Corporate Failings on Climate Change Reporting Revealed in Regulator’s Thematic Review Alongside New Requirements Introduced by the Government
Over the past four years in the United States, there has been an increasing disconnect between public and private action on climate. The current administration de-prioritized (and many believe sabotaged) any efforts to mitigate the impact of climate change. Nevertheless, companies and investors based in the United States maintained or even increased their commitment to emission reduction and climate risk assessment. Under President-elect Joe Biden, the United States is widely expected to rejoin the Paris Agreement on climate change. Other parts of the world – and the UK in particular – have continued to advance the ball on climate action. However, the Financial Reporting Council (FRC) recently published a wide-ranging thematic review (the “Review”) of climate-related considerations by boards, companies, auditors, professional bodies and investors which suggests the focus is well-short of what is needed.
The Review and the government’s plans go to the heart of Environmental, Social and Governance (ESG) compliance which is now emblematic of corporate culture and ethical standards – not least in reaction to the mounting evidence on the impact of climate change on business and, more broadly, on human life on this planet.
The FRC has issued this stark warning to companies:
“Climate change is one of the defining issues of our time and, by its nature, material to companies’ long-term success. Boards have a responsibility to consider their impact on the environment and the likely consequences of any business decisions in the long-term.”
The FRC is the UK regulator for auditors, accountants and actuaries and sets the UK Corporate Governance and Stewardship Codes. It promotes transparency and integrity in business. Its work is aimed at investors and others who rely on company reports, audit and high-quality risk management. The FRC’s focus on ESG coincides with announcements by the government of more robust environmental disclosure standards so that investors can better understand their exposure to climate change. The Chancellor, Rishi Sunak, plans for companies with a premium listing on the London Stock Exchange to provide climate risk information in their 2021 accounts. This would place a particular burden on those companies which are significant in emissions-intensive sectors like energy, transportation and agriculture Evidence in the Review suggests corporates in that category are well short of that level of compliance.
The Review has identified some “bright spots” but has concluded that more needs to be done in all aspects of corporate governance, corporate reporting and audits as well as by investors and regulators.
Referring to the goal of the Paris Agreement to limit the increase in global average temperature to below 2°C above pre-industrial levels, the Review highlights the risks and opportunities for business:
“Many climate-related risks and opportunities are foreseeable. While companies will be affected in different ways, as the implications of a changing climate become clearer, increasingly consumers will adapt their behaviour, businesses will make different investment decisions and governments will act, making the impacts more immediate for companies.
The UK Government is one of a number of governments to set a ‘net zero’ target. Details about how these targets will be achieved are in many instances still being considered, but they provide a unique signal for the future for which both companies and investors can aim.”
Against that background, the Review drew the following conclusions:
- How are boards of directors taking account of climate-related challenges?
It is the board’s responsibility to consider climate change risks, but there is little evidence that business models and company strategy are currently sufficiently influenced by integrating climate considerations into governance frameworks. The implications of climate change will affect the operations of a wide range of companies and in developing a company’s strategic direction, boards should be taking into account all of the possible effects of climate change.
- How are companies developing their reporting on climate-related challenges?
An increasing number of companies are providing narrative reporting on climate-related issues. While minimum legal requirements are often being met, shareholders, customers and employees alike are calling for additional disclosures to inform their decision-making. The actions a company should take on ESG (and climate in particular) vary greatly by industry. Some companies have announced strategic goals such as ‘net zero’ or emissions reduction targets; this is separate and distinct from climate risk analysis reporting. It is often unclear from current reporting how progress towards these goals will be achieved, monitored or assured. Specifically, consideration and disclosure of climate risk in the financial statements lags behind such narrative reporting. The FRC identified areas of potential non-compliance with the requirements of International Financial Reporting Standards (IFRS).
- What is the UK government’s expectations on climate-related reporting?
For UK companies, the Government has pledged to reach ‘net zero’ by 2050, and in the Green Finance Strategy outlined its expectation that listed companies and large asset owners should be reporting on climate change risk using a framework established by the Taskforce on Climate related Financial Disclosures (TCFD) by 2022.
- How are auditors taking account of climate-related challenges?
The quality of support, training and resources provided to the audit practice varied considerably across firms. Firms also need to do more to ensure that their internal quality monitoring has appropriate regard for climate change considerations. Audits reviewed indicated that auditors need to improve their consideration of climate-related risks when planning and executing their audits. Expectations are developing rapidly, and whilst boards have the first responsibility to consider climate-related issues, auditors play an important role in challenging, testing, and improving the accounting for, and disclosure of, climate risks.
- How are professional bodies and audit regulators taking account of climate change in their regulatory responsibilities?
UK professional bodies, and audit regulators in the Crown Dependencies, are responding to climate change, but approaches differ in terms of substance and granularity regarding references to climate-related reporting and the impacts of climate change.
To consider the many facets of an issue like climate change, those in and entering the professions need to be trained appropriately to face these challenges within their work.
- What do investors want to see?
Investors support the TCFD, but also expect to see disclosures regarding the financial implications of climate change. Investors are themselves facing a changing regulatory environment. Investors support companies using the TFCD recommended disclosures but these are voluntary and further improvement is necessary and will soon be required.
Investors must also consider their own reporting, as the Green Finance Strategy ambitions also apply to those in the investment chain.
The significance of ESG compliance is only increasing over time and appears to be accelerating during the current COVID-19 induced crisis. And evaluation of the impact of climate change – both on emissions and on operations – is a central pillar of ESG compliance. The Review emphasises the importance of the FRC as a regulator at the heart of ESG compliance. The government intends to re-brand the FRC as the Audit, Reporting and Governance Authority (ARGA) with new statutory powers over directors alongside its existing powers over statutory audit. The thrust for change came from criticism of failures in corporate disclosures, audit and governance which the FRC did not have the power to take action against. ARGA will be a stronger regulator and ESG compliance will need to increase to reflect the greater requirements.