It has been obvious for decades that financial disclosures no longer present a comprehensive picture of a company’s situation. As intangibles account for a growing proportion of modern corporate balance sheets, so audited financial statements provide assurance over a shrinking share of a company’s total value. From the market’s perspective, nonfinancial disclosures on a huge range of subjects – environmental impacts, governance standards, brand stewardship, human capital, supply chains and so on – can at times be more material to decision-making than a company’s financial statements.
Corporate reporting has been evolving to address this long-term shift: important advances include the Task Force on Climate-related Financial Disclosures (TCFD) framework, the work of the Embankment Project for Inclusive Capitalism (EPIC) and the EY long-term value framework. Now, however, progress in addressing the need for more robust and comparable nonfinancial reporting must accelerate significantly. This is because climate change – by far the most pressing nonfinancial issue to confront the corporate world, and highlighted in the EY Megatrends 2020 and beyond report – has reached an inflection point.
Seismic economic shifts
The speed and scale of climate change over the next two decades will go beyond anything we have witnessed so far. The climate transformation that is already being seen around the world is taking place in the context of a 0.7oC increase in global warming relative to the pre-industrial age. The most ambitious international targets call for warming to be limited to 1.5oC by the end of the century. Implicit in that target are seismic shifts in the shape of the world economy: greenhouse gas emissions from fossil fuels used to generate electricity and to power transport will have to cease globally within 20 to 40 years, and carbon sequestration will have to expand massively.
The changes forced on the world by COVID-19 could support this transition. In part, this is because the pandemic has shown people that changing their behavior – the amount they travel, for example – can be much less difficult and disruptive than they had previously believed. Equally, government responses to COVID-19 in many countries include large stimulus packages focused on accelerating the transition to a low-carbon economy.
But it must be recognized that emission reductions resulting from the pandemic, even during the strictest periods of lockdown, are far smaller than will be needed to alter the trajectory of global warming in the long term.
Against this background of rapidly accelerating climate change, and as regulators move to restrict greenhouse gas emissions, the scale of the transition risk facing companies is obvious. This is on top of the significant physical risk to their operations from climate change itself – even if warming can be limited to 1.5oC. Yet these obvious risks have not been reliably reflected in published financial statements. For example, climate-related regulatory change affecting power utilities in the European Union did not necessarily result in asset impairments in their financial statements, even though the market’s view of those asset values changed, and share prices fell as a result.
