank you both. I think that now we got a good picture of the background and what investors are doing about this. So let’s dig a little bit deeper. Barbara, could you tell us about Carbon Tracker’s report Flying Blind?

Barbara Davidson
Yes, I’d be happy to. So, in September last year we published a report called Flying blind - the glaring absence of climate related risks and financial reporting, we refer to that as flying blind, and this is off the back of all these discussions that we’ve just had. So the clarifications by standard settlers and investor, uh, requirements and the goal of this report, which was a summary of analyses and studies that we did was to determine the effect to which financial statements, sorry, the financial effects of climate related risks were reflected in company’s financial statements. We also looked at whether the auditors considered the effects of such issues in their audits. So, remember now both of these are required today, a little bit more background on the audit side and their audit reports auditors in most jurisdictions are required to include key or critical audit matters. These matters are related to items for which significant judgements and our estimates were needed both by management when they were preparing the financial statements, as well as the auditors 6 when they’re auditing these items. So based on the nature of the companies that we reviewed, the uncertainty that there is around the climate, around the effects of climate and transition related risks, as well as the nature of the items that are considered to be key or critical audit matters such as asset impairment testing, we would’ve expected auditors to have a consideration of climate related risks. And so also discuss that in their audit reports, as a result of their audits of these companies.

Livia Rossi
Can you expand on what do you mean by the nature of the companies that you reviewed? What exactly were the companies that you cover?

Barbara Davidson
Yes, so we reviewed, and when I say we I’m referring to the team at Carbon Tracker and also a team at the climate accounting project, which was an in independent team of experts that was commissioned in fact by the PRI. We reviewed 107 carbon intensive companies. 94 of the companies of this population actually formed part of the Climate Action 100+ focus companies. And so, and those companies, the Climate Action 100+ focus companies are responsible for over 80% of industrial greenhouse gas emissions. So effectively we looked at 94 companies that are part of a population that are responsible for a significant amount of industrial greenhouse gas emissions. So already there’s one piece of the population, these companies also functioned across various sectors, but they were primarily in the energy industrials and transportation sectors. There were significant international coverage of companies, but most of the companies were located in the UK, the EU or the US. Examples of the companies that we were included in our review are companies such as Chevron, Exxon, BP, Total, BMW, Volkswagen, Air France and American airlines. So this is why we’ve started. We started our reviews with an underlying assumption that the energy transition would already be material to these companies, their and their operations.

Livia Rossi
And can you tell us what were the key takeaways of this report?

Barbara Davidson
Yes, the report, unfortunately, the key findings were disappointing. 70% of these 107 companies, again, remember we expected to see climate related issues in for these companies, 70% of them, and 80% of their auditors actually provided no indication that they considered the financial effects of climate when they’re preparing the financial statements or when the auditors were auditing the financial statements. So, this means that investors affect have no way of knowing if these companies have been considering and understanding how relevant policies and regulations that are being adopted as part of the energy transition, such as, again, reductions to emissions or the phasing out of high emission products or changes to consumer preferences, or even the company’s own climate targets would affect their financials. We can’t tell if these companies are appreciating that and 7 considering that this also means that companies are likely to continue to allocate to capital expenditures. And so future invest, make future investments in loss, making activities. Like I said, 80% of the audit reports didn’t provide evidence of consideration of the effects of climate. So we don’t know either if auditors considered the impact of climate related issues when they were auditing these companies. So by way of example, impairment was the most frequently mentioned audit matter for these companies, 70% of the audit reports that we looked at for these companies identified impairment of property, plant and equipment as a key or critical audit matter because of the significant judgments and estimates that are required to estimate impairment of these assets. And as I said earlier, impairment tests often rely on estimates of future cash flows, which could be materially affected by the energy transition. Again, things like commodity prices, or asset lies will affect future cash flows. However, of the auditors that identified impairment as an audit matter, only 25% of them even gave any evidence that they consider the energy transition or changes in prices as a result when they were testing these issues. So effectively, we saw a key audit matter that would be significantly impacted by the energy transition, but a very small amount of the auditors actually seemed to consider the effects of the energy transition when auditing impairment.

Livia Rossi
Yeah. It seems like a lot of the relevant information seemed isn’t being disclosed. What else did the report tell us about this?

