Climate Risk: the evolving landscape for auditors

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Climate Risk: the evolving landscape for auditors

Published 22 July 2022

The implementation of the UK sustainability disclosure requirements (“SDR”) regime is now well underway.  The increase in compulsory climate related disclosures comes at a time where statements about green credentials and climate risk are increasingly being scrutinised by regulators, consumers, investors and activists.

What are auditors’ roles in all of this? And what should they be aware of to ensure they comply with their professional obligations?

Climate risk and financial statements

Climate change will impact all businesses to some extent, either directly through a climate event (chronic or acute), or indirectly, for example, through their supply chain, customer base or laws and regulations. Companies should therefore already be considering climate risks in producing their financial statements, and the requirement to make a s172 statement in a company’s strategic report or FRS102 disclosures will also be influenced by significant ESG (Environmental, Social and Governance) related risks.

An auditor must therefore consider climate risks during the audit of a company’s financial statements.  An auditor’s overall objective is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement.  They need to consider whether the financial statements appropriately reflect the risk climate change poses to the entity in question.  For example, they should consider their obligations under ISA 315 (Identifying and Assessing the Risks of Material Misstatement), ISA 540 (Accounting Estimates and Related Disclosures) and ISA 570 (Going Concern) – extreme weather events or significant  climate related litigation may be relevant to the auditor’s going concern assessment. 

An ISAAB Staff Audit Practice Alert published in October 2020 (available here) provides a summary of what auditors need to consider with respect to climate risk under relevant ISAs.

The focus of this article is on how auditors’ responsibilities fit into the new compulsory climate related disclosures under the developing SDR.

Mandatory climate related disclosures

Since April 2019, large companies, LLPs and other entities meeting threshold criteria have been required to report publicly on their UK energy use and carbon emissions through the SECR policy, which built on (rather than replaced) existing requirements such as mandatory greenhouse gas reporting for listed companies.  The SECR rules set out the required statutory disclosures regarding direct and indirect emissions (amongst others matters) in the Directors’ Report or (where energy use and carbon emissions are considered strategically important), in the Strategic Report (cross referenced from the Directors’ Report).

The SDR, which overlays the SECR rules, is based on the work of the Task Force on Climate-Related Financial Disclosures (“TCFD”).  This was established in 2015 at COP25 in Paris by the Financial Stability Board.  Its purpose was to develop recommendations on the types of information that companies should disclose to support investors, lenders, and insurance underwriters in appropriately assessing (and pricing) the risks associated with climate change.  The TCFD has set the framework which many countries, including the UK, have adopted in their own climate disclosure regimes.

The four core elements of the TCFD recommended climate-related financial disclosures are as follows:

  1. Governance: disclosing the organisation’s governance around climate-related risks and opportunities;
  2. Strategy: disclosing the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning where such information is material;
  3. Risk Management: disclosing how the organisation identifies, assesses, and manages climate-related risks; and
  4. Metrics and Targets: disclosing the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.

As part of its Green Finance Strategy the UK government created a taskforce which established a roadmap for implementing mandatory climate-related disclosures across the economy by 2025 (accessed here).  This was followed in October 2021 with the Greening Finance: A Roadmap to Sustainable Investing which provided further detail on the SDR framework.

Now halfway through the five-year roadmap, mandatory TCFD-aligned requirements have been introduced across a large part of the economy:

  1. FCA Listing Rules: Listed companies

Under the FCA’s Listing Rules, premium listed companies for accounting periods beginning on or after 1 January 2021, and standard listed companies for accounting periods beginning on or after 1 January 2022, are required to make a TCFD-Compliance Statement in their annual financial report (“AFR”).

  1. ESG Sourcebook: Asset Managers and Asset Owners

From 1 January 2022 a new ESG Sourcebook was introduced into the FCA Handbook and introduced disclosure obligations for the largest in-scope firms (asset management firms with over £50 billion in assets under management (“AUM”) and asset owner firms with assets over £25 billion).  The rules will apply to smaller firms above a threshold of £5 billion in AUM (such threshold to be reviewed after three years of disclosures) from 1 January 2023.

The ESG Sourcebook requires in-scope asset managers and asset owners to publish (1) a TCFD Entity Report, and (2) TCFD Product Report.

For more details on compulsory climate related disclosures for asset managers and listed companies required by the FCA Handbook, please see our article here.

