COP 26 will begin in three days. There are many topics that will be covered in this event. One that probably won’t receive enough coverage although it deserves serious attention is the relationship between climate change and financial audits. This is admittedly not as easy to relate to as the pressing need to reduce carbon emissions and invest in renewable energy, but it is a way to help ensure the capital markets are playing as big of a role as they can. Work has already been done here from the perspective of both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S. GAAP). For the former, I relied heavily on the work of Mr. David Pitt-Watson. For the latter, I did the same with respect to Ms. Samantha Ross.
Since I wrote these pieces an interesting and important report has been published by the think tank Carbon Tracker: “Flying blind: the glaring absence of climate risks in financial reporting.” The simple answer to the question in this title of this post is “No.” Or, to elaborate just a bit more, “Over 70% of some of world’s biggest corporate emitters failed to disclose the effects of climate risk in 2020 financial statements. 80% of their auditors showed no evidence of assessing climate risk when reporting.” Elaborating still further, Rob Schuwerk, Executive Director of Carbon Tracker and one of the report authors stated that: “These are disappointing findings, especially considering that these same companies acknowledge that their results will likely be negatively impacted by the energy transition.”
This can’t be due to the lack of guidance from relevant standard setters. In 2019, the International Accounting Standards Board (IASB) published an article on this topic, and the next year followed up with some educational material. The International Audit and Assurance Standards Board (IAASB) published staff guidance clarifying that climate-related risks should be considered as part of audits. The U.S. Financial Accounting Standards Board (FASB) has weighed in as well some with governance in early 2021 about the relevance of material environmental, social, and governance (ESG) issues, including climate change, under U.S. GAAP. Finally, the auditors themselves through their Global Public Policy Committee, wrote to the IASB in December 2020 that they will communicate the IASB and IAASB guidance to their networks and encourage “greater transparency on the impact of climate-related matters on companies’ financial statements.”
As is often the case in life, there can be a gap between communicated commitments and execution. There are two possible reasons for this. The first is that there is no intent to match commitment to execution or, as the term seems to be used in so many ways these days, “greenwashing.” The other is that it simply takes time to develop the necessary capabilities for new practices and so a lag is inevitable. In this case, communicated commitment is a good thing since it is a strong motivator to match deeds to words.
Since the auditing profession—dominated by the big four of Deloitte, EY, KPMG, and PwC—has an essential role in the capital markets and a highly regulated one, I think the second explanation is the more likely one. In that spirit, I see this report as providing some useful insights for the auditing profession to consider as they develop their capabilities on this obviously essential issue. Audited financial statements are important input to investors’ decisions and thus they want to be sure they have been properly done regarding a phenomenon which has scientifically validated, albeit with some holdouts of particular political ideologies.
The study evaluated the audits of 107 companies, largely taken from the target companies of Climate Action 100+. The report asked a number of questions. In particular was there any evidence that these companies which are exposed to climate risk had taken this into account in drawing up their accounts. Were assumptions clear? Were these two processes audited? Were the financial numbers consistent with other statements made in the accounts, as demanded by accounting standards? And were the assumptions used consistent with a sustainable climate? Sadly, the general answer to all these questions was, “No.”
Source: Carbon Tracker and CAP team analyses
Figure 1 from the report dramatically shows how much work needs to be done. Of the six criteria evaluated, none of these 107 companies had audit reports that would be considered “Good practice” as defined by the reviewers. That would have involved a clear explanation of how climate issues had been considered and what assumptions had been used and how these had been tested. Those assumptions would be consistent with other statements the company was making. As befits an audit of a climate exposed company, the Key Audit Matters (or Critical Audit Matters in the U.S.) would have noted that this had been done. And finally the assumptions would, in good faith, have been ones which were compatible with sustainability.
At the other extreme of “Significant concerns,” this was the case for the vast majority. The best of the worst was 59 percent for Auditors—consistency check while nearly all of the statements (93 percent) fell down when it came to Paris alignment of assumptions. Commenting on these findings, Barbara Davidson, Senior Analyst, Regulatory & Accounting at Carbon Tracker and lead author on the report observed that “the severe lack of consistency and transparency means that investors will continue to struggle to understand if a company’s financials include the effects of climate related issues, and any relevant targets.”