Barbara Davidson
Yeah, so I think a lot of information isn’t being disclosed. So, we also looked at whether companies disclose what we refer to as relevant climate related assumptions and estimates, and only 25% of the companies that we looked at disclose this information. Again, this is information that is material to investors in their investment making decisions. And so it would be required to be disclosed by companies. So what do I mean by quantitative climate related assumptions and estimates, examples are commodity prices, useful lives of assets, the timeframe over which a company may have to meet its decommissioning obligations or the effects of changes in production or demand estimates. These, again, these are assumptions and estimates that are used when estimating future cash flows for companies and investors need to understand this information cause it helps them understand the extent to which climate was, is being considered in the assumptions and estimates that a company uses. And so whether a company is actually resilient to the energy transition and it helps investors make their own adjustments as they deem necessary.

Livia Rossi
What are the risks of the lack of information?

Barbara Davidson 8
The implications of ignoring the effects of these issues, well one of the implications are potential for material misstatement and financial statements. As I said before, there could be continued investment in loss making activities because this will result in overstated assets, understated, liabilities, overstated profits. And so as a result of this, companies or investors may to non sustainable business activities and investors have a large potential to lose large amounts of capital. There’s also greater potential for greenwash without this information and without this consistency.

Livia Rossi
Yeah. So in if companies are not disclosing assumptions in their financial reporting, I imagine that is not easy to understand if companies are actually leading doing what they say they’re doing to carbonise their activities. What did the report find in this sense?

Barbara Davidson
Yes, that’s right. So, we looked at whether companies appeared to be providing consistent information or consistent climate narrative, if you will. And 72% of the companies that we reviewed appeared to actually tell an inconsistent climate story. So, if they provided climate related discussions outside of the financial statements, what we might call the front half of annual reports or in their sustainability reports, we look to see if these discussions were consistent with the information that companies use to prepare the financial statements. So for example, where the remaining productive carbon intensive asset lives aligned with the company’s timing to reduce emissions. So how did the use of carbon intensive assets for the next 30 years align with the company’s interim reduction plans to reduce their emissions in the next 10 years? We look to see if the company used the same assumptions for investment in planning as they did in the financial statements. Did the company use at least one set of assumptions when they were calculating or providing TCFD scenarios that were also aligned with those assumptions? They used in the financial statements. We found inconsistencies in companies, even where companies stated that they thought climate related risks would be financial material. We still didn’t see evidence of their consideration of these issues in the financial statements. And so, there was no, there was often no clear through line from a company’s discussions around sustainability or transition risks to the company’s financial reporting. And additionally, auditors are required to check for consistency of a company’s financial statement with other information that they must review or read. And that is to also assess whether there is a material misstatement in the financial statements or in the company’s other information. But we had significant concerns for over 59% of the consistency checks that auditors performed, where they said nothing about any inconsistencies, even though we found inconsistencies in the company’s reporting and the information that the auditors should have reviewed as part of their work.

Livia Rossi 9
Yeah. These are very interesting findings. Caroline, can you talk about how it’s reopen using the analysis for, from carbon tracker and others to shape your engagement and voting this year?

Caroline Escott
I think the first thing to say is that Railpen is unusual amongst UK asset owners. In that we do have this in-house sustainable ownership team, which is dedicated responsible investment. We have been engaging with companies on climate activities for many years, and we have been clear that the only way a company can achieve its net zero commitment is to allocate capital in a way which is consistent with that ambition and all the good things that Barbara has been talking about. However, like many investors, we don’t have anyone on our team with a specific audit or accountancy background. So, when we were thinking about our 2021 voting and engagement plan, we knew that we would need extra expert support and input if we wanted to make a meaningful impact on climate accounting at our portfolio companies. And this was where the Carbon Tracker and climate accounting project analysis and the support from Barbara and team came in. And we used all of this research in a number of ways. The first was updating our voting policy for 2021. We publish our voting policy each year at the beginning or sometimes even towards the end of the previous year. And this is an external facing policy, which puts our portfolio companies on notice about how we will vote to express support or sanction for their behaviour on what we deem to be material and priority ES and G issues and our conversations with Barbara and the team when we were pulling together our policy for 2021 indicates that we would be able to use this analysis in our engagement and in our voting decisions. And so, our voting policy that was published in February of 2021 included new lines on climate accounting specifically for the first time. And this policy then provides a framework for our voting activity over the course of the following year in 2021. We ended up voting on several occasions against the auditor appointment and the chair or the members of the audit committee, those highly carbon intensive companies, where we thought that insufficient progress had been made on climate accounting and our vote depended or the nature of our vote and the precise resolution that we chose to express our view depended in part on where and with whom we thought most responsibility lay for the specific issues. And this decision was based on both the Carbon Tracker and climate accounting project analysis, as well as intelligence from our own engagements and exploration of the source material. We also used this analysis as the basis for a number of questions at company AGMs. We are doing this more and more because we think that asking questions at AGMs can be a really effective way to highlight an issue and are a particularly impactful way of escalating prior engagement. And of course our voting is always aligned with our engagement. So as well as Railpen support some Climate Action 100+ investor leads at some companies on climate accounting specifically, we’ve also used very helpful analysis that Barbara and the team have produced to support our own direct engagements with some of our 10 priority holdings where climate change is a material issue and where there were specific climate accounting issues. And we’ve been trying to speak to CFOs and audit committee chairs specifically, and we’ll be continuing to do so in 2022.

