The Role of Auditing and Accounting In Addressing Climate Change

Climate Change

Climate change is one of the central points of concern from global point of view, and has been so for years now. The global economy is constantly in search of ways to curb the negative impact of greenhouse emissions. We have been spectators to large submits conducted in hopes to find ways to reduce the carbon foot print left on the environment by industries across the globe.

With the growing pressure to counter negative impacts, it is quite reasonable for us to expect large corporations to show accountability to climate change. While one may not necessarily correlate accounting and auditing with climate change responsibility, the connection between the two is a straightforward one.

To begin with, it is common knowledge that various functions and operations carried on by corporations lead to climate change. However large or small they might be. The impact is omnipresent and is also two-fold. On one hand, various functions carried on by organizations lead to GHG emissions and create carbon foot print. On the other hand, climate change in return negatively affects the organizations’ assets like it does to the rest of the world. These include physical risks such as destruction of assets/ facilities due to fire or flood etc.

Why Is Accounting, Auditing, and Reporting of Climate Risks Important?

The SEC and other entities across nations are eager to inculcate proper auditing and accounting of climate change risks. They hope to promote transparent and clear reporting of climate risks a corporations poses, including GHG emissions and more. Here is why such auditing and accounting is necessary:

  • Proper disclosure of climate risks helps determine what part of the company earnings comes from good management. And what part of those earnings are a result of pushing the costs onto the society and environment.
  • In other words, proper and actual reporting helps hold corporations accountable for the impact they have on the environment. And that in itself has many benefits.
  • For example, disclosure of a corporation’s climate risks/ impact help ensure proper allocation of resources within the organization. The aim is to allocate funds to include negative impact and makeup for it.
  • In addition, these reports are functional in charting out a future plan of action for corporations, while optimizing reduction of carbon foot print.
  • Also, companies that calculate profits considering the climate risks, help investors. That is because transparent reports serves as tools for investors to engage their funds in portfolio companies according to their climate transition strategies.
  • It is true that it’s the investor’s prerogative to best utilize their funds. But it becomes difficult if the auditing and accounting of climate risks, and reporting of future plans is not transparent.
  • The reports thus help investors allocate their funds to entities that are most probable to transition to low-carbon models. Or the ones that are already on a solid pathway to reducing their carbon footprint.

This shows to how important the role of auditing and accounting is in addressing climate change. Even though a large chunk of populations understands the need for proper disclosure, does not mean all is well.

The Problem?

The frequency of extreme events such as heavy precipitation, heat waves, tropical cyclones, and droughts is growing.  Keeping this and the external pressure exerted on them in mind, majority of huge corporation in US and across the globe issue ESG reports. In fact, many huge corporation woe to reduce their carbon foot print to negligible or even zero by 2050.

ESG stands for environmental, social and governance reports, disclosing how their operations affect these three segments. However, most of the corporations that voluntarily do this, issue reports that make it difficult assess the entity’s actual performance.

The corporation’s own accountants and auditors are the ones issuing these reports. There is no saying how accurate and realistic the actual reporting is. The regime by the U.S. Securities and Exchange Commission (SEC) for example has a disclosure regime.

But its implementation to date is faulty and relies on the general principle per which companies should disclose information considered important by reasonable investors. But this an extremely broad principle which does not necessarily showcase or promote accuracy. Many such reports are more anecdotal and present the best-case scenarios, rather than giving the real picture.

What should be done?

It is evident that accounting and auditing are both key in communicating reliable climate information to the market, authorities and investors. But the current reporting regimes, as mentioned before, are not enforced properly. In fact the regimes are also lacking efficiency and are costly to follow through.

SEC can ensure credible accounting of carbon footprint

As per an article on the Center for American Progress, the SEC must do something to promote robust disclosure. They call on SEC to make reporting more efficient and to ensure proper implementation by taking four steps. These are:

  1. Enforcing existing requirements/ regimes to reflect actual financial and material impact of climate related risks. As well as the impact made in an effort to transition to a low-carbon economy.

