…in effect, a new International Accounting Standard for net zero commitments is due to be adopted in late April 2024
By Andrew Watson, Co-Founder of Rethinking Capital
In December 2023 at COP28, Bridgewater’s Ray Dalio said that private capital can only finance climate solutions if the returns make sense, saying ‘You have to make it profitable!’ But by today’s accounting practice, investments to reduce carbon emissions are ‘made’ the opposite, as costs, with the only benefit of choosing that treatment being to reduce tax—which is illogical and just feels like bad accounting. Boards can and should demand better accounting.
I first wrote about the insight of ‘upside down incentives’ in 2021 in the paper Constrained by Accounting. And have since described this as the true root cause of the systemic inability to tackle the climate and biodiversity crises.
To explain—applied to say Anglo American’s commitment to a ‘30% reduction in Scopes 1 and 2 emissions by 2030’, the incentives to meet it are upside down—in that accounting practice treats the commitment as an externality, and investments purposed to meet it, such as innovation and carbon credits, as costs rather than balance sheet assets.
At last the rules of the game can be changed—flipped in fact. Because, in effect, a new International Accounting Standard for net zero commitments is due to be adopted by the IASB in late April 2024. This should begin the pathway for accounting that can and should be done to make net zero profitable—the challenge being then to work out how profitable by putting a price on the impact of emissions saved by meeting or accelerating a commitment.
I say ‘in effect’ because this new Standard interprets and clarifies the rules of an existing IFRS Standard—IAS37. As an interpretation of an existing Standard, one searching question boards should ask of management is why IAS37 (which must be followed) wasn’t followed when emission reduction commitments were made and affirmed in FY’s ‘20—23.
This has far-reaching effects in board governance of accounting for net zero commitments and needs new decisions. If demanded, the positive effects will include to start the pathway to make investing to reduce carbon emissions profitable and unlock material hidden medium and long term returns from a net zero strategy and investment program—by better accounting that recognises each $1 invested and purposed to meet the commitment as an asset.
Those hidden returns are very large. Applied to say Anglo American’s commitment to reduce carbon emissions by 2030, meeting its commitment would increase its balance sheet assets by around $495m—and materially improve its key financial metrics (profit, EPS, ROE, debt to equity ratios) and be taken into account in credit rating as explained in this S&P paper—and increase balance sheet assets by at least $1.5bn and flow into other metrics if accelerated.
Unlocking these benefits begins with recognising that a commitment to reduce emissions by 2030 has created expectations that it will be met—meaning to recognise it as a ‘constructive obligation’ under IAS37. And accepting accountability by first using different accounting treatment in management accounts used in decision governance.
Three key takeaways for boards…
- Demand higher profits and better real returns. This is simply accounting for assets and obligations that exist in reality but aren’t recognised by accounting practice. It means that accounting can and should be done to show that, in reality, a net zero strategy is profitable—and will improve returns over time. Asset owners’ fiduciary duties include to unlock these better real returns. Directors’ rights and duties should now include to demand the company provide the accounting to do so.
- Use judgement and ask the right questions. A board has the right and duty to decide what’s an asset or obligation and this will need new judgement. The right questions to inform this decision include
- Could the company’s 2030 emission reduction commitments be one or more constructive obligations?
- Have affirmative actions been taken to evidence the company recognising its own commitments?
- What accounting decisions were made in the years in which commitments were made and affirmed?
- Make this an independent board governance issue and create an impact analysis. The potential for retrospective effect also elevates accounting for transition commitments from an accounting into a board governance and accountability issue. Asset owners, insurers, banks and others are impacted and need reassuring that the board is actively and independently governing it. Legal teams should be engaged early. An impact analysis is the first step.
What’s led to this interpretation and how it enables boards to use judgement…
I led two submissions to the Interpretations Committee of the IASB, known as IFRIC. The second focused on commitments to reduce emissions by 2030 and was made with the International Foundation for Valuing Impacts.
The submissions explained that a provision (a quantified accounting liability) should be recognised for a commitment to reduce carbon emissions by 2030—because the commitment and affirmative actions that recognise it meet IAS37’s definition of a ‘constructive obligation’—'an obligation that derives from an entity’s actions where:
- by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities.
- as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities’.
In my view, the simple logic to use in deciding whether a provision should be recognised was best explained by KPMG’s Brian O’ Donovan from minutes 6.55 to 8.43 of second IFRIC meeting available here—that ‘affirmative actions by a company are powerful evidence that the company itself accepts that it has created a constructive obligation’.
Applied to say bp’s 2030 commitments, typical of those made and affirmed in 2020 to 2023, this simple logic flows—
- bp’s own affirmative actions, such as creating, negotiating and/or updating a detailed 2030 transition plan, are powerful evidence that bp itself accepts that it has created a constructive obligation.
- Implicitly those same affirmative actions also evidence that bp accepts that something has already happened that led to those affirmative actions—that a past event has occurred.
- A provision should be recognised unless at the time the constructive obligation is or was created, it’s probable that capital will not have to be allocated to meet the commitment.
- When a provision is recognised, investments purposed to meet it should be recognised as assets.
In other words, accounting can and should be done that will create accountability, make net zero profitable and materially increase returns over time. The board’s right is to demand this accounting be done.
Conclusion…
The outcome should be a major shift in accounting practice which could happen very fast—if boards and investors demand it. The IASB’s April approval intends to enable new decisions in preparation for FY ’24 year ends.
The global audit firms represented on IFRIC described their clients as being ‘on a journey’ to recognise its effects in preparations for FY ‘24 year ends. Since the IFRIC decision on 5th March, we’ve started a dialogue with the Global Public Policy Committee to engage the global audit firms in our 2024 program.
The effects should also be to set the conditions for demand for commitments and transition plans to be restated in 2024 assuming these returns—a mindset shift and the catalyst to slash carbon emissions by 2030. And means that emission reduction plans created in 2021 but thought to be unaffordable, instead become immediately profitable.
This should narrow the board’s choice to either embrace it early or be forced to do so later. Rethinking Capital’s advice is to embrace it early. There is much to gain and nothing to lose. We aim to enable the shift to begin first in financial accounting for net zero commitments—using ‘normative’ accounting treatment in management accounts for net zero decision governance and decision reporting as explained on our website.
To support this, we’ve created space on our website to get real-time news and insights on what’s happening, what it means and guidance on what boards and legal teams should do.