19 July 2016
Markets are demanding full disclosure of climate-related risks
The bankruptcy of the US mining giant Peabody in April has underlined the need for all companies to take the need for transparency in both their financial and narrative reporting seriously. The bankruptcy follows a long investigation by the Attorney General of New York into Peabody’s alleged failures to report honestly about known risks to the company’s business model.
This applies to all companies but has a special significance to companies, like Peabody, which operate in sectors that are facing big challenges, such as the fossil fuel sector.
The Attorney General’s case included the allegation that Peabody had falsely claimed that it was unable to predict the impact of government policy on its revenues – the company’s own internal projections had shown that coal sales in the US could fall by at least 33% as a result of those policies.
Peabody was also accused of basing its published presentation of its risks and future prospects on only one of the three hypothetical scenarios presented by the International Energy Agency (IEA), namely the scenario which offered the least pessimistic view of the future of the coal sector.
In essence, the allegation was that, in communicating its corporate position to the markets, the company was consciously misinterpreting relevant facts and circumstances and thereby giving a misleading impression to users.
Audited financial statements and accompanying narrative reports constitute the main body of information that is available to most users. Users are entitled to be given information that is as accurate and relevant as it can be, as it helps them to assess a company’s financial health and to consider whether to invest or disinvest in it.
This is underlined by international financial reporting standards (IFRS), the central purpose of which is stated to be ‘to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’.
In the UK and the EU, financial statements must, by law, give a true and fair view. Inherent in that is the duty to comply with relevant accounting standards and disclosure rules.
This onus on transparency extends to the qualitative information that companies are required to provide in their narrative reports. In the UK’s statutory strategic report, a company’s directors must discuss the principal risks and uncertainties that they consider their company faces.
They must also give a fair, balanced and comprehensive analysis of the development and performance of the company’s business and of its position at the end of the year – non-statutory guidance issued by the FRC suggests that the discussion of end-year position should incorporate comment about future prospects.
In addition, quoted companies must, by law, include in their strategic reports an explanation of their strategy and business model and a discussion of the main factors likely to affect their future development.
The guiding objective of the report is to help the company’s members assess how the directors have performed their statutory duty to promote the success of the company. This incorporates a duty to take into account all relevant factors, such as the likely long-term consequences of decisions and the impact of the company’s operations on the environment.
The preparation of strategic reports in the UK is covered by section 463 of the Companies Act 2006. It says that directors may become personally liable for omissions of material facts or for statements included in the report that they know to be untrue or misleading. Where liability is established, it will take the form of compensation to the company for any loss it has suffered as a result of the directors’ breach.
Given these parameters, companies should be thorough and transparent when reporting publicly about the risks they are facing and how they are managing them. However, it is unclear that energy companies are currently demonstrating in their corporate reporting that they are responding as they should to the magnitude of the challenge that climate change is presenting to them.
That challenge is coalescing around the factors that flow from the regulatory commitment to the reduction of greenhouse gases. This commitment has reached a new level with the international agreement – at the COP 21 conference in December 2015 – to achieve a maximum global temperature rise of no more than 2 degrees above pre-industrial levels by 2050.
To have an 80% chance of meeting this target, Carbon Tracker Initiative (CTI) estimates that the world’s total ‘carbon budget’ – the amount of greenhouse gases we can afford to be emitted – for the period to 2050 is no more than 900 billion tonnes (or gigatonnes (Gts)).
To put this in context, total CO2 emissions in 2015 alone are thought to be in the region of 32 Gts.
Since the total equivalent amount of CO2 believed to be embedded in the world’s proven fossil fuel reserves is currently in excess of 2,800 Gts, this means that for us to stay on track the great majority of those reserves (coal, oil and gas) must simply stay in the ground.
It follows that a great deal of the capital expenditure being incurred by energy companies in relation to the exploration of new fossil fuel reserves is likely, from here on, to be wasted.
The risks and opportunities faced by energy companies are by no means restricted to the implications of what some will still see as a politically-driven and anti-business campaign for us all to ‘go green’.
