What do Climate Change and Accounting Have in Common? Our Misconceptions.
Climate change. A phrase that frequently appears on news headlines. Everyone has heard about it. Some of us find ways to address it. Others deny it.
However, we all experience it.
Climate change is no longer just an environmental issue — it has evolved into a human rights issue.
In 2017 alone, 18.8 million people have lost homes because of disasters related to climate change. These displacements are mostly caused by floods due to rising sea levels.
Misconception: Melting Ice Caps Increases Sea Levels
What if you were told that melting ice sheets do not cause rising sea levels and instead decreases sea levels?
You must be thinking — that’s crazy. Of course melting ice contributes to rising sea levels — where else would the water go?
You’re right. But not fully.
It seems counterintuitive, but the location of the ice sheets matters.
When an ice sheet melts, the sea level nearby radius decreases.
Wait. How is that possible?
Geologist Jerry Mitrovica’s explains this well.
An ice sheet, like the moon, produces gravitational attraction on the surrounding water. As it melts, the gravitational attraction weakens — which causes the sea levels in vicinity to fall.
This, however, cause higher sea level rises in oceans on the other side of the earth.
“If the Greenland ice sheet melts, sea level in most of the Southern Hemisphere will increase about 30 percent more than the global average. So this is no small effect.”
How odd is that?
We used our intuitions to understand rising sea levels, which is akin to the logic of turning a tap on — water flows from one side to the other.
However, sea levels don't rise like that.
Whilst our intuitions are sort-of-right, it did not capture the full picture. Our intuitions failed to consider how it happens on a larger scale.
Ready for another counter-intuitive statement?
What if I told you accounting could help address climate change?
You must be thinking : “That’s absurd.”
Well, I don’t blame you. We have the misconception that accounting bears the stereotype of mundane book keeping.
However, it can be interesting — particularly so as it is crucial to how the world of finance operates.
Accounting is the building block of finance. It enables corporations to collect and prepare financial information. Investors make decisions based on such information — choosing where to channel their resources to.
Most investors and creditors (i.e., parties who loan money out) primarily value financial gains and whether a company will be operating in the upcoming years.
To allow investors and creditors to understand and evaluate financial information, companies have to record and present their financial information in a standardised way — they have to abide by accounting standards (such as International Financial Recording Standards).
Changes in accounting standards have repercussions on how a company makes decisions.
This is because such changes indicate that companies will have to present their financial information differently — which impacts how investors perceive them.
Let’s take bring this back to a relatable scenario.
Imagine you’re about to go on an organised blind date session (I secretly pray that you won’t ever have to). You’ve picked out a smart, dapper outfit — because you want to look your best.
However, you’re suddenly told that you can only wear blue-clothing — as that is the dress code of the date.
You would now have to rethink your clothing strategy — how can you standout within a crowd of other suitors wearing blue?
Alike accounting standards, corporations have to rethink their business decisions when these changes occur.
For instance, a new accounting standard recently implemented (i.e., “IFRS 16”) have mandated the disclosure of property that is rented (i.e., ‘leases’) in their financial information.
What impact did this have on corporations? Plenty.
- Companies will need employees to act as detectives to uncover and analyse potential leases and the consequences of classifying something as a lease (i.e., ‘rented property’).
- Organisations will have to be cautious with how they tailor contracts. Modifications to a contract could result in needing to disclose financial information — new information which they did not have to before.
These indicate that changes in accounting standards have domino effects on how corporations make decisions.
And, through changes in accounting standards, accounting could also help address climate change.
Does that still seem counter intuitive?
If it does, let’s solidify this to further to gain more clarity.
Climate change is no longer just an environmental problem. Investors see it as a business risk.
Here is number of ways that climate change pose as business risks:
1) Potential fines from the government from fines and not complying with laws (i.e., legal liabilities)
Here are examples of cases of investors bringing up litigation suits :
- Australia — Mark McVeigh, a 23-year-old member and beneficiary of the pension fund REST, filed a lawsuit against the fund, arguing that its failure to provide adequate information relating to its exposure to climate-related risks prevents him from making an informed judgment about the management and financial condition of the fund (McVeigh v. Australian Retail Employees Superannuation Trust [REST]).
