Cool heads: The accountant's role in climate action

In May 2021, a tremor ran around the business world with the news that Royal Dutch Shell had been ordered by a bottom tier court in the Netherlands to drastically cut its global carbon emissions targets.

The climate campaigners who brought the action claimed the company, through its worldwide emissions, was violating human rights in the Netherlands because of the impact of rising sea levels on the country’s coastline.

The twist in the ruling was that it extended to Shell’s global Scope 2 and 3 emissions. The ruling’s requirements on those emissions were not strict, but ordering even a “significant best-efforts” reduction in Scope 2 and 3 emissions is tantamount to asking a company to change its sources of energy and its product line.

Greenhouse gas reduction commitments are signed by national governments. In contrast, the entities generating the emissions are companies. They’re not bound by such commitments, although many are taking it upon themselves to pledge to net zero emissions within their own operations.

The obvious way for a country to reconcile its international commitments with domestic economic activity is through government regulation to constrain greenhouse gas emissions by companies, or, otherwise, incentivise them embarking on this transformation.

Other forces are at work, too. They include consumer choice, investor pressure and, increasingly, climate litigation.

Where the debate is now

In September this year, CPA Australia brought together experts from across Asia-Pacific for a roundtable discussion on climate change and decarbonisation.

The discussion highlighted the growing acceptance by the region’s governments that they needed to rise to the challenges set by the Paris Agreement.

Additionally, there is a groundswell of public support for measures to safeguard the biodiversity of the region’s natural environment.

Data from Statista shows the carbon emissions curve has flattened across all geographic areas over the past several years, including in Asia-Pacific.

If this trend extends beyond the pandemic, it might be a sign that the multiple pressures on companies to cut carbon emissions are starting to work.

However, flattening the trajectory of carbon emissions is not enough to achieve the global goal of limiting temperature rises. Greenhouse gas emissions in all jurisdictions have to drop, and quickly, to achieve this; hence this year’s alarming assessment from the Intergovernmental Panel on Climate Change. 

Among the options available to governments are incentives for investment in new sources of energy and facilitating the adaptation of electricity grids to accommodate volatile and diverse sources of power.

In all these scenarios, though, companies are responding to external pressure.

There is a strong case for forward-thinking accountants and finance professionals who have the ear of the decision-makers – to take the initiative, says Cherine Fok, director of sustainability services at KPMG Singapore.

“We should be ready to exercise our professional judgement in challenging the assumptions that we are used to – even fundamental tenets such as ‘going concern’ – when assessing the financial statements.”

In practice, the kind of open corporate culture that would accept such questioning depends on the attitudes at the highest levels of leadership, says Laura Hillis, director of corporate engagement with Investor Group on Climate Change, which represents institutional investors throughout Australia and New Zealand.

“It has taken boards a long time to realise how material the financial risks are from climate change,” she says. “Those risks are not purely about reputation or regulation. They are also about the threat that rapid climate change poses to business as usual.”

The shift to entreprise value

Traditionally, financial materiality – and therefore reporting – had applied to environmental, social and governance (ESG) issues only when they had direct and quantifiable impacts within a defined timeframe, says Fok.

Environmental and social risks have introduced additional, and often incalculable, volatility to economic performance. “These need to be addressed in the financial statements if accounting is to remain relevant,” Fok says.

 

"It has taken boards a long time to realise how material the financial risks are from climate change. Those risks are not purely about reputation or regualtion. They are also about the threat that rapid climate change poses to business as usual."

 

Together, the International Accounting Standards Board (IASB) guidance and Paris-aligned accounting are having the desired effect of promoting clear disclosure of climate change in financial statements.

“We accountants can choose to take the lens of enterprise value materiality for a longer and wider view,” Fok says.

“However, we should be keenly aware that this approach calls for us to accept more uncertainty, while rigorously challenging the quality of data and underlying accounting assumptions.”

IFRS and sustainability reporting

Enterprise value is the centrepiece of the International Financial Reporting Standards (IFRS) Foundation’s recent establishing of the International Sustainability Standards Board (ISSB), resembling the IASB.

The ISSB plans to start issuing sustainability standards in 2022 in an attempt to bring the plethora of non-financial reporting methods under one umbrella. The first standard will deal with climate change.

The International Organization of Securities Commissions supports the initiative, as do the International Federation of Accountants and groups of large international investors such as the Investor Group on Climate Change.

Carbon reduction strategies

While the corporate world awaits the first of the ISSB standards, Nick Ridehalgh, leader of KPMG’s Better Business Reporting Group, points to a useful entry point for corporate accountants wanting to get started on helping reduce their company’s carbon emissions.

“A company’s carbon reduction strategy is typically driven by the board and executive,” Ridehalgh notes.

Once a company adopts carbon reduction targets, he says, accountants can work with the technical experts in operations and the sustainability department to determine projects that will reduce emissions.

“The accountants will then help prepare the business cases, including the costings, of initiatives to reduce a planned level of greenhouse gas emissions,” says Ridehalgh.

“These are the business cases that determine what projects have the lowest cost per tonne of carbon dioxide (or carbon dioxide equivalent) abated, and so should be prioritised.”

Currently, global carbon prices vary by jurisdiction, ranging from about A$20 in Australia up to about €60 (A$95) in Europe. Whatever the carbon price, it will likely raise the cost of current practices, and that will help the company evaluate its choices.