A recent report by the Grantham Institute and Vivid Economics puts the wider economic cost of a temperature rise to 2.5 degrees by 2100 at $2.5 trillion. There are commercial reasons why reducing expenditure on fossil fuel projects makes sense.
First, we are continuing to see great advances in renewable sources of energy. The cost of developing and producing wind and solar energy has continued to drop; wind turbine costs have consistently fallen by double digits with every doubling of cumulative production, and the price of electricity generated by solar power dropped from $76 per watt in 1977 to just $0.74 per watt in 2013.
In 2014, one quarter of all German electricity was generated from renewable sources. This year a report by Goldman Sachs found that the already rapid pace of the shift to renewables is accelerating and announced ‘the end of the beginning for the low carbon economy.’
Second, market logic is making the cost of fossil fuel production increasingly uneconomic. Peabody, referred to earlier, is only one of the major US coal producers that have filed for bankruptcy protection in recent years. In addition, falls in market prices point to oversupply in export markets in particular.
Oil is less badly placed, yet a new era of competitive pricing in the sector has seen the market price per barrel slump to as low as $28. This means that the massive cost of many new development projects risks far exceeding their capacity to generate an economic return.
The position of gas is again slightly different and is likely to be less badly affected than coal or oil. However, global demand for gas, according to the IEA’s ‘450 Scenario’, is projected to decline by 22% by 2040.
Third, we are seeing a number of contributory developments in the wider environment. One of these concerns the traditional assumption that links population growth with energy demand. Energy intensity, in other words the amount of energy used per unit of GDP, has been falling worldwide. In OECD nations as a whole the measure fell by 76% between 1980 and 2012, even though GDP grew on average by 5.4% annually.
Even in China, which saw a substantial growth in energy demand in the years after 2000, reported demand fell by 4.3% in 2012 and 2.6% in 2014.
This ‘de-coupling’ of energy demand from GDP undermines the argument still being put forward by some energy companies that they need to continue to produce fuel on the basis of the same business model in order to promote global economic development.
The combined result of these trends is that fossil fuel companies are facing unprecedented challenges to their commercial viability. These challenges must be faced up to openly in reports to shareholders and the markets.
CTI’s research has reviewed data on global demand and current and scheduled exploration projects. It found that a ‘business as usual’ approach leads to the pumping out of carbon emissions at a level that compromises the ability meet the 2 degrees ceiling target.
Just as importantly from the economic perspective, the research also found that this leads to some $2 trillion of capital expenditure being wasted, as related investments will be unable to generate a financial return for investors. Continuing to focus heavily on fossil fuel development and extraction, in defiance of political pressure and economic logic, will put billions of dollars invested in corporate assets at risk of being ‘stranded’, i.e. losing their ability to generate an economic return.
Full disclosure of energy companies’ plans for mitigating climate change risk is essential. This will enable shareholders to have the information they need to hold their boards to account and to play a meaningful role in the good governance of their companies.
To date, investors are not receiving the information they need – this is as true under the developing framework of ‘integrated reporting’ as it is under traditional approaches to financial and narrative reporting.
The demand for more and better information is growing. Shareholder pressure has already been successful at Shell and BP. Investors in Exxon Mobil and Chevron narrowly failed with resolutions to require those companies’ boards to prepare dedicated reports on how they are responding to climate risk and its likely impact on shareholder returns.
Mary Schapiro, the former chair of the US Securities Exchange Commission (SEC), has said: ‘Investors are desperate for this information. They are actively seeking out clear and honest and comparable data about climate risk so that they can make decisions about where to allocate their capital, and compare companies within an industry and across industries.’
A task force established by the Financial Stability Board is currently exploring ways of standardising new disclosures on climate-related risks and expects to report back by the end of 2016. The guidelines to be issued by the task force are intended only to be voluntary, but they will have strong political legitimacy. They are likely to constitute an important benchmark of good disclosure practice over the years to come.
It is vital that investors seize the opportunity presented by these new disclosure guidelines to insist on full explanations from energy companies about the implications for their strategies and business models of what is already a dramatically changing business environment.