Proper accounting for carbon emissions in financial reporting
Pressure groups are calling for European utilities to consistently disclose key data on their carbon intensity as part of their financial reporting. Lis Jeffries explains why.
Had German utility RWE reconsidered political risk, its financial performance in 2016/17 might have been stronger. The company’s shares fell in September after news that the Green party could form part of a new German government coalition.
In addition, earlier in 2017 it announced that it had made a loss of €5.7 billion in 2016 and scrapped its dividend for the second year in a row. These actions resulted partly from changing trends in the German market which allowed more wind and solar power on to the system.
In short, Energiewende (energy transformation) – the German government policy underlying the switch to renewable generation – has hit RWE’s profitability hard. In 2016 it even prompted the company to separate its conventional generation from its renewables business, Innogy.
Luke Fletcher, utility analyst at non-profit campaigning organisation CDP, describes RWE’s restructuring as a “drastic action” and a clear example of how bold climate policy like Energiewende can “have a huge impact on shareholders”.
As a result of its financial performance and the carbon intensity of its portfolio, RWE comes last in an international ranking of electricity utilities (see table, below) which measures readiness for a low-carbon transition, including its assessment of physical, regulatory and reputational risks.
CDP compiled the ranking in support of the Task Force on Climate-Related Financial Disclosures (TCFD), a group calling for systematic climate-related risk assessments to be included in companies’ annual reports. The TCFD was set up by the Financial Stability Board, an international organisation established as a result of the 2008 financial crash.
Commenting on the league table and associated analysis, Fletcher observes that RWE in particular is struggling with the low-carbon transition. But the German energy giant is by no means the only European utility grappling with the challenges that decarbonisation is piling on to business models hewn in the age of coal.
A more considered approach to climate risk across the sector as a whole is needed in order to allow new business models to flourish, argues Fletcher.
Classifying assets, liabilities and acquisitions under the lens of climate-related risk would, according to CPD and the TCFD, facilitate the more appropriate pricing of risks and allocation of capital in the context of climate change. This would work as a voluntary initiative, helping speed the transition to a low-carbon economy, and would shift the corporate perspective beyond immediate concerns.
However, most industries are not reporting in-depth on this values-based assumption.
Improvements have been made over the past decade and utilities have responded to government and activist demands for data on their current or historic greenhouse gas emissions.
But now the pressure, as expressed by the TCFD, is aimed at getting them to disclose climate-risk assumptions robustly and consistently in financial filings, and to look further into the future.
TCFD’s recommendations do not require any innovative accounting, but more in-depth information. “It would change what the directors are telling us in the strategic report but wouldn’t change [the structure of] the balance sheet and profit and loss account,” explains Russell Picot, special adviser to the TCFD and former chief accounting officer at HSBC.
Leaders have already emerged in this space, but the wider picture is very mixed. At the European scale, CDP finds Austrian power company Verbund the best performer and Scottish Power parent company Iberdrola second on low-carbon readiness in its 2017 study of the sector, Charged or Static. SSE and Centrica come fifth and sixth respectively, so SSE is the top UK performer.
SSE considers risks and opportunities arising from climate change in its annual report with a longer discussion in its sustainability report. Unusually, it has modelled the resilience of its business against three core future energy scenarios, where global temperature rises to 2 degrees Celsius, 1.5 degrees Celsius and business-as-usual – in line with 3-4 degrees Celsius. The analysis showed the likely events that would take place if each scenario played out and how SSE would respond.
Meanwhile, Centrica claims it is in a key position to influence consumer action on climate “by providing them with more insight and more tools with which to use less energy and to have more choice to produce, store and save it”. However, its loss of customers and declining market share suggest the business has not yet effectively managed the risk originating from energy efficiency policies in its efforts to move towards distributed energy and consumer-facing products.
“Energy consumption has been falling and there are new market entrants on the scene at the same time as Centrica has been shifting to energy services. But it could still make money in the process. The company should have had a bit of foresight in forecasting demand,” says Fletcher
While most companies employ conventional economic metrics to justify decisions in financial filings, European utilities in particular express carbon pricing. This can be perceived as another way to consider risk exposure to carbon market changes or other regulation that could arise from carbon pricing, and to test a company’s resilience in that light. Most EU utilities assessed are now applying internal carbon prices as an input to capital investment decisions. Leaders apply a significant shadow carbon price, and stress test investment options versus a number of carbon price scenarios.
CDP finds RWE’s profitability is most exposed to carbon pricing, so that its carbon costs reduce its earnings before interest and tax by 13.7 per cent, assuming a 2015 average traded carbon market price of €7.70. By contrast, the comparable figure for Centrica and Iberdrola is less than 1 per cent.
The TCFD report thus comes at a time of transition. Most utilities are talking about climate risk. Some are acting to manage both the regulatory and physical risks of climate change, others are paying lip service. An obvious example of directional shift is Centrica, which is making major investments (£1.2 billion in 2016-20) in smart solutions such as the connected home and distributed energy. The company recently established Centrica Innovations (£100 million over five years) to help accelerate new technologies.
The taskforce wants more. If the corporate community systematically adopted its recommendations, balance sheet, income statements and strategic reports would most likely need modifications. “Including climate risk would sharpen disclosures on the impairment of cash flows arising from assets,” says CFD’s Picot. As in the SSE case, investors would be able to access a set of comparable sector scenario analysis relating at least to a 2C scenario as well as, for instance, scenarios related to Nationally Determined Contributions and business-as-usual (greater than 2C) scenarios.
However, the actual frameworks have yet to be shaped. “We need to see a period of experimentation. Three or four years down the road we could potentially be assessing what is useful in the voluntary disclosures, and see it codified by institutions through, for example, stock exchange guidelines,” says Picot.
However, he suggests the most significant progression would be found in strategic discussions in financial statements. “This is not going to result in a huge data drop by companies but rather a thoughtful narrative description from board directors. It will hopefully be used as an engagement tool as well as a divestment tool,” he says. A move towards less carbon-intensive business models could result. However, says Picot: “We’re not saying they should alter their business model but that the information needs to get out there so that the market can decide.”
Disclosures on climate-related risk are less unusual in this heavily regulated sector than in other carbon-intensive industries. Arguably, the risks to financial performance are considerable if a company moves away too quickly from its traditional business model or abandons its store of expertise. This is a highly politicised topic. Private-sector utilities may well improve the quality of disclosures on future carbon emissions or physical resilience. However, they still have considerable power to influence the future of the climate, rather than fend off the risks associated with its fluctuations.
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