The Climate Tragedy of Accounting

Authors

José Luis Blasco?PhD candidate, Economy and Business Department. Universidad Autónoma de Madrid.

Elena Carrión PhD candidate, Environmental Accounting. Universidad de Burgos.

Published in Spanish - Awarded at the 29th AECA International Award for Articles on Accounting and Business Administration 2023

In September 2015, at Lloyd's headquarters in London, Mark Carney, the Governor of the Bank of England at the time, addressed a room filled with some of the top executives of global banking with a warning that has gone down in history: if climate change continued unchecked, global financial stability would be compromised in what he termed the "Tragedy of the Horizon." Since the current generation will not experience the worst effects of climate change, investors have little incentive to change their behaviour in the prosperous economic system based on fossil fuels we have enjoyed for the past 150 years. However, it seems that the acceleration of the climate dynamics predicted by scientists has begun, evident through increasingly intense and frequent climate events, with a higher number of victims (Munich Re, 2023).

In response to this situation, 130 countries representing over 92% of global GDP have committed to transitioning to a future with zero carbon dioxide emissions (i.e., net-zero by 2050) (Net Zero Tracker, 2022). This transformation raises the question of how the primary source of market information available to companies and investors - financial accounting - can respond.

Accounting regulations (IAS-IFRS) specify that financial statements should adequately reflect the risks faced by the company, as long as they are material from a financial perspective (EU, 2021; ICAC & BOE, 2022). Although accounting and auditing standards do not explicitly mention climate change, the major international accounting standard-setters, driven by the need to integrate climate and other environmental and social aspects, are preparing new standards in which companies will demonstrate their understanding of the risks and opportunities posed by variables such as global warming. However, financial accounting can also be a valuable decarbonization tool for companies and investors.

For example, it can be applied in the responsible assessment by managers of the company's future viability (IAS 1), the potential obsolescence of the company's inventory (IAS 2), the fair value of assets (IFRS 13), the reduction or extension of the useful life of assets (IAS 16), as well as impairment of their value (IAS 36) or changes in provisions and contingent liabilities arising from sanctions (IAS 37) (IFRS Foundation, 2020). All these factors represent risks arising from the impacts of decarbonization policies and the physical effects of climate change that company assets are beginning to experience.

Companies with carbon-intensive assets will gradually be affected as a result of countries' neutrality commitments. But should companies that make neutrality commitments also reflect them in their accounting?

In Spain, over 70% of companies listed on the IBEX 35 have made climate neutrality commitments (Ecoact, 2022). These companies should reflect in their corporate financial statements the impact, if it occurs, of reducing emissions from their facilities and products by 50% by 2030, as well as the complete elimination of all operations and products that currently produce greenhouse gases within the next 25 years.

International Accounting Standard 16 Property, Plant and Equipment (IAS 16) and IAS 36 Impairment of Assets can help quantify companies' climate risks resulting from the transition to climate neutrality. For example, according to the rationale of IAS 16, even if an energy company is increasing its exploration and exploitation of hydrocarbons or petroleum refining activities, the transition to decarbonization would prevent it from realizing future profits, thus not meeting the criteria for recognition as an asset. On the other hand, standards such as IAS 36 can help make the impacts of carbon-intensive activities visible, as the entity must consider external and internal circumstances when assessing whether there are indications that an asset's value may have been impaired. Currently, it is difficult to materialize the impairment of the value of certain operations because their amortization period may be shorter than the complete decarbonization timeline.

The challenge of valuing risks that are not immediately visible could create a mismatch between the value attributed to carbon-intensive assets in the financial statements and their valuation in a decarbonization scenario. According to Carbon Tracker (2021), over 70% of the world's largest greenhouse gas-emitting companies do not disclose the effects of climate risk in their financial statements. Furthermore, 80% of their auditors did not assess climate risk when preparing their reports, according to the same publication. While auditors have acknowledged the complexity of evaluating such risks, ensuring the information's reliability is essential to avoid greenwashing. In the case of companies with public commitments, these commitments should provide clarity and serve as one of the foundations for the preparation of their financial statements.

Accounting has a performative function, so it reflects reality and constructs it. Creating the necessary incentives and accounting mechanisms to measure how the climate risks of transitioning to net zero affect financial performance should be a priority for the profession. This way, investors' decision-making will be supported by more accurate information, fulfilling one of the essential objectives of accounting.

Nearly a decade after Carney's speech on that autumn afternoon, the situation has started to change. The decarbonization of the economy is within closer reach. New industries are emerging, and others are at the beginning of their disappearance. It is an unprecedented opportunity for transformation, especially for Spain and Europe, but it is also an opportunity for the evolution of financial accounting.