  1. Extension to other large companies and LLPs

For accounting periods from 6 April 2022 onwards, large companies with more than 500 employees and more than £500m annual turnover, and LLPs with over 500 employees (and in the case of LLPs which are not traded or banking LLPs, those with a turnover of more than £500m) are now required to produce TCFD aligned disclosures.[1]

In scope companies must disclose climate-related financial disclosures within the Non-Financial and Sustainability Information Statement of the company’s Strategic Report. LLPs should include disclosures in the Energy and Carbon Report or, if a Strategic Report is prepared, within that report.

UK companies with more than 500 employees and within the scope of the FCA rules will therefore be subject to both the Regulations and the FCA Listing Rules.  Government guidance has provided that disclosure for the purposes of the FCA’s Listing Rules is likely to involve use of similar information as for the Regulations and should normally meet the requirements for both.

Auditor’s responsibilities

In particular, when looking at a company’s climate-related disclosures, an auditor must consider ISA 720 and whether a company’s climate risk disclosures are consistent with its financial statements or the information gathered during the course of the audit work:

  • ISA 720 deals with an auditor’s responsibilities relating to “other information” (covering financial or non-financial, and statutory or non-statutory information) included in an entity’s annual report. Under the ISA, an auditor is required to read and consider whether any “other information” is materially inconsistent with the financial statements or the knowledge obtained by the auditor during the course of the audit, with a view to assessing whether there is a material misstatement of the financial statements or whether a material misstatement of the other information exists.
  • The disclosures required under the Listing Rules, the SECR rules and the rules affecting large LLPs and companies from April 2022 will fall under “other information” in accordance with ISA 720. Therefore, when considering these disclosures, an auditor must have ISA 720 in mind.
  • The rules for Asset Managers and Asset Owners in the FCA’s ESG Sourcebook say that the TCFD Entity Report and TCFD Product Report should be published in a way that makes it easy for prospective readers to locate and access: should the reports be incorporated into the annual report by cross-reference, auditors should consider their responsibilities under ISA 720 with respect to the disclosures carefully.

The FRC’s February 2022 “staff fact sheet”, sets out information for auditors to help them assess their responsibilities under ISA 720 when auditing the financial statements of companies required to include TCFD and SECR disclosures (available here).

However, this isn’t always straight forward.  The underlying data and systems which support climate-related disclosures can provide a challenge for accountants. The current systems that produce the information for climate-related disclosures are significantly less sophisticated than for financial information. This can present an issue for ensuring consistency and comparability.  Much climate-related reporting is also largely aspirational and high-level, e.g. meeting a net-zero target, which presents a challenge in ensuring that the underlying data presented in support of this is adequate and sufficiently credible. 

Audit firms must remain alert as to their requirement to exercise professional scepticism when reviewing climate related disclosures - particularly when evaluating the evidence behind such disclosures.  It is essential that they remain alert for contradictory evidence that may undermine the sufficiency of the evidence obtained.

Like many industries, the rapid change in expectation with respect to climate change means training and guidance is required to upskill teams.  The FRC’s Climate Thematic Report in November 2020 found that auditors needed to do more.  It said:

“For over half of the audits we reviewed, we found auditors had not considered climate change when identifying and assessing the risks of material misstatement to the financial statements. Audit teams had neither considered the range of physical and transition risks to which the entity might be exposed, nor the risks that climate change pose for its customer base or supply chain over different time horizons. Where management had included a principal or emerging risk in relation to climate change, only a few audit teams showed how they had considered this in their own risk assessment.”

The Climate Thematic Report suggests that firms should develop ways to embed climate change considerations into their audit methodology and software to ensure the audit work is of consistent quality. 

Conclusion

The new compulsory climate-related disclosures come at a time when we are seeing statements with respect to climate change or sustainability (in any context – e.g. advertising, packaging, prospectuses and financial statements) being scrutinised by consumers, investors, regulators and activists.  There is no doubt that these new compulsory disclosures will be scrutinised and taken into account in investment decisions.  Any incidences of greenwashing (or of false or misleading statements) arising from the disclosures will see stakeholders looking for a party to take the blame. Auditors need to be up to speed with how their existing obligations should be applied to the new disclosures, to avoid the finger being pointed at them.

 

[1] Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 and the Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022 (collectively “the Regulations”) have amended the Companies Act 2006 and Limited Liability Partnerships (Accounts and Audit) (Application of Companies Act 2006) Regulations 2008

 

Authors

Annabel Walker

Annabel Walker

London - Walbrook

+44(0)20 7894 6112

Victoria Grantham

Victoria Grantham

London - Walbrook

+44 20 7894 6506

Amie Roberts

Amie Roberts

London - Walbrook

+44(0)20 7894 6219

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