The findings of the report are sobering. Most particularly it suggests that, unless things change, companies are cherry picking the accounting standards they want to use, and auditors are turning a blind eye. This is particularly true for companies using IFRS (International Financial Reporting Standards), where, as I have noted, guidance is crystal clear. The four recommendations of the report are sensible and strong and provide useful guidance to companies, their auditors, regulators, and investors, about what must happen for the 2022 audits.
Recommendation No. 1: Companies Should Increase Both The Consideration Of And The Transparency Around The Incorporation Of Climate Matters In Their Financial Statements.
Since the company has ultimate responsibility for preparing its financial statements, it makes sense that management focus more on climate issues when doing so. This requires appropriate consideration, and clear statements that material climate-related risks have been incorporated, disclosure of quantitative climate-related estimates and assumptions, a description of how these climate-related risks and their own targets have been taken into account and an explanation of whether and how they are using Paris Agreement-aligned assumptions and estimates.
Recommendation No. 2: Auditors Must Provide Better Transparency Around Whether And How They Addressed Climate-Related Matters In Their Audits. This Is Particularly Important In The Light Of The GPPC’s December 2020 Letter.
Once management has prepared the financial statements, the auditor’s responsibility is to make sure that this was done properly. There are five ways to do so. First, in terms of the audit process, the auditor needs to make it clear how their work addressed climate-related issues, including how they exercised professional skepticism regarding management’s approach. Second, the auditor needs to ensure that the climate assumptions made in preparing the financial statements are consistent with other disclosures the company has made, such as in a sustainability report or reporting done in accordance with the recommendations of the Task Force on Climate-related Climate Disclosures (TCFD). Third, the auditor needs to ensure consideration and transparent communication of climate-related assumptions and estimates. Fourth, the auditor needs to have firm-wide policies that cover these three issues. Finally, since the role of a professional is to provide the client (e.g., investors) with its informed view, whether it is asked for or not, the auditor should encourage management to meet investor demands for Paris-aligned assumptions and sensitivities.
Recommendation No. 3: Regulators Should Identify Whether Companies Have Incorporated Material Climate-Related Matters In Their Financial Statements, Look For Inconsistencies And Identify Audit Failures.
In the U.S., the standard setters, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board, are under the oversight of the SEC. Outside the USA there are many different regulatory structures. The principles and rules laid out by the standards setters need to be enforced. In particular, regulators should note that ‘materiality’ needs to be seen through the eyes of the investor. Surely no-one can argue that after so many statements and initiatives, that investors do not find climate issues material. Related to this, more specificity should be given to what is covered by “other information” accessed to ensure audit consistency, such as sustainability or TCFD reports. Regulators also have the power to focus the minds of both management and the auditors by announcing that forthcoming supervisory and enforcement reviews will include these issues.
Recommendation No. 4: Investors Can Use The Results Of This Study To Inform Ongoing Engagement, Voting and Investment Decisions.
I have written about four strategies for effective engagement. Over the past few years I have interviewed over 100 investors (both asset owners and asset managers). One clear trend is investors increasingly recognizing their responsibility to engage with their portfolio companies and the benefits of doing so. Since good ESG performance contributes to good financial performance, it is strongly in their interest to do so. One output of this research is four strategies for effective engagement—conservatism, opportunism, constructivism, and activism. All four of them can be applied to the elements of this recommendation: establish expectations of climate-related matters for the 2021 accounts and 2022 proxy season; communicate with the audit committee and appropriate others, such as the General Counsel and Chief Compliance and Risk officers, their responsibility to ensure proper governance of climate-related issues; and also communicate their expectations to the authors, both directly and through proxy voting if necessary.
These recommendations make clear that it is a collective responsibility for ensuring that financial audits take account of climate change. Yes, the auditors clearly have some work to do. But they need support from management, regulators, and investors. Still, I think it’s appropriate for auditors to take the lead on this since they are the ones at the coal face who sign off on the accounts.