Last year, The Financial Inclusion Centre published a major report called Time for Action – Greening the Financial System.[1] We are following up that report with a project called The Devil is in the policy detail – will financial regulation align financial market behaviours with climate goals?
This project is evaluating specific policy and regulatory measures proposed by the main financial regulators to align the behaviours of financial markets, institutions, and consumers with climate goals. We are very grateful to Friends Provident Foundation for also supporting this follow up project.
As part of the project, we are producing a series of podcasts on the key regulatory issues. The first podcast set the scene and provided a high level view of the approach followed by the government and main financial regulators. The second podcast looked in detail at the role of the Financial Conduct Authority (FCA), touching on The Pensions Regulator (TPR). The third podcast looked in more detail at the role of Parliament, government, the Bank of England, and the Prudential Regulation Authority (PRA).
This fourth podcast considers in detail disclosure and reporting standards. In particular, it covers the role of the international and national standards setting bodies, and the audit and accountancy professions. Financial journalist John Lappin interviews Professor Robin Jarvis one of the team leading the project.
The role of the International Sustainability Standards Board (ISSB) in the development of the disclosure of climate change issues by companies
From an investor’s prospective there is growing evidence that reducing greenhouse gas emissions is the top ESG priority for businesses. It is worth noting however, that much of this evidence was gathered before the war in Ukraine and the surge in the increase of energy prices. Some would argue the focus on climate change has been diluted in a number of industries because of the concern on energy prices. The earlier reference to investors priorities arguably should be extended to other stakeholders of companies and civil society.
The International Financial Reporting Standards (IFRS) Foundation announced the setting up of the International Sustainability Standards Board (ISSB), at COP26. The intention is that the ISSB will sit alongside the IFRS Board. The ISSB’s focus is very much on investors and their risks from a climate change perspective and therefore the need to disclose these risks.
It is clearly very important that climate change issues are addressed from a “global” perspective. The fragmentation of these standards set up separately by various jurisdictions would clearly be confusing and inappropriate in a global economy with trading across borders and stock exchanges in various jurisdictions with differing rules etc.
The International Financial Reporting Standards (IFRS) Foundation will create a new board to oversee the implementation of these standards in June 2022. However, it is important to recognise that the IFRS Foundation has already set up a Technical Readiness Working Group that has undertaken preparatory work for the ISSB.
The main challenges for the ISSB
Clearly, the IFRS Foundation have, over the years, a lot of experience in developing and administering standard setting, that is, International Accounting Standards. However, standards developed to address climate change issues require much wider knowledge and expertise than that for accounting standards.
The question is: will the ISSB call on people and institutions who have an important but differing perspective with regard to climate change issues? For example, people representing civil society. The focus on investors and financial risk is arguably not wide enough to capture other stakeholder’s concerns.
Another issue is the significant role accountants will play in the process of reporting climate change issues in respect of companies. Karthik Ramanna, Professor of Business and Public Policy at Oxford University questions the attributes and capabilities of accountants with regard to climate change and the need to address this issue and other ESG issues. As he comments: “accountants and standard setters got in on the act. But accounting has become more serious which means incorporating the features of high quality accounting rules.”
The main sustainability disclosure issues will be in the form of narrative reporting. A significant challenge is the perceived and actual lack of consistency between company’s management (narrative) reporting on what a company is doing about climate change including targets, the assumptions and estimates disclosed.
In certain industries there will be a need to retire and replace carbon-intensive assets on an accelerated basis. Climate change is likely to impact disclosure with regard to recognition and derecognition of assets and liabilities and the measurement of such assets and liabilities e.g. estimates about the assets useful lives and residual values are likely to need adjusting. In some cases, this adjustment will be dramatic affecting the company’s income and value. Note “estimates” are judgements!
Academics have been very critical of the process to date of the approach to standard setting for sustainability. The Professors of Accounting, which include editors of the leading publishers of research in this field, accuse standard setters of a “lack of adequate evidence based justification for their conclusions and a number of the findings from academic research refute assertions in the IFRS Foundations Consultative Paper”. They are concerned primarily at the lack of formal engagements with academics in developing these standards from an evidence base perspective.
Probably the biggest challenge is timeliness. It is widely recognised that it will take time to develop these standards, and this delay may be critical in the timely reduction carbon emissions to meet global targets.
The European Union
The Europe Union appears to be more well advanced than any other jurisdiction in the development of regulation on company disclosure relating to climate change issues.
