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There is an urgent need for the audit of the future to provide a better assessment of the climate risks faced by businesses.
In brief
- Financial disclosures do not provide a full view of a company, and a number of initiatives have tried to address the need for robust nonfinancial reporting.
- Current disclosure requirements do not give investors a clear picture of how companies are responding to climate risks.
- Progress is being made toward improving the usefulness of nonfinancial disclosures, but the challenge is to create metrics that are consistent yet flexible.
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.
Inadequate disclosures
It is hardly surprising, therefore, that a survey of global investors indicates that they are growing increasingly impatient with the quality of the nonfinancial disclosures that companies are providing. In the fifth EY global investor survey on companies’ ESG performance, published in July 2020, the proportion that are dissatisfied with environmental risk disclosures has increased by 14 percentage points since 2018. This does not signify that corporate disclosures on environmental risks are getting worse, but simply that investors regard these risks as increasingly important and feel the quality of corporate reporting in this area is not improving quickly enough. In the same survey, three quarters of investors said they would value independent assurance over the rigor of an organization’s planning for climate risks.
Disclosure requirements under existing financial reporting standards do not currently give investors the right data or information to support decision-making. The standards struggle to account for systemic economic or financial risks such as climate change, or to connect these systemic risks to the circumstances and performance of individual companies. They do not permit companies to revalue assets to reflect anticipated regulatory change – the imposition of carbon pricing, for example – until the risk has crystallized and regulatory change has been formally enacted. Nor can they capture the financial impacts of the uncertain timing of climate change: if a company assumes global warming will reach 2oC in 2035 rather than 2030, for example, that has a profound effect on the way its financial statements should look today.
There is a wide disconnect between financial reporting standards and the nonfinancial disclosures that companies urgently need to make to reflect the climate risks they face. The situation calls for a shift in the way companies report and a consequent shift in what is audited. Stakeholders need assurance that companies are identifying nonfinancial risks appropriately, using robust tools and data, and making credible assumptions in modeling those risks. They also require assurance of companies’ performance in managing and addressing those risks.
Inevitably, this will involve companies providing stakeholders with a range of scenarios to capture potential outcomes. To use the framework established by the TCFD, a company might propose a scenario in which global warming is limited to 2oC above the pre-industrial age, in which case it will need to make disclosures based on the implications that will follow around the type and degree of transition risk that it will face, depending on which sector it is in.
Equally, it might also create a second scenario in which use of fossil fuels persists and the climate warms by 4oC. Under this scenario, the company might face less transition risk due to regulatory change, but much greater physical risk from the effects of a warming world. Regardless of which scenario they believe is more plausible, stakeholders will expect assurance on the evidence companies present to demonstrate that they are measuring and addressing the risks implicit in both situations.
Progress and challenges on nonfinancial disclosures
Improving the quality and usefulness of nonfinancial disclosures is an urgent challenge, but important progress has already been made. The TCFD framework is a major step forward in helping companies report on climate risk and is becoming mandatory in some jurisdictions. However, investors clearly believe there is much further to go to create a robust system for nonfinancial disclosures, as the latest EY investor survey demonstrates.
The World Economic Forum (WEF) white paper, Towards Common Metrics and Consistent Reporting of Sustainable Value Creation, published in September 2020 with support from the “Big Four” professional services organizations including EY, represents a further important step forward. Its aim is “to catalyze progress towards a systemic solution such as a generally accepted international accounting or other reporting standard” for nonfinancial disclosures.
There are huge challenges in attempting this. Any set of universal metrics must be flexible enough to accommodate the corporate world’s diverse business and operating models. Investors use a multitude of financial metrics to evaluate and compare companies, depending on which issues are material to that company or industry. The same needs to happen for nonfinancial disclosures. In this context, the WEF is right to acknowledge that issues of materiality may require “additional sector- and company-specific metrics to be developed over time.”
At its heart, the effort must be to link financial and nonfinancial disclosures in a coherent, consistent way. EPIC and the EY long-term value framework take the approach of identifying a company’s intangible assets and valuing them, to help enable stakeholders to make comparisons against a universal baseline of value. This is the right direction of travel: delivering a set of standards that make it possible to identify and value the full range of a company’s nonfinancial assets is the goal to aim for. Over the next 5-10 years, this should lead to corporate reports that are more comparable and contain more targeted and focused information on the key elements of intangible value.
Summary
The rapid acceleration of climate change has made the need for robust and comparable reporting of nonfinancial information more urgent, as investors want a clearer view of how companies are responding to climate-related risks. Work carried out by initiatives such as the Task Force on Climate-related Financial Disclosures and the Embankment Project for Inclusive Capitalism is moving in the right direction. However, more needs to be done to link financial and nonfinancial disclosures in a coherent and consistent way.
How EY can help
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Through enhanced corporate reporting, EY can support finance teams to meet demands for high-quality enhanced financial and nonfinancial information.
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