The Financial Reporting Council (FRC) highlighted an aspect of environmental, social and governance (ESG) reporting last July that leading UK corporates have overlooked.

In a thematic review of financial statements from 25 premium, listed companies, the FRC examined whether those organisations had reported in line with new Task Force on Climate-related Financial Disclosures (TCFD) criteria in its Listing Rule. While the watchdog hailed the first year of mandatory TCFD disclosures as “a significant step forwards”, it warned that companies must continue to develop their relevant narrative and financial reporting.

One particular area that the FRC highlighted for improvement was the connectivity between front-end and back-end – such as how net-zero commitments affect the annual review of the useful economic lives of long-term assets.

Telltale signs

According to the FRC, some companies in the study, including those that intended to replace or upgrade certain assets or production facilities – or that had set specific, net-zero targets – had failed to set out how they had taken climate change into account when determining relevant assets’ useful economic lives.

For example, the review pointed out, while several companies had signalled commitments to electrifying key equipment or parts of their vehicle fleets, none had explained how they had considered the impact of those plans on the valuation and useful economic lives of the assets in question.

As such, the FRC reminded companies that it expects them to explain in their evaluation of assets’ useful economic lives:

• how they have taken account of any published plans to replace long-term, material assets, or to transform the business in which they are used; and

• how they have reflected known plans to reduce carbon emissions as a result of regulation, eg, in sectors such as shipping or oil and gas.

For Jose Hopkins – Sustainability and ESG Director at MHA UK – those points go right to the heart of how corporates’ global conduct will be perceived as this type of reporting evolves. And disclosures from companies that have failed to account for the useful economic lives of assets will have certain, telltale signs.

“For example,” Hopkins says, “you may have a company that covers only, say, 30% of scope 1 and 2 emissions in its reporting and none of scope 3, but tells the market that it plans to be Paris aligned. There are two issues here. First, if you support Paris, you should disclose scope 1, 2 and 3 in full. Anything less is greenwashing – and, in the event of that reputational risk, stakeholders could start pulling capital if they are unsatisfied with the integrity of your climate strategy. 

“But just as importantly, lax reporting on scope 1, 2 and 3 indicates that the company concerned hasn’t adequately reviewed its fixed asset register – a critical tool for identifying stranded assets in the context of net-zero commitments.”

In Hopkins’ assessment, the assets that corporates need to consider with the greatest urgency are buildings.

Material impacts

“With vehicle fleets, companies will typically finish a lease in five years and then give the vehicles back,” he says. If we turn to equipment, a plant may have a stone breaker with 10 years of life on it and a conveyor belt with two years: a range of relatively short lifespans for different components. But because buildings are most likely to be materially impacted by regulations or weather effects, they are what companies’ asset reviews should prioritise.”

Hopkins notes that, if an auditor were to comb through a fixed asset register and find that the relevant company owned a selection of high-emitting buildings with lives set to far outlast the UK’s 2050 net-zero target, that company would have a problem.

As such, he says: “Our message to corporates is, don’t worry about what the letter of UK regulation currently states – the only viable lens for making these assessments is TCFD. Set your governance accordingly and look at your physical risks right now because those buildings may effectively become stranded assets.”

A stranded asset, Hopkins explains, is one outmoded by regulatory or industry shifts long before the expiry of its projected service term – thereby reaching the end of its economic life ahead of schedule and presenting its owner with financial and reputational risks. For example, an energy company may decide to meet net-zero targets by removing oil and gas from its operations by 2050 – but may still have refineries left on its register beyond that date. “They’re assets that the business can’t use in the same way as before,” he says, “so they’ll require either significant capital expenditure to modify, or outright disposal.”

Hopkins points out: “From an accounting perspective, those assets may still be able to generate financial benefits long into the future. But from a TCFD perspective, you must consider them impaired. That’s a major disconnect that companies need to tackle.”

Control deficiency 

Looking at steps that accountants should take to lead corporates through this territory, Hopkins says that they must help clients compile a repository of physical risk information – based not only on regulatory requirements, but projected climate shifts that could render real-estate assets unusable in key locations by certain dates.

“We’re telling management that they need to add new columns to their fixed asset register to monitor this,” he says, “so the impairment review feeds into going concern. Then, it’s a matter of carrying out the assessment once a year, just before the reporting period. In my view, if management has recently issued a huge sustainability report, but hasn’t conducted a thorough assessment of physical risk, that’s a control deficiency – and we would typically raise that with a client in a letter to management.”

Overarching that, Hopkins says: “Help companies to define what sustainability and ESG mean for their specific business models. The Chapter Zero network recently issued an excellent Board Scorecard – which is endorsed by ICAEW – that you can share with management to get them thinking about what sort of framework is right for their business and how governance should support that.

“Plus, encourage management to ask banking and insurance stakeholders what visibility they have on premiums increasing in climate-affected regions. According to a forecast from the Climate Council, one in 25 houses in Australia are set to become uninsurable by 2030 because of weather changes – just imagine what multinationals could be facing.”

Hopkins urges corporates: “Understand your key locations for physical risk. Apply the appropriate governance. Then focus on honing your asset evaluations in the UK before expanding the methods you’ve developed to your overseas operations.”

ICAEW Climate Change Manager Sarah Reay says: “Climate risks are often viewed from a macro lens in relation to the economic or regulatory changes that may lead to stranded assets. In terms of physical risk, for certain assets it is important to take a Locate, Evaluate, Assess, Prepare (LEAP) approach – similar to that found in the draft TNFD framework – as climate impacts will vary locally. Critical pieces of Infrastructure, such as plants, may become increasingly susceptible to flooding or drought, which could devalue those assets or significantly reduce their useful economic lives.”

As such, Reay adds: “Accountants must increase their understanding of place-based risks, as well as the macro environment in which they operate, to adequately prepare TCFD reports. They must also seek advice from subject matter experts to ensure they make more informed accounting judgements.”