Livia Rossi
So Caroline mentioned how transparency helps investors to understand where companies are and how is this important to achieving the goals of the Paris agreement. So coming back to you and Barbara, can you link the results of the report with that idea?

Barbara Davidson
Yes, I’d be happy to. So although not required by accounting standards, investors have also asked companies to use assumptions and estimates that are aligned with achieving the goals of the Paris agreement or to provide an in a sensitivity to those inputs when they prepare the financial statements, which is something I’d mentioned in the beginning, we had also referred to these as sustainable assumptions and estimates. These same investors have also asked auditors to assess the company’s inputs and for the auditors to provide their own sensitivity to the relevant items in the financial statements. If the companies didn’t align with so-called the Paris line adjustment. So investors need this information to assess resilience to the energy transition and to engage both as, as Caroline had noted before, however, none of the companies that we reviewed had so-called aligned accounts, according to the definition that we, we are using, and only 9% of the auditors addressed these investors request to even assess the company’s estimates to external climate scenarios and to assess them against what we would see as Paris aligned scenarios. And of these auditors that, that have said something about this assessment. It’s interesting and notable that Shell’s auditor actually indicated its view that assessing these inputs against Paris aligned assumptions and assessments were, was outside of its remit. And it was outside of its responsibility or its level of expertise.

Livia Rossi
How did you assess this information when reviewing the company financial statements?

Barbara Davidson
The way we assessed it – the estimates and assumptions was by looking at the IEA’s net zero by 2050 scenario. That was that they included in their world energy outlook in October, 2021. So this scenario included various assumptions and estimates such as commodity prices or demand or production estimates that would be aligned with achieving these outcomes. Again, that would be net zero by 2050, or sooner, and no more than 1.5 degree warming. So, what we did was we compared the assumptions and estimates that management used in the financial statements, if they did provide this information, of course, with the pricing and discussions that the IEA is provided in their net zero by 2050 scenario.

Livia Rossi 11
And now, in your opinion, what was the most shocking conclusion coming from this analysis?

Barbara Davidson
Yeah, most surprising to me, I have to say was the lack of discussion in the audit reports about around these issues. And, and particularly for the US auditors of the oil and gas may ages. As I mentioned before, only 20% of the auditors that we reviewed made, gave any indication that they considered the effects of the energy transition on the companies that they audited. And in fact, none of the audit reports or the auditors of the US companies discussed any consideration at all of climate related risks of the energy transition, even companies own a mission targets as part of the audit work that they did. And there are differences. There are some differences between audit requirements, um, outside the us and inside the us, but the audit requirements would not differ to this extent, um, across jurisdictions that we should see this difference. The other thing that we found, so very surprisingly is that there were, uh, companies, the auditors of companies that were dual listed. So they’re listed in their own, um, location. And then in the United States have two audit reports. This is a common thing, but what surprised us was that they often removed any reference to consideration of climate in their us audit report. And again, there was no reason to have this difference in based on the, this, the requirements. The only other thing I would note is the lack of discussion in the financial statements and the apparently inconsistent climate stories that are told by the oil and gas companies and the automotive companies who were surprisingly poor at discussing these issues in their financials, despite having or providing significant discussions outside their financial statements about their shift towards electrification and decarbonisation.

