Auditors must commit to calling out companies on climate

"It is hard to think of a situation where a robustly independent audit is more vital to society than the climate crisis."

Company auditors are not an obvious group to ask for help to save us from global warming. But they could turn out to be knights in shining armour, writes Natasha Landell-Mills, head of stewardship, Sarasin & Partners (pictured).

Their central role in vetting financial statements awards them unique power to press companies to align their numbers with the Paris Agreement on climate change. This would transform the odds in our battle to stabilise the planet.

Company accounts provide vital information to management, boards of directors, shareholders and indeed all stakeholders about the profit a business has earned and capital it has put to work. The numbers underpin key decisions about how much money there is to invest and where funds would be best deployed to generate future returns. They are also the single most important determinant of most executives’ bonuses. Accounts act as a nerve centre for decision-making. Where they are faulty, the capital machine will misfire.

Yet when we analyse listed companies’ accounts the vast majority appear to be leaving out climate-related impacts, such as how shifting weather patterns will affect business, or how the global drive to reduce emissions of carbon dioxide to net zero by 2050, as set by the Paris Agreement, will impact future earnings.

The UK Financial Reporting Council came to a similar conclusion in a recent review of financial statements. Only six of 24 companies it examined made any reference to climate change in their financial statements, despite being heavily exposed to climate risk. The silence was often at odds with detailed disclosures of climate impacts in the strategic and risk sections in these companies’ annual reports, along the lines required under the Task Force on Climate-related Financial Disclosures.

Beyond the obvious question of potential misrepresentation, such mistaken accounting is likely to lead to excessive investment in carbon-intensive activities, with tragic consequences for society.

If the accounts of a coal-fired power company, for example, ignore the decarbonisation required under the Paris Agreement, management will presume stronger future cash flows and longer lives for assets. The company will continue to reinvest in coal power, fail to write down its assets, and ignore the need to put aside funds to cover cleanup costs.

Meanwhile, executives are likely to receive large payouts for their efforts.

Auditor role

Enter the auditor. Like a well-trained engineer, the auditor checks the number-machine is in working order and identifies faults. A good auditor knows where to look for potential misrepresentation and then investigates more deeply.

By ensuring that companies’ numbers can be relied on, auditors protect investors, but also staff, customers, suppliers and – ultimately – the public. The recent failures of UK outsourcing company Carillion and German payments processor Wirecard show the harm imposed when the audit system appears to break down.

It is hard to think of a situation where a robustly independent audit is more vital to society than the climate crisis. That is why investors representing over $9trn last year called for auditors to sound the alarm where they identified financial statements that ignore the global move to net zero by 2050. The investor group further pressed auditors to identify unsustainable dividends predicated on continued or rising fossil fuel consumption.

This call for auditor leadership complements a broader drive towards climate-aware accounts backed by both the industry’s standard-setters: the International Accounting Standards Board and the International Auditing and Assurance Standards Board.

Meanwhile, in September 2020 global investors representing over $100trn published a statement calling for companies to ensure their financial statements were prepared using assumptions consistent with the Paris Agreement.

Time to act

Beyond the clear role for directors to ensure their accounts are sustainable, auditors have a responsibility to lead. They have the ability to call out accounts that fail to reflect the net-zero transition, and do not require permission from management or regulators. They can – and should – act today.

Auditors appear to be listening. Last spring Deloitte and EY made ground-breaking disclosures in their respective audits of oil giants BP and Royal Dutch Shell. Both included climate risks and the energy transition in their Key Audit Matters and explained how the Paris Agreement was considered in their review of management accounts. Critically, the auditors also provided their view as to whether the assumptions aligned with the goal of limiting global warming to less than 2 degrees Celsius above pre-industrial levels.

Deloitte was clear the oil prices BP used in impairment tests were too high. A few weeks later, the British company’s board decided to lower these critical assumptions and indicated a likely impairment of between $13bn and $17.5bn, equivalent to just under 20% of the company’s net assets.

Other audit firms are now also stepping forward. Earlier this month, the big six global audit firms – Deloitte, EY, PwC, KPMG, BDO and Grant Thornton – published a commitment to play their part in stepping up to the climate crisis.

Altjough welcome, the commitment doesn’t go far enough. The auditors promise to check whether companies have considered climate risks in their financial statements, but say nothing about aligning with the Paris Agreement. This leaves the door open for directors to assume the deal is not implemented, and therefore has no material impact. In essence, they can assume away foreseeable climate risks. Auditors should commit to calling out any inconsistencies with the global drive to net-zero emissions.

If the knights in shining armour are suffering from nerves before battle, they should know we are behind them. In the end auditors serve all those who, through their pensions and other vehicles, entrust their capital to companies. Audits also serve a vital public purpose: they underpin trust and stability in markets. If auditors sign off accounts that fail to align with a sustainable planet, they will fail in their most basic duty: to protect all of us.

Natasha Landell-Mills is an ESG Clarity editorial panellist.