United States: Climate Risk Disclosure "glaringly Absent" In Financial Statements? Will Regulators Act To Require More?

In one of the illustrative comments in Corp Fin's just published  sample comment letter on climate issues, Corp Fin asks companies to explain what consideration they may have given to providing in their SEC filings the same type of expansive climate-related disclosure that's in their corporate social responsibility reports. One place in companies' SEC filings where climate-related disclosure is “glaringly absent,” according to this  report from the Carbon Tracker Initiative, is in the financial statements.  Although many companies face serious climate risk, and many have even made net-zero pledges, the report “found little evidence that companies or their auditors considered climate-related matters in the 2020 financial statements.”  According to the lead author of the report, “[b]ased on the significant exposure these companies have to transition risks, and with many announcing emissions targets, we expected substantially more consideration of climate matters in the financials than we found. Without this information there is little way of knowing the extent of capital at risk, or if funds are being allocated to unsustainable businesses….” Financial statement disclosure was so deficient, the report concluded, investors were essentially “flying blind.”

One reason may be, as a commentator observed in this  Bloomberg article, that there's a lot of focus on anticipating requirements the SEC may impose in the future, but companies might be overlooking the current requirements. According to the commentator, “[n]o U.S. accounting rule spells out how to account for climate change or environmental impact.” Nevertheless, “many rules require judgments and assumptions that contemplate environmental considerations….'Companies can have a blind spot around that.'”

You might recall that, in May, Lindsay McCord, Corp Fin Chief Accountant, said that the SEC staff were “scrutinizing how public companies account for climate-related risks and impacts to their business based on existing accounting rules.” According to McCord, as they conducted reviews of SEC filings, the staff would be considering the impact of environmental matters in the application of current accounting standards, such as the standards for asset retirement, environmental obligations and loss contingencies.  March  guidance from FASB addressed a number of GAAP topics and provided illustrative examples of how they might “intersect” with ESG. These included the “going concern” evaluation,  risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term, net realizable value of inventory, tax, contingencies and asset retirement obligations, and impairment of tangible and intangible assets, such as goodwill or other indefinite-lived intangibles.

For example, according to the FASB guidance, environmental matters could affect the estimated useful life of a finite-lived intangible asset, such as developed technologies.  Similarly, a more energy-efficient product could have been developed in replacement of a legacy product based on a less energy-efficient technology, or a green technology may have been acquired but may not have been as successful commercially as expected. Tangible assets, such as property, plant and equipment, are subject to depreciation.  In that case, the estimated salvage value or useful life of those assets could be affected by the introduction of more energy-efficient products.  In addition, when impairment indicators are present, a long-lived asset must be evaluated for recoverability.  Environmental matters that could indicate impairment of a manufacturing plant might include, for example, material declines in market demand for products or changes in regulations that adversely affect the company. (See  this PubCo post.)

At least in the U.S., those financial statement requirements may well be modified to address climate risks more explicitly. This  Bloomberg article reports that the PCAOB's acting chief auditor told a conference last week that PCAOB staff are “watching the debate” over ESG reporting, and “test[ing] and review[ing] expanded climate disclosure rules,” given the likelihood that the SEC will require more disclosure. “‘We are taking a look at what we have and how it might be modified,'” she said.  According to the article, PCAOB rules “addressing how auditors review information included in the notes to the financial statement and management's discussion and analysis could be in play, as could a general attestation standard.”

Like the SEC, FASB has invited public comment on its future standard-setting agenda, including climate-related issues, such as whether there are “common ESG-related transactions in which there is a
lack of clarity or a need to improve the associated accounting requirements.” For example, as reported by  Bloomberg, these might include “questions about accounting for investments in emissions allowances, carbon offsets, renewable energy credits, and wind farms, or if there are other common ESG-related transactions where accountants need more clarity.”

The report from the Carbon Tracker Initiative looked at 107 public carbon-intensive companies to assess whether they “considered material climate-related risks in financial reporting.”  Of the 107 companies, 94 were Climate Action (CA)100+ focus companies (described as companies “identified as having significant carbon footprints and/or as crucial to the energy transition”).  The companies studied were in the following industry sectors: “33% Oil and Gas, 17% Transportation, 13% Utilities, 7% Cement, 7% Consumer Goods and Services, and 23% Other industrials (including mining, chemicals and steel).”   In addition, 41% were located in the UK/Europe, 37% in the US/Canada, 14% in Asia, and 8% in Emerging Markets (outside of Asia). The report concluded that over 70% of the companies reviewed “fail[ed] to disclose climate risk in the financials” (although companies in the UK/Europe were found to be the most transparent). The report also found that, perhaps given their long histories with emissions and similar environmental issues, “energy companies provided the most evidence of, and transparency around, consideration of climate-related matters in their financials and audit reports…..These companies were the most visible in terms of providing/detailing the assumptions used, even if they did not always consider climate in those assumptions, nor align them with preferred Paris outcomes.”

Below are some of the report's key findings:

• “There is little evidence that companies incorporate material climate-related matters into their financial statements.
• Most climate-related assumptions and estimates are not visible in the financial statements.
• Most companies do not tell a consistent story across their reporting.
• There is little evidence that auditors consider the effects of material climate-related financial risks or companies' announced climate strategies.
• Even with considerable observable inconsistencies across company reporting (‘other information' and financial statements), auditors rarely comment on any differences.
• Companies do not appear to use ‘Paris-aligned' assumptions and estimates.”

For example, the report noted, as in the FASB guidance, impairment of long-lived assets could be adversely affected “by the energy transition due to declining demand for products or commodity prices, among others.  However, few companies disclosed these inputs, leaving no way to know if climate had been considered.  This is distinctly separate from information that is outside of the financial statements, such as sustainability disclosures.” The report also found that none of the companies incorporated Paris-aligned assumptions into their financial statements, even via sensitivity analyses, requests from numerous investors notwithstanding.  

In addition, consistent with the Corp Fin sample comment noted above about consideration of information in CSR reports for inclusion in SEC filings, the report also raised concerns about the “lack of consistency across company reporting.” The report found that “72% of companies showed no evidence of follow through from other discussions of climate risks or emissions targets to their treatment in the financial statements, or explained any differences.  Despite this, 63% of the auditor consistency checks did not identify these inconsistencies.” On this point, a co-author of the report expressed his disappointment that “companies acknowledge that the energy transition is likely to adversely impact their results, to have their auditors identify forward-looking assumptions as critical audit matters subject to significant uncertainties, and yet see little to no disclosure about the assumptions underpinning the accounts, much less an understanding of how management and auditors believed those assumptions to be reasonable.”

Researchers recommended that companies “disclose climate-related forward-looking estimates and assumptions, such as remaining useful lives and projected carbon or commodity prices, to show how they are taking climate-related risks (and their own climate targets) into account.” The recommendations also suggested that auditors “ensure that the financial statements are consistent with other company disclosures about climate-related matters, that climate-impacted assumptions and estimates are adequately scrutinized in the audits and transparently disclosed in company reports, and that investor demands for downside sensitivities are satisfied.”

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