Net-zero: How can we prioritize the delivery of promises in 2022?

Haven’t we done well? Following the latest climate Conference of Parties (COP26) in Glasgow in November, world leaders have amassed enough promises and ambitions to limit global warning to 1.8°C, according to the International Energy Agency. This is within reach of the 1.5°C temperature target scientists tell us we must achieve to avoid dangerous societal harm.

But will it happen? COP26 is unlikely to have changed the minds of the public, which according to the 2021 Edelman Trust Barometer is both deeply worried about climate change and sceptical about the likelihood of disaster being avoided. Some 70% of the 33,000 interviewed globally by Edelman say they are worried or extremely worried about climate change. About half of the 14,000 interviewed for a subsequent 2021 Edelman Trust Barometer Special Report: Climate Change have concluded that the fight on climate is already lost. A majority believe both governments and businesses are pulling the wool over their eyes when it comes to promised climate action. Climate anxiety is high.

There are many factors at work, but at its simplest, the public knows that incentives are still not aligned with taking robust action to combat climate change. When an oil and gas company promises to get to net zero emissions by 2050, and thereby wipe out its current core business activity and the associated profits, it is treated with a high degree of distrust. Turkeys don’t vote for Christmas. As long as markets reward companies and their leaders for climate destruction, we cannot expect them to do the opposite.

Likewise, while governments know they need to rewire market incentives, broadly speaking, politicians struggle to act for the long-term good where this requires short-term sacrifice that may hurt them at the polls.

Nevertheless, as public opinion turns in favour of action (as the Edelman trust data shows), we are seeing steps forward. Banning harmful activities, such as coal-fired power or internal combustion engine vehicles, are obvious examples. Agreeing to end deforestation by 2030, as was promised at COP26, is enormously welcome. Continued expansion of carbon taxes or carbon-trading regimes also clearly shift incentives away from emitting carbon— making it no longer free to do so. These policies must be ramped up quickly.

There is another lever, however, buried within the bowels of corporate decision-making that has so far been largely over-looked. Yet it has the power to transform the incentives facing business executives and investors to align with rapid decarbonisation. And it can be pulled immediately.

It is this: Companies must be required to reflect the economic impacts of a 1.5°C pathway in their published financial statements.

Accounts are there to tell the truth about what is profitable and what is not. One of the foundations of trust in business, they thereby guide investment decision-making and also provide a mechanism for holding executives to account. In the case of carbon- intensive companies, if the accounts ignore the decarbonisation associated with combating climate change, they will very likely provide an illusory view of profitability and capital strength.

If the accounts of a coal-fired power company, for example, ignore the decarbonisation required to deliver the world’s 1.5°C goal, management will presume stronger future cash flows and longer lives for assets. The company will leave out likely carbon taxes associated with future production and probably understate the required clean-up costs, which they will assume are decades away rather than close at hand.

Such blinkered accounting will make this company appear profitable. Management will be incentivised to throw good money after bad and reinvest into coal power. Adding salt to the wound, executives would probably receive large bonuses for the very efforts that put our planet at risk.

Accounts essentially act like a control panel for directing capital flows. Until company accounts reflect a 1.5°C pathway, few executives will treat a 1.5°C outlook as real, and investment will continue to flow towards harmful activities. No amount of promises and ambitions will stand in the way of such powerful accounting incentives.

The potential for material misrepresentation in company accounts— and thus harmful incentives— does not just apply to the fossil fuel extractive companies. Any entity that relies on carbon emissions for its economic health— whether that is part of its supply chain, production process, or the use of its goods and services— will need to consider how accelerating decarbonisation could impact their assets and liabilities.

Even banks are exposed where they lend to carbon- intensive companies and fail to price the risk appropriately. Indeed, the parallels with the financial crisis of 2008 should alarm us. Could banks once again be building up hidden risks on their balance sheets on the back of poor lending and asset purchases? Whereas the financial crisis took roughly a decade to recover from, the damage done by the climate crisis could well be irreversible.