  • The existing rules set under the reporting regime already require the disclosure of material impacts. However, many ignore this aspect of reporting. There is hence a need to consciously report not only financial but material climate-related impacts as well.
  • The SEC issued the climate-related risk reporting guidance in 2010, but its enforcement is questionable. According to some external reviews, the efforts made by SEC to monitor compliance of its regime is inadequate.
  • The SEC must make conscious effort to vigorously monitor and enforce compliance by its staff.
  1. The SEC must update the climate risk related disclosure requirements. They should also identify the best practices and promote their usage across industries.

  • The PCAOB and SEC staff are perfect candidates to collect vital information about the disclosure procedures.
  • For example, they are bound to monitor the adherence to issued requirements. And hence also more likely to know of the weaknesses and irregularities of the processes. They can collect this info and the SEC can further use the information to update disclosure practice procedures.
  • Another way is to issue staff accounting bulletins comprising of the best practices and troubleshoots to promote efficiency in reporting, across industries and markets.
  1. Leverage audits to bridge climate-related risks and corporate financial reporting. Expanding audits can enhance and make climate-related risk disclosures more robust.

  • Most company auditors don’t have a liability to ensure that climate reporting corresponds to correct financial figures.
  • Leveraging independent audits in this case, and ensure the reliability of corporate disclosures.
  • Issuing audit guides, amending existing/ developing new auditing standards are good ways to promote clear reporting.
  1. Address the ways the existing systemic risks in U.S. climate relating accounting standards.

  • The existing accounting system and reporting procedures have many systemic risks and redundancies.
  • The SEC should take steps to address and remove these risks and make reporting more efficient.

All in all, in order for the markets to price and manage climate financial risks, they must have comparable and reliable information. The SEC plays a critical role in ensuring that the U.S. disclosure regimes are robust and provide ample information for companies to produce transparent and reliable reports.

E-Liability Accounting System

The battle to carbon transition and proper climate-risk related reporting is far from won. An article in the Harvard Business Review highlights the issues with the GHG protocol and suggests ways to make climate reporting more credible.

The solutions presented by them integrate advancements in measuring emissions and block chain technologies to auditing and accounting. Review by HBR recognizes 3 types of GHG emissions, namely:

  1. The direct emissions by sources directly controlled or even owned by a corporation. For example, the transport and production equipment.
  2. Emissions by the facilities that produce electricity the companies buy and/ or consume.
  3. Emissions that are a result of upstream operations from the corporation’s supply chain. As well as emissions from downstream activities of the customers/ end-consumers of the company.

As per HBR, the first type of emissions are easiest to keep track of and measure. But the remaining 2 types of emissions are indirectly linked to a company’s operations. And hence are difficult to measure. In fact many companies miscalculate these emissions, thus misreporting climate risks.

In order to counter these, HBR proposes an e-liability accounting system. E-liability stands for environment liability and hopes to tackle ESG reporting in a more auditable and targeted manner. They consider GHG emissions to be ideal starting place, as they represent most immediate danger to the planet. However, this does not mean that they only measure environmentally damaging outputs and ignore social damages.

The general idea behind E-liability

For the most part, it is true that the poor accountability of most ESG reports comes from the flaws in GHG protocol. HBR proposes to correct these flaws as best as possible.

  • The e-liability accounting protocol calls for tracking emissions across the entire value chain of a corporation.
  • It then calls for two other basic steps to ensure robust reporting. And ensure that a company does not subtract an undue amount from its liability this shifting the liability to end-users/ consumers.
  • The first step is to calculate net e-liabilities that the company creates and eliminates during a time period. Then add to them the e-liabilities the company acquires of accumulates.
  • The second step is to allocate all or some of the total e-liabilities to unit output production of the company.
  • E-liability mechanism also calls for the GHG emissions by an outsourced supplier to be transferred to the company, along with the purchase they make.
  • This regime eliminates double/ duplicate counting of emissions and also reduces incentives for companies to game or manipulate the figures.
  • In the end, a company’s end e-liability amount is auditable much like its financial assets and liability. This ensuring that the reporting is transparent, accurate and robust all throughout the process. Refer to the article for further details.

Conclusion

It is certain that credible reporting, auditing and accounting of climate risks is extremely important in our battle for our environment. In order to win this battle, all players- investors, authorities, proprietors, auditors and accountants- must successfully carry out their duties.

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