Demand accounting that makes net zero profitable

…in effect, a new International Accounting Standard for net zero commitments is due to be adopted in late April 2024

In December 2023 at COP28, Bridgewater’s Ray Dalio said that private capital can only finance climate solutions if the returns make sense, saying ‘You have to make it profitable!’  But by today’s accounting practice, investments to reduce carbon emissions are ‘made’ the opposite, as costs, with the only benefit of choosing that treatment being to reduce tax - which is illogical and just feels like bad accounting. Better accounting can and should be demanded.

We first wrote about the insight of ‘upside down incentives’ in 2021 in the paper Constrained by Accounting. And have since described this as the true root cause of the systemic inability to tackle the climate and biodiversity crises.

To explain - applied to say Anglo American’s commitment to a ‘30% reduction in Scopes 1 and 2 emissions by 2030’, the incentives to meet it are upside down - in that accounting practice treats the commitment as an externality, and investments purposed to meet it, such as innovation and carbon credits, as costs rather than balance sheet assets.

At last the rules of the game can be changed - flipped in fact. Because, in effect, a new International Accounting Standard for net zero commitments is due to be adopted by the IASB in late April 2024. This should begin the pathway for accounting that can and should be done to make net zero profitable - the challenge being then to work out how profitable by putting a price on the impact of emissions saved by meeting or accelerating a commitment.

We say ‘in effect’ because this new Standard interprets and clarifies the rules of an existing IFRS Standard - IAS37. As an interpretation of an existing Standard, one searching question that should be asked is why IAS37 (which must be followed) wasn’t followed when emission reduction commitments were made and affirmed in FY’s ‘2020 - 23.

This has far-reaching effects for asset owners and investment managers and in board governance. If demanded, the positive effects will include to start the pathway to make investing to reduce carbon emissions profitable and unlock material hidden medium and long-term returns from a net zero strategy and investment program - starting with better accounting that recognises each $1 invested with the purpose to meet the commitment as an asset.

Those hidden returns are very large. Applied to say Anglo American’s commitment to reduce carbon emissions by 2030, meeting its commitment would increase its balance sheet assets by around $495m - and materially improve its key financial metrics (profit, EPS, ROE, debt to equity ratios) and be taken into account in credit rating as explained in this S&P paper - and increase balance sheet assets by at least $1.5bn and flow into other metrics if accelerated.

Unlocking these benefits begins with investee companies recognising that a commitment to reduce emissions by 2030 has created expectations with asset owners and others that it will be met - meaning asset owners requiring companies to recognise it as a ‘constructive obligation’ under IAS37 - and requiring accountability by first using different accounting treatment in management accounts for decision governance and reporting to asset owners.

Three key takeaways for boards, asset owners and investment managers

• Demand higher profits and better real returns. This is simply accounting for assets and obligations that exist in reality but aren’t recognised by accounting practice. It means that accounting can and should be done to show that, in reality, a net zero strategy is profitable - and will improve returns over time. Asset owners’ fiduciary duties include to unlock these returns. Directors’ duties are to position the company to unlock them. Investment managers should factor ‘new’ returns into strategic asset allocation and portfolio management.
• Use judgement and ask the right questions. This needs new judgement. The right questions to ask include:
  • Could the company’s 2030 emission reduction commitments be constructive obligations? And have affirmative actions been taken by which it evidences recognising those commitments?
  • Did these set expectations with investors and did they make commitments made to others as a result?
  • What accounting and audit decisions were made by the company in previous years when the commitments were made and affirmed?
• Require this to be an independent board governance issue and an impact analysis created. The potential for retrospective effect also elevates accounting for transition commitments from an accounting into a board governance and accountability issue. Asset owners, insurers, banks and others are impacted and need reassuring that the board is actively and independently governing it. Legal teams should be engaged early. An impact analysis is the first step.

What’s led to this interpretation, and how it enables new judgement

Two Rethinking Capital submissions were made to the Interpretations Committee of the IASB, known as IFRIC. The second focused on commitments to reduce emissions by 2030 and was made with the International Foundation for Valuing Impacts - with whom we’ve worked since 2020 and wrote the paper Constrained by Accounting.

The submissions explained that a provision (a quantified accounting liability) should be recognised for a commitment to reduce carbon emissions by 2030 - because the commitment and affirmative actions that recognise it meet IAS37’s definition of a ‘constructive obligation’ - 'an obligation that derives from an entity’s actions where:

1. by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities.
2. as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities’.

In our view, the simple logic to use in deciding whether a provision should be recognised was best explained by KPMG’s Brian O’ Donovan from minutes 6.55 to 8.43 of second IFRIC meeting available here - that ‘affirmative actions by a company are powerful evidence that the company itself accepts that it has created a constructive obligation’.

Applied to say bp’s 2030 commitments, typical of those made and affirmed in 2020 to 2023, this simple logic flows:

• bp’s own affirmative actions, such as creating, negotiating and/or updating a detailed 2030 transition plan, are powerful evidence that bp itself accepts that it has created a constructive obligation.
• Implicitly those same affirmative actions also evidence that bp accepts that something has already happened that led to those affirmative actions - that a past event has occurred.
• A provision should be recognised unless at the time the constructive obligation is created, it’s probable that capital will not have to be allocated to meet the commitment.
• When a provision is recognised, investments purposed to meet it should be recognised as assets.

In other words, accounting can and should be done that will create accountability, make net zero profitable and materially increase returns over time. It’s a board and asset owners right and duty to demand this accounting.‍

Conclusion

The outcome should be a major shift in accounting and audit practice which could happen very fast - if boards, asset owners and investment managers demand it. The IASB intends to enable decisions in preparation for FY 2024 year ends by approving the decision on 25th April 2024.

The global audit firms represented on IFRIC described their clients as being ‘on a journey’ to recognise its effects in preparations for FY 2024 year ends. Since the IFRIC decision was made, we’ve started a dialogue with the Global Public Policy Committee to engage the global audit firms in our 2024 program.

The effects should also be to set the conditions for demand for commitments and transition plans to be restated in 2024 assuming these returns - a mindset shift and  the catalyst to slash carbon emissions by 2030. And means that emission reduction plans created in 2021 but thought to be unaffordable, instead become immediately profitable.

This should narrow the choice to either embrace it early or be forced to do so later. Rethinking Capital’s advice is to embrace it early. There is much to gain and nothing to lose. We aim to enable the shift to begin first in financial accounting for net zero commitments - using ‘normative’ accounting treatment in management accounts for net zero decision governance and decision reporting - explained below.

To support this, we’ve created spaces on our website to get real-time news and insights on what’s happening, what it means and guidance on what each stakeholder should do. With technology and other partners, we’re also setting up two Normative Accounting & Governance Labs for those who want to become the earliest innovators.