Terence Jeyaretnam, partner with EY Oceania’s Climate Change and Sustainability practice and senior adviser for the Value Reporting Foundation, encourages accountants to advocate for the company to set an internal carbon price.

“An internal carbon price tells you what a carbon price might do to your business, and that’s good transition planning,” Jeyaretnam says. Various commercial calculators are available to help factor in amounts of carbon produced by various modes of transport and the carbon emissions produced by the original industrial process.

Consider sustainable debt finance

Jeyaretnam suggests that corporate accountants consider sustainable debt finance. This includes “green bonds”, used for specific projects designed to boost specific environmental objectives, as well as general borrowing programs.

Sustainability link loans, for example, allow a company to borrow at a lower interest rate if it meets negotiated enterprise-wide objectives. If the company does not meet the objectives, which must be independently assured, it will have to pay a higher interest rate.

“You can’t do a sustainability link loan without the finance team ‘owning it’,” says Jeyaretnam. “The sustainability team plays a role in terms of setting performance, targets and goals – and measurement and assurance – and the finance team will oversee the debt product.”

Learn about integrated reporting

Accountants should also become familiar with a form of non-financial reporting called integrated reporting, Jeyaretnam advises.

“Understanding integrated reporting will help accountants think about biodiversity as a natural capital. Under integrated reporting you have to ask, if the business has to pay for the cost of carbon because of the impact it has on natural capital, how might that change the overall business model?”

 

"Under integrated reporting you have to ask, in the business has to pay for the cost of carbon because of the impact it has on natural capital, how might that change the overall business model?"

 

Integrated reporting is a widely accepted method for a company to consider how different elements add to, or detract from, enterprise value.

Fok says curiosity is key for accountants and finance professionals when it comes to helping their businesses and their clients address the challenges of climate change and decarbonisation.

“I’d ask, ‘Have strategic decisions been made with a sound upfront assessment of how they may impact both financial and enterprise value in the short and long term?’.”

Categorising emissions

Scope 1: Direct GHG Emissions

Scope 1 emissions are direct greenhouse gas (GHG) emissions from sources owned or controlled by an organisation. Examples of Scope 1 emissions include emissions from combustion in owned or controlled boilers, furnaces and vehicles or from chemical production in owned or controlled process equipment.

Scope 2: Electricity indirect GHG Emissions

Scope 2 emissions occur from the generation of purchased electricity (electricity that is purchased or otherwise brought into the organisational boundary of the company) consumed by a company. Scope 2 emissions physically occur at the facility where electricity is generated.

Scope 3: Other indirect GHG Emissions

Scope 3 is an optional reporting category covering all other indirect emissions occuring as a consequence of the company’s activities, but from sources not owned or controlled by the company. Examples include extraction and production of purchased materials, transportation of purchased fuels and use of sold products and services.

Source: ghgprotocol.org

Beyond IASB guidance

Paris-aligned financial accounting boils down the complexity of the climate debate to one key question - how would your business fare if the entire world moved to limiting overall carbon emissions to net zero by 2050?

Companies must factor different variables into their financial accounts, including:

• an estimate of the prices a company’s emissions-intensive products would command if demand fell
• an analysis of increased depreciation if the viable economic life of an asset were shortened
• an estimate of the costs (for example, of buying carbon credits or of carbon capture and sequestration) if strict global regulations mandated net zero carbon emissions by 2050
• an estimate of the impairment costs involved due to the effects of extreme weather events or sea level rises

The 2015 Paris Agreement did not specify “net zero by 2050”. However, this approach is called “Paris-aligned accounting” because it is required in order to meet the Paris Agreement targets, according to the 2018 Intergovernmental Panel on Climate Change.

Sarasin & Partners, a UK-based asset management company, has been working to offer shareholders better visibility of the financial benefits of a low-carbon world.

“We were concerned, because we thought the financial accounts of the big oil and gas producers were ignoring the economic reality of decarbonisation,” says Natasha Landell-Mills, Sarasin & Partners’ head of stewardship.

In 2017, the company made a complaint to the UK’s Financial Reporting Council that Royal Dutch Shell was not disclosing its long-term commodity price assumptions. “And then they did,” says Landell-Mills.

“Since then, I think oil and gas companies have realised it’s not tenable to be making very aggressive assumptions in their accounts, and they need to start bringing that down. In fact, this year BP has brought their assumption down from US$75 [A$104] a barrel to US$55 [A$76]. “Oil and gas aren’t the only sectors of concern,” says Landell-Mills. “There are questions about vehicles linked to the production of internal combustion engines. They’ll also have commodity price assumptions, alongside other judgements linked to property, plant and equipment assets that may need to be revised. Also, for instance, cement companies – are they leaving out the cost of carbon capture and storage, which they are likely to require to implement in order to achieve net zero?”

Companies don’t have to subscribe to the theory that severe measures to constrain carbon emissions are inevitable. However, they should still provide “net zero by 2050” sensitivity analysis in the notes to their financial accounts, Landell-Mills believes.

“In my view, if a sufficient number of investors are saying, ‘You need to tell us the impact of a net zero scenario for your financials’, that makes it material.

“You can make lots of narrative disclosures in the front half of the annual report,” says Landell-Mills, “but unless the numbers properly reflect that net zero pathway, then the key driver of how capital is allocated will not be in line with your narrative. And it should be consistent.”