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Accounting for climate change

Accounting for rising sea levels and other uncertain effects of climate change present significant new challenges to companies and accountants, says Dr Michael Willis, Director of the Master of Accounting (MAcc) programme at Cambridge Judge Business School.

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Michael Willis

Dr Michael Willis

For some time, companies have been required to disclose the financial impact of certain environmental liabilities and risks – for example, a mining firm’s cost estimate of restoring mined land to its initial state after minerals are extracted.

This already makes for very complicated number-crunching, because the timing and amount of expenditure are all highly uncertain. But it may be that we’ve seen nothing yet in terms of complexity when it comes to accounting for environmental factors.

Instead of estimating a company’s future cost of land restoration, what if firms instead had to predict how their assets, operations and supply chains may be affected by sea levels that rise X feet from current levels due to climate change? How about X feet times two?

Changes in weather patterns or precipitation could make certain raw materials more scarce and therefore much more expensive. This could be very disruptive for a firm that relied heavily on a few natural resources as inputs – for example, a paper producer – and changes in regulation or customer preference could disrupt everything from revenue streams to production technologies to operating assets.

This is hardly fictional: regulators have discussed requiring firms to prepare far more detailed climate-related financial impact forecasts. The French government already requires investment managers to disclose the environmental profile of their portfolios, and a recent report by the UK Parliament’s Environmental Audit Committee proposed mandatory new disclosure requirements beginning in 2022.

“We can see the advantages in giving companies and investors time to adapt and develop how they report on climate risks and opportunities,” the report said. “But only if reporting is mandatory are we likely to see comprehensive and comparable climate risk disclosures.”

While current accounting rules require disclosure of uncertain future liabilities when their occurrence is probable and the amount estimable, new regulations that address such long-time horizons and high degrees of uncertainty present significant new challenges.

For accountants, it means that they will be increasingly at the forefront of environmental and climate-related financial disclosures. Firms will need to have a deeper understanding of climate change and undertake a much broader forward-looking analysis of how different climate change scenarios might affect a firm’s financial obligations. This will require accountants to have the right skills, and will also require external auditors to be familiar with the key issues and methodologies related to these disclosures.

Beyond these potential new regulations, investors are increasingly demanding transparency on environmental risk from the organisations they trust to manage their money. This imperative recently led the Financial Stability Board to create a Task Force on Climate-related Financial Disclosure (TCFD), which has set out voluntary recommendations for how public companies should report to investors on risks and opportunities relating to climate change.

“One of the most significant, and perhaps most misunderstood, risks that organisations face today relates to climate changes,” says the report. “The large-scale and long-term nature of the problem makes it uniquely challenging, especially in the context of economic decision-making. Accordingly, many organisations incorrectly perceive the implications of climate change to be long term and, therefore, not necessarily relevant to decisions made today.”

Accounting has always entailed both the recording and analysis of financial information. The uncertainty of climate change brings a challenging element to such analysis, so the profession will need to adapt new rules – and quickly – to meet such a challenge.