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Climate risk: What accountants need to know

The 21st century shapes as a significant period where we’ll be dealing with a myriad of global risks. None deserve our long-term attention quite like climate change, it was argued in a recent CPA Australia webinar.

By Prue Moodie

Most corporate accountants have little experience translating information from non-financial reports into financial statements. Nor have auditors typically tested such information.

CPA Australia’s recent webinar, titled Climate change – what accountants need to know, is a thorough look at the interaction of climate change-related risks, the Paris Agreement, non-financial reporting and corporate reporting, from the point of view of accountants and financial reporting.

The webinar brought together the authors of a report commissioned by CPA Australia and written by Professor Jacqueline Peel, University of Melbourne Law School; Sarah Barker, head of Climate Risk Governance, MinterEllison; and Ellie Mulholland, director, Commonwealth Climate and Law Initiative and senior associate of MinterEllison.

The report, issued in January 2020, is called Australia’s international climate change commitments – associated accounting assumptions and auditing of climate risk disclosures.

Opening the discussion, CPA Australia policy adviser for environmental, social and governance issues, John Purcell said that climate change was a matter which would affect management and directors’ assumptions about the future.

“It will affect their estimates in relation not only to cash flows, but their estimates of the robustness of their business model.”

Acclimatising to a new world

The 21st century is shaping up as a world of global risks. We’ve seen the effects of global terrorism, systemic financial failure and pandemic, and we’ve adjusted (or are in the process of adjusting) to the policy responses deployed to contain these risks.

The scientific consensus about global warming is significant and we are recognising that preventing the worst effects of climate change needs effort on multiple fronts.

A company’s greenhouse gas emissions, typically contained in the corporate responsibility report, is important information. But its relevance to mainstream investors and lenders is only what it tells them about reputation risk and other forms of non-financial risk.

On the other hand, quantifying the likely rise in insurance premiums because of weather events is immediately relevant to investors and lenders. As is the impact that a carbon price might have on the business.

This is the sort of information that is contained in a well-prepared Task force on Climate-related Financial Disclosures (TCFD) report. The TCFD framework was published in 2017 with the aim of improving the flow of decision-useful information to investors and lenders who make decisions about capital allocation and credit risk.

Mulholland defined TCFD as a set of recommendations for narrative reporting on climate risk, with an emphasis on forward looking scenarios.

“What we see in the rearview mirror won’t show us what’s going to happen in the future. We really need to do that horizon scan and look into the future with scenario analysis and stress testing,” she wrote.

A TCFD report typically forms part of the front part of an annual report. It is voluntary, non-financial reporting.

Reporting on climate risk

Meanwhile, in April 2019 the Australian Accounting Standards Board (AASB) and the Auditing and Assurance Standards Board (AUASB) issued the final version of its view on how climate risk should be reported.

“Entities can no longer treat climate-related risks as merely a matter of corporate responsibility and may need to consider them also in the context of their financial statements,” it said in the introduction.

Like the TCFD, the AASB/AUASB guidance is also voluntary.

Barker explains the link between the growing number of TCFD reports and the issuance of the AASB/AUASB guidance.

“They [AASB/AUASB] thought, well, if this information about climate-related risk on a forward looking basis is material enough to be disclosed then surely to some extent it does have an impact on the financial statements, particularly on the accounting estimates that go in the balance sheet,” she said.

Barker noted that the guidance makes clear the distinction between materiality in a business context, and materiality in a disclosure context.

“In a business context, you might use a rule of thumb of plus or minus 5 per cent of revenue as being material.

“But we know, in a disclosure context, that’s not the test. The test for whether or not information is material from a disclosure point of view is: ‘Is this information decision-useful for a reasonable investor?’

“And the answer to that question is contained in the joint guidance. Very much in the affirmative. It emphasises that this is an issue that is of critical importance to investors.

“You take the analysis that has been done in relation to climate risk. If it is a financial risk, make sure it is then integrated into the financial statements.

“AASB/AUASB emphasise things like: what do these assumptions mean for asset useful lives; what do they mean for non-current assets that might be stated at fair value; what do they mean for the statement of asset impairment; what do they mean for provisions for bad and doubtful debts?”

Climate change: What accountants can do

CPA Australia’s Purcell discussed the guidance in more detail.

“There are a number of accounting standards on which issues of climate change, both physical and transitional risk, will have a direct bearing,” said Purcell.

Purcell focused on IAS 36 (impairments) and IAS 37 (dealing with provisions and contingent liabilities).

“The identification of which assets may need to be impaired is central to the impairment standard. It gives us fairly black letter statements on matters which need to be drawn into consideration. It addresses both external factors and internal factors which need to be brought to bear in this impairment decision.

“Meanwhile, at the heart of the TCFD is scenario testing which involves applying different levels of global warming to understand what is happening to the value of your assets over time horizons.

“Now, if an internal examination of a scenario analysis throws up a particular concern in relation to assumptions about the future, that becomes a matter relevant to impairment decisions.”

With regard to IASB 37, climate-related risk reporting could take the following forms:

  • recognition of an erroneous contract provision for potential loss of revenue or increased costs described in the TCFD’s climate-related risk scenarios
  • an increase of provisions recognised for decommissioning plant or rehabilitating environmental damage in existing industries due to regulatory change or shortened project life
  • disclosure of contingent liability for potential litigation and fines or penalties because of other environmental regulations where the company may have been proven to have broken these regulations.

Australia’s role in a greener future

Peel linked the discussion to Australia’s commitments under the Paris Agreement.

Australia’s commitment (called a nationally determined contribution, NDC) is a 26-28 per cent reduction in 2005-level greenhouse gases by 2030.

Peel characterised this as a low ambition target.

“Our assessment is that it’s going to become more and more difficult for countries with lower ambition NDCs, like Australia, to maintain those targets and not move towards more ambitious targets.

“We were interested to think about the extent to which a country’s NDC – our specific focus was on Australia’s NDC –  might be a relevant variable.

“The overall conclusion was that yes, it is relevant as one variable in determining a reporting entity’s exposure to economic transition risk. It provides a signal of the direction of travel or policy in Australia in the progress towards [the] Paris Agreement’s goals.”

Because Australia is far from a first mover in the battle to constrain emissions, that leaves the country at risk of a more painful economic transition further down the track. That may need to be factored into a company’s climate risk reporting.

This article was originally published in IN THE BLACK