- United States — Case filed by shareholder Sarah Von Colditz against ExxonMobil, some of its executives (current and former) and board members. The claimant (i.e, Sarah Von Colditz) argued that they misled investors by understating how much risk climate change poses to the company’s assets.
Note that this is the third lawsuit that Exxon has faced over alleged misrepresentation of asset values to investors — another is the fraud action filed in October 2018 by the New York Attorney General.
2) Changes in Technology
The value of the technology and assets companies currently have.
Depending on the technology, the useful value of the technological asset will severely be affected (i.e., for accountants out there, this means higher asset-write and write-offs). This mainly due to changes to a greener economy.
Such changes could include changes in laws which makes the technology or asset no longer usable.
For instance, the value of oil fracking technologies and assets might severely be affected — especially if they are banned, or have legal restrictions on their use. Or, this could also be due to greener technological improvements — which diminishes the value of asset are not as green.
3) Scarcity of Resources
Scarcity of raw goods supply affects the ability of companies to produce — hence reducing their ability to generate profit.
For instance, the scarcity of materials such as oil or wood will either increase the cost of such raw goods — which increases the cost of production.
Note that scarcity does not only apply to raw goods for production, but also resources needed for basic sustenance — such as water, energy and even food.
4) Changes of Costs of Insurance and Financing due to Climate Related Risks
As physical assets become vulnerable to climate related disasters (such as floods), the cost of insurance is going to be higher.
Insurance companies are already factoring these risks into determining insurance costs. And, companies that are disclosing sustainability measures have lower cost of finance (i.e., debt and equity).
Naturally, companies that are greener tend to be less risky. As greener companies are more robust in the face of climate-change related risks, the cost of getting finance for such companies are lower. And vice versa.
5) Consumer Demand
Consumers are starting to take note of factors beyond price. This is particularly so with the rise of ethical consumption trends — such as minimalism and veganism.
As consumers become more concerned with environmental issues, making it the norm to be an ethical consumers, the revenue of companies from sectors such as fast fashion producers will be affected.
That was a lot to take in — here’s a picture that summarises everything.
Climate change risks are now financial risks.
Hence, companies that are more prone to climate-change risks should start reflecting these risks in their current business practices.
However, whilst climate related changes pose as risks, they also pose as opportunities.
It is these opportunities that companies should focus on. To mitigate such risks, companies could invest in initiatives that help reduce their impact on the environment.
Such opportunities include :
- Resource efficiency. Investing in production methods research that results in reusing, recycling and ultimately reducing or upcycling waste.
- Renewable energy sources. Particularly investing in renewable energy technologies or switching to renewable energy sources.
- Investing in infrastructure that is disaster resilient. This entails investing in advanced disaster technology, more robust infrastructure requirements and disaster forecasting technology.
- Product and Services Redesign. Innovating on production of goods and services to being greener and less wasteful.
These opportunities are rather obvious solutions. And, some companies are already investing in them.
But, the world needs a lot more of these initiatives.
Ultimately, we want companies to shift away from engaging in ‘risky’ practices and move more towards ‘opportunities’.
We want companies to shift away from activities that deplete the environment, and, invest in research and development towards a greener economy.
One of the ways to achieve both of that is to disincentivise companies that are actively contributing to climate change, and, reward companies for investing in green initiatives.
How do we do that?
By including climate change related information on their financial information disclosures.
Such information allows for investors to assess a companies’ robustness in the face of climate change. This not only protects the investors funds, but as well as drives investment in companies that engage in greener practices.
With time, investor’s funds will slowly shift away from companies that are engaging in environmentally destructive practices.
Corporations will then have a clear incentive to engage in greener practices and move away from environmentally destructive ones.
That sounds great — but is this even realistic? Can it be done?
The TCFD (Task Force for Climate Related Financial Disclosures) have been working on this. Here’s a breakdown of how this could be done.
Financial institutions and experts are deeply looking into making this work.
And, if you’re in the world of accounting, finance or professional services, you could learn more about it at TCFD’s Learning Hub.
There are free and accessible courses that can help you understand how this could be implemented. Here's where you can access it.
Climate change is an issue that is happening right in front of our eyes. As individuals, we have a part to play in this as well.
Making climate related risk financial disclosures mandatory can be done. This is definitely achievable — as the United States have recently passed the law for climate-related disclosures.