Livia Rossi
All right, since you’ve both spoken about investor engagements, I wanted to talk a little bit about Climate Action 100+. Since the initiative will publish the second version of the Climate Action 100+ Net Zero Company Benchmark, which is a framework that help investors assess the performance of focus companies against the initiative goals. In this version of the benchmark, we will incorporate an indicator about climate accounting and Carbon Tracker was directly involved in creating the methodology for assessing that indicator. So want, I wanted you Barbara to tell us a little bit about this.

Barbara Davidson
Yes, as you mentioned, this is a new indicator, the climate accounting and audit alignment assessment. As the name implies, it’s intended to assess a company’s accounting and auditing disclosure and alignment. And so investors with their engagement and voting practices, there will be three pieces to the assessment or three sub sub-indicators if you will. The first relates to assessing financial statements in accordance with the accounting standards. The second relates to assessing the audit reports in accordance with the audit standards. And then the third will be assessing 12 assumptions and estimates to see if they’re aligned with what we’re defining as Paris achieving the goals of the Paris agreement. As I explained before, so called Paris alignment. As with the net zero benchmark, we will be assessing companies and auditors using a traffic light system. So based on the result of the reviews we’ve already done for Flying Blind. So those would be the 2020 financial statements where no company or auditor achieved a score, really a high score on the assessment of Paris alignment, no company will fully meet the accounting and audit assessment for 2020, because they will likely receive a no for the Paris alignment assessment. So that means that the best score for any company for the 2022 benchmark for the alignment assessment that’s coming out in March would be a partial score. And just to clarify, we are looking right now at the 2020 financial reporting for this indicator or the accounting and audit line assessment because those are the most recent reports that are out for companies. So the 2021 reports will be assessed at a later date. So the result of the benchmark are planned to be published in March of this year 2022.

Livia Rossi
Thank you, Barbara. And now to wrap up Caroline, what can we expect from investors in the coming years to accelerate the changes needed?

Caroline Escott
I would say that the investor community is increasingly alive to the materiality of climate accounting as an issue at our portfolio companies and, you know, from what Barbara has mentioned and, and from some of the things I’ve been saying as well, I think it’s clear that we are already seeing heightened activity on this issue. And in addition to the steps that Barbara mentioned about incorporating climate accounting into the Climate Action 100+ company benchmark, Railpen has been in part of a core group of investors engaging in support of the IIGCC’s para line account initiative, that was also mentioned previously. And the later step for this particular piece of work is writing to companies attaching their specific Carbon Tracker analysis and highlighting those actions that we’d expect each company to take address particular concerns and gaps. I think it’s also likely that we are going to see increased escalation through the voting mechanism from the investor community on climate accounting grounds specifically. This issue is maturing rapidly now some companies have been engaged with extensively on climate accounting, and of course it should have been clear for some time to both companies and auditors that the regulators do expect climate change, where material to be reflected in the accounts or in the audit planning and execution. So there really is an increasingly little excuse for companies that hire carbon intensive, not to be acting on these issues and the same for their auditors. The escalation could be done in a number of ways. It could be done through votes against the entire audit committee. It could be done through votes against the reporting accounts or even votes against both the appointment and the immune iteration of the auditors. Again, as I was saying previously, depending on where investors consider responsibility to lie, finally, um, like many 13 investors, we have been having our own conversations with our proxy advisors about the need and desirability of incorporating climate accounting into their standard advice for clients. And when we first started these conversations, there were quite a few blank faces when we mentioned the issue, but we think the progress is now being made. And we had some really promising conversations, even just a few weeks ago about these issues with our proxy advisors. And of course, any shift within this community will support the rest of the investor, including those who aren’t part of climate actual plus, or who might have relatively fewer responsible investment resources to appropriately consider climate accounting in their votes, and to send a clear message to companies that business as usual in this space simply isn’t good enough.

Livia Rossi
It seems like great work and it appears that there’s a lot to be done, but also that we are finally going the right direction and hopefully this will help us keep 1.5 alive. I want to thank both of our guests for their participation. Thank you Barbara. Thank you, Caroline for disengaging the discussion. Thank you for listening. Don’t forget to rate and subscribe and for more information on responsible investment visit unpri.org.