The good news is that to get companies to reflect the economic impacts of a 1.5°C pathway, no new rules or regulations are required. Companies are already prohibited under existing laws and accounting standards from misrepresenting their true economic position. Financial statements must not omit the expected costs of their carbon emissions, leave out climate-related liabilities, nor ignore the economic consequences of anticipated decarbonisation.

Moreover, beyond requiring that all companies include foreseeable climate-related costs and liabilities into their financials, the standards demand that information deemed important to investor decision-making be disclosed. This information is termed ‘material’ under the standards, whether or not directors agree that it is important. With investors representing over $100 trillion in assets calling for accounts consistent with a 1.5°C pathway, it behoves companies to provide this visibility. This point has been underlined in the past year by the International Accounting Standards Board and the International Audit and Assurance Standards Board.

The bad news is that these rules nonetheless appear to be widely flouted. In a review of 107 carbon- intensive companies’ latest financial statements, less than 30% mentioned climate change, decarbonisation, or the energy transition. Virtually none considered the global 1.5°C goal in drawing up critical, forward-looking accounting assumptions. More surprising still, even as companies have rushed to make “net zero” promises, most of them appear to have left out the costs of these commitments from their accounting. If ever we needed evidence of greenwash, this would be it.

Radio silence on climate change in company accounts should be a wake-up call for directors, auditors, regulators, and investors. Each group needs to act.

First, company directors must ensure their financial statements are taking expected decarbonisation into account; and disclose how a 1.5°C pathway would likely impact the entity’s financial position. Taking the coal example above, is the company ensuring that its asset lives do not exceed 2030, or the relevant date when coal power will be banned? Have they made sufficient provisions to cover clean up costs at that point? Have they included expected carbon taxes associated with the production until phase out?

Second, auditors should call out companies that fail to properly reflect climate risks in their accounts. They should sound the alarm where the accounts are predicated on unsustainable emissions pathways that would take the world above the 1.5°C warming target. They should call out greenwash too-- where a company promises to deliver net zero emissions, but then ignores this in its forward-looking accounting assumptions.

Third, regulators need to enforce the rules that exist today and make crystal clear this also means providing visibility on financial impacts of a 1.5°C pathway.

While there are signs that this may be starting, with the European Securities and Markets Authority and the UK’s Financial Reporting Council recently issuing statements that they will investigate whether companies’ financial statements are including climate factors, they are silent on whether this includes disclosures for a 1.5°C world. Elsewhere, notably in the US and China, we’ve seen little sign that regulators are looking at enforcing climate-aware accounting.

Not only is this relaxed approach to enforcement concerning in and of itself, it is also hard to square with governments’ promises of achieving 1.5°C. Here we have an immediate and powerful policy lever to shift capital onto a 1.5°C pathway. Why are regulators holding back?

Finally, while investors have led the charge in calling for more sustainable financials, they should now use their powers to hold directors and auditors to account in delivering 1.5°C aligned financial statements. According to research by Greenpeace on investor voting in 2021, in all but five of the high carbon companies they examined, auditors were reappointed with over 95% support. In the remaining five companies, auditors received over 90% support. With financial statements systemically ignoring climate factors, investors appear to be asleep at the wheel.

Again, we see signs of change. As COP26 got underway, investors with combined assets of $4.5 trillion wrote to the Big Four audit firms in the UK setting out their intention to vote against auditor reappointment where they failed to call out climate misrepresentation in the accounts. This auditor outreach builds on letters last year to company directors, coordinated by the Institutional Investor Group on Climate Change, setting out clear expectations for 1.5°C-aligned accounting.

Trust is built where promises are kept. The clear priority for 2022 must be to ensure capital flows that deliver net zero promises. To achieve this, few levers are as powerful as ensuring that all companies produce climate-conscious accounts. We need to stop companies reporting illusory profits and capital on the back of climate harm. If we do not, we are arguably turning a blind eye to the most harmful fraud the world has ever seen. We will have no one to blame but ourselves.