The EU focus recognises the importance of climate change issues, with the emphasis not on investors but on EU citizens. The approach can be summarised as ‘a healthier environment for present and future generations and more transparency enabling informed choice.’
With reference to EU/EC actions:
- On 23 February 2022 the EC adopted a proposal for a Directive on corporate sustainability due diligence. The aim of the Directive is to foster sustainable and responsible corporate behaviour and to anchor human rights and environmental considerations in companies’ operations and corporate governance.
- EU has set up a new EFRAG sustainability reporting body responsible for developing draft standards to be published in mid- October 2022.
- However, the EU will inevitably adopt the standards set by the ISSB but will, no doubt, go through the scrutiny of EFRAG before being endorsed by the EU similarly to the procedure for IFRS in the EU.
The UK
The Financial Reporting Council is primarily responsible for overseeing company reporting and assurance on climate change in the UK.
The Financial Stability Board created the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information. The TCFD has set out recommendations for disclosure.
The FCA has Listing Rules and under these rules UK incorporated and overseas commercial companies with a premium listing are required to state in their annual financial report whether they have made disclosures consistent with the recommendations of the Taskforce on Climate related Financial Disclosure (TCFD) or explain if they have not done so.
These disclosures will be mandatory across the UK economy by 2025, with listed companies expected to be required to disclose for years beginning on/after 1 January 2021.It is interesting to note that the TCFD focuses on investors with little mention of other stakeholders.
Inevitably, the UK will endorse ISSB standards when they are introduced.
Audit and Assurance
A big question is: how effective will be the audit and assurance process to ensure companies do not exaggerate or misrepresent the benefits of their activities from an environmental perspective (commonly referred to as green washing)?
The process of auditing and assurance on company disclosures relating to climate change issues is probably the most worrying aspect of company disclosures and ensuring that companies do not misrepresent the benefits of their activities (greenwashing).
Primarily the problem is the auditing of narrative disclosures which are problematic vis-à-vis the audit of quantitative information. Also, much of the disclosures will be anticipating and setting targets for the future e.g. target emission levels.
The International Auditing and Assurance Standards Board will be responsible globally for developing standards for auditing climate related issues disclosed by companies. However, there seems to be a consensus that creating these standards will take time. One also questions if the IAASB have the right personnel on the Board to produce meaningful workable standards.
But the audit of climate change issues and particularly carbon emission is going to be big business to the large audit firms. EY, for example, plan to spend £100 million and recruit 1,300 staff over the next three years in Britain to meet the growing demand from companies cutting their carbon emissions.
There is of course much criticism of the current standards of auditing and what is perceived in the future. Sir John Kingman’s report (2018) refers to the audit not being fit for purpose and calls for an end of the FRC as the audit regulator. Natasha Landell-Mills head of stewardship at Sarasin and Partners said that “You will get sustainability reports that are now being audited but they’re being audited to a very low standard.” Michael Urban, deputy head of sustainability research at Lombard Odlier, said even with better rules the complexity of sustainability data would still make auditing tough.
Small and Medium Size Entities
The focus of setting standards for companies and the subsequent disclose by companies on climate change issues will be on listed companies. However, these companies represent, in economic metrics, less than half of the enterprises in the UK. What are the arguments for and against extending these standards to non-listed companies particularly those defined as SMEs?
At present in most jurisdictions SMEs are not required to report as they are not included in the scope of the appropriate regulation. They can however, disclose voluntarily. There are various frameworks for reporting that SMEs may follow e.g. Global Reporting Initiative (GRI). Similarly, there is no requirement for assurance on these voluntary reports.
However, SMEs may be required to produce sustainability information to satisfy the reporting obligations of providers of finance and to large customers in their value chain.
In terms of the future there is much opposition for SMEs to report climate change issues due to costs. However, it is clear that SMEs could be a significant source of carbon emissions!
Supply Chains
What are the issues associated with Supply Chains and reporting on climate change issues by companies?
Supply chains present probably the biggest problems for controlling carbon emissions and other climate related issues. The UN Global Compact participants rank supply chain practices as the biggest challenges to improving their performance.
The environmental impact is significant. The supply chain accounts for more than 90% of most consumer goods companies’ environmental impact, according to McKinsey & Company.
Clearly, the regulators must intervene in the market place to address the complex issue of sustainability and supply chains.
We hope the podcast is informative and interesting. If you have any questions or would like further information on the project, please contact Mick McAteer on mick.mcateer@inclusioncentre.org.uk or mickmcateer92@gmail.com
[1] Time for Action – Greening the Financial System | The Financial Inclusion Centre