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Accounting for climate change: from scenario analysis to fraud in three easy steps

The critical link between internal financial planning and external reporting.

Register now to hear Greg Rogers speak at the 11th annual RI New York meeting 4-5 December: Click the link for info

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
In response to the G7 Investor Leadership Network (ILN) report on TCFD analysis, this article addresses legal implications for failure to integrate climate-related financial metrics into asset and liability valuations in line with existing U.S. accounting principles and securities regulations.
As ILN and PRI members prepare their respective investor TCFD reporting frameworks, we review the link between internal financial planning and external financial reporting and explain how publicly financed companies, particularly oil companies, can go from scenario analysis to accounting fraud in three easy steps:
1. Institutional investors with $100 trillion in assets under management call on publicly financed oil companies to include climate scenario analysis in their strategic planning. They further ask that those firms explain how their strategies are resilient in a 2°C climate scenario and to disclose supporting metrics such as internal carbon prices.
2. A large integrated oil company reports an assumed $40/ton price for direct and indirect carbon emissions in its strategic planning and capital investment decisions to account for possible future policy impacts: “Everything gets tested against this pricing scenario,” the CEO says to any investors who ask about the company’s resilience to climate change. The company confidently assures investors that none of its hydrocarbon reserves are now, or will become, stranded.
3. Notwithstanding its reassuring statements, when testing its assets for impairment under generally accepted accounting principles (GAAP), the company omits consideration of carbon prices entirely. The firm’s finance executives mistakenly reason that carbon pricing is decision-useful for internal financial planning purposes but not for investors who finance the company’s business. Every accountant knows that managerialaccounting is for use by management, while financial accounting is for use by external stakeholders, and the two do not overlap. Wrong. Longstanding guidance from the U.S. Financial Accounting Standard Board and Securities Exchange Commission makes clear that cash flow projections used in impairment analysis must be both internally consistent with the firm’s other projections and externally consistent with financial statements and other public disclosures. Publicly financed firms cannot have it both ways: both assuring investors that carbon pricing is integral to the company’s economic outlook while excluding carbon pricing from their respective asset and liability valuations.
Carbon pricing, particularly when applied to indirect emissions from fossil fuel sales, can have a material quantitative impact on the financial statements by reducing expected net cash flows (undiscounted revenues minus expenses) over the productive life of a company’s existing assets. Oil companies tend to have very long-lived assets (up to 60 to 80 years) burdened by very expensive decommissioning liabilities that accountants call asset retirement obligations or “AROs”. Lower expected cash flows over decades of future production can have the compounding adverse effects of lower asset values, higher impairment losses, shorter estimated useful lives, earlier asset retirement costs, and higher ARO liabilities. Without regard to quantitative impact, failure to flow through carbon pricing assumptions from internal financial planning to external financial reporting likely would have a qualitative influence on investors’ decision-making. The integrity of financial reporting processes matters in addition to outputs.
The distinction between internal scenario planning and financial reporting is a Catch-22.
In Joseph Heller’s novel an army psychiatrist invokes “Catch-22” to explain why any pilot requesting mental evaluation for insanity – hoping to be found not sane enough to fly and thereby escape dangerous missions – demonstrates their sanity in creating the request and thus cannot be declared insane. Catch 22 is a dilemma from which there is no escape because of mutually
conflicting or dependent conditions. The oil and gas sector and other high-emissions sectors now find themselves in this position. As the energy transition unfolds, assumptions about medium and long-term commodity prices, demand forecasts, production costs and carbon constraints will be continuously vulnerable to sudden and dramatic change. This puts oil companies in a Catch-22 situation. If they transparently account for transition risk “as seen through the eyes of management”—as recommended by the TCFD and required by the SEC—they risk divestment by climate-wary investors. Conversely, if they obfuscate, they risk divestment by deceived and aggrieved investors in the aftermath of securities fraud litigation of the type that is now encircling Exxon. Transparent reporting provides a remedy for the climate risk scenario analysis Catch 22. An absence of good options, however, is not an excuse for oil executives to bury their heads in the sand. Willful blindness to potential ruin is failure to exercise fiduciary duty of care.With a global market cap of close to $2 trillion, the top twenty NYSE-listed oil and gas companies, and their investors, have a lot to lose from inaccurate and misleading reporting.
Scenario analysis is about envisioning future financial impacts in order to build resiliency to unpredictable environmental, technological, market and policy disruptions. Accounting for climate change is about accounting for those potential future impacts today via proper asset and ARO liability valuations. Investors should expect that oil companies will do both to the best of their ability. Assumptions used in companies’ internal financial planning for climate change must be consistent with public reporting on asset valuations and retirement obligations.

Greg Rogers, J.D., CPA, is a founder of Eratosthenes and an internationally recognized expert on environmental and climate-related financial disclosure. He is an advisor to the Master of Accounting Program and honorary Fellow at the Cambridge Judge Business School, visiting lecturer at the Stanford Graduate School of Business, past Chairman of the American Bar Association’s Committee on Environmental Disclosure, and an original member of the Sustainability Accounting Standards Board (SASB) standards council.

Register now to hear Greg Rogers speak at the 11th annual RI New York meeting 4-5 December: Click the link for info