Climate Risks Hiding in Plain Sight: Interaction between the ISSB and the Financial Statements
Published: September 14, 2022
The IFRS Foundation has recently established a ‘sister’ standard setter to the International Accounting Standards Board (IASB). The remit of the International Sustainability Standards Board (ISSB), announced in November 2021, is to meet investor demand for “high quality, transparent, reliable and comparable reporting by companies on climate and other ESG matters.”1 This is complementary, but separate to, existing accounting standards2, which already require consideration of the impacts of material climate-related matters in financial statements.
As per its remit, the ISSB recently closed a pair of consultations for its first sustainability standards through two exposure drafts.3 These drafts propose a baseline set of new reporting requirements for market participants and include both sector-specific and climate-specific guidance, some of which draws from existing sustainability frameworks.
In order to make informed judgments about a company’s enterprise value, its use of capital, and the validity and viability of its future climate strategy, investors need timely, transparent, reliable, and comparable climate-related information. The lack of information hinders the appropriate allocation of capital.
As noted, consideration of these matters is already required in the preparation of IFRS financial statements (and audits thereof).4 Despite this, evidence of such practice is scant.
Carbon Tracker’s desktop review of 107 corporate filings for the financial year 2020/2021 revealed a considerable lack of transparency as to how climate has been considered by both management and auditors as well as instances in which financial reporting appeared at odds with other reporting by the same companies – whether in the front end of regulatory filings or sustainability reports.5 Indeed, 80% of the 107 carbon-intensive companies’ filings provided no evidence that they had considered material climate-related matters when preparing the financial statements despite frequent references to the materiality of climate-related risks in the front end of those same reports.
The creation of the ISSB and its first standard-setting activities are therefore a much-needed effort to provide useful information that will help highlight whether companies are considering climate-related risks in the accounts and if so, how. There are numerous elements of financial reporting that involve estimates as well as assumptions and judgments about future states that are likely to be materially impacted by climate-related risks and decarbonisation efforts. Corporate managers may choose to adapt to these new realities or not, but in either case their position, which should be consistent throughout its reporting, should be transparent to the markets.
While the new ISSB standards fill an important gap, there is a risk that we fall into the trap of not being able to see the wood for the trees. In a joint consultation response from Carbon Tracker and Planet Tracker, we underscore two critical issues.6
First, investor needs for climate-related information include quantitative (numerical or dollar value) information, especially around estimates and assumptions about the future that can be expected to be materially impacted by climate change and decarbonisation and which underpin existing financial reporting. Will demand for petrol remain high as electric vehicles take market share from internal combustion engine (ICE) vehicles? Will factories producing ICE vehicles and parts retain their book value in the face of diminished demand and lower utilisation? Will leases for such vehicles remain a robust source of revenues in securitised loan portfolios? The answers depend on how the future unfolds, but assumptions about the future are made in the accounts today. Markets should understand what those assumptions are and the ISSB can play a role by bridging climate-related scenarios and their economic and business implications.
Second and relatedly, the ISSB needs to improve connectivity between general purpose reporting and financial statements. Climate-related risks are a prime example of that. By requiring more granular disclosures around decarbonisation efforts and targets, the ISSB standards will help shareholders assess whether and how those targets are incorporated into a company’s financial reporting. The ISSB standards are not intended to create a parallel universe of financial reporting, they are intended to supplement the current system and for this reason should be complementary and consistent with financial reporting standards today.
The standardisation of sustainability reporting practice should be welcomed by investors, issuers, and preparers alike. Climate risks will become more prominent over time; this means that the need for globally comparable and reliable reporting and disclosure will definitely not go away. The ISSB standards should help elucidate the connection between a vacillating transition to a decarbonised energy system, the financial implications of that transition, and how that transition will impact current financial reporting.