Bruegel: Owning up to sustainability risks: the EU should champion international standards

26 April 2022

To keep European Union capital markets open and integrated, new international standards should be reflected in future European law and accounting practice to provide further incentives for a reallocation of capital, reflecting in particular climate risks.

The publication in late March of proposals by the International Sustainability Standards Board (ISSB) put the European Union’s own agenda on corporate disclosures under the spotlight once again. The ISSB is part of the international accounting body IFRS (International Financial Reporting Standards), which has already defined a global standard for financial statements. The ISSB sustainability disclosure standards could similarly become a global benchmark. This could address financial stability risks, given that the impact of the climate emergency may not have been properly reflected in asset values.

A new EU model for corporate sustainability disclosures was published last year and will also be finalised in the coming months. The EU has promoted what seems a more ambitious concept of ‘double materiality’ which captures a firm’s impact on people and the planet, in addition to the risks to enterprise value. In order for EU capital markets to remain open, the just-announced international standards should be a building block of European standards to the greatest extent possible.

What gets measured gets managed

IFRS 9, the latest version of the global accounting standard, has been applied by in the EU since 2018. This seeks to provide a “true and fair” picture of a company’s finances. Yet, a company’s accounts are rarely sufficient to reflect risks from climate change and other sustainability risks. Comprehensive disclosure of such risks is needed alongside the published accounts. Numerous surveys have underlined that institutional investors, such as pension funds, still don’t have access to sufficiently clear and consistent information on such risks. Serious long-term investors are keen to understand how such risks are managed and what targets are set, in particular to reduce risks resulting from the low-carbon energy transition.

The IFRS 9 accounting standard introduced major changes in the form of forward-looking provisions, as firms need to anticipate losses. In reality, this is insufficient to capture sustainability risks companies face from the low-carbon energy transition, and companies and financial firms have had too much leeway. Three types of sustainability risk illustrate why financial accounts and disclosures do not capture climate risks well:

• Firms should in principle explain future liabilities, even though the scale and timing of these liabilities are unclear. Decommissioning a coal plant ahead of its project lifetime or climate litigation could be significant expenses which will increasingly materialise over the coming years. IFRS guidance already requires such expenses to be shown if liabilities are more likely than not, while United States accounting rules only reflects such expenses if they are highly likely. In practice, there are few incentives to recognise provisions until liabilities are about to crystallise.
• A related problem is the write down of assets that are exposed to the low-carbon transition. Stranded assets could emerge, for instance where proven oil reserves turn out to be un-burnable, or where residential property is exposed to floods or coastal erosion. Such ‘material’ information should in principle be disclosed in financial statements, though interpretations of this requirement vary widely. As a result, markets may be overvaluing assets significantly.
• Finally, investors increasingly demand information on companies’ carbon exposures that arise in their upstream or downstream value chains, in particular in the emissions financed by banks or asset managers. Such indirect emissions could expose the reporting company or bank to risks arising in the climate transition. Computing these so-called ‘scope-3’ emissions is complicated by both lack of data and unclear methodologies.

Greater transparency through good disclosures and reporting should reveal material issues for a company’s future financial performance and hold boards to account in managing these future liabilities. In this way, markets may be spared abrupt re-pricing once the scale of the climate transition is revealed. Capital could be mobilised for those firms least exposed to risks, or for investment opportunities in which low-carbon technologies are deployed.

Together with a company’s accounts there should be a full disclosure of sustainability risks. Firms’ sustainability risk reports should be standardised...

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