In a 1991 New Yorker cartoon by Robert Weber, a boss puts his hands on the shoulders of the company’s accountant and says, "It's up to you now, Miller. The only thing that can save us is an accounting breakthrough." Who knew the crisis was climate change? Now, three decades later, Miller has a plan.
U.S. Treasury Secretary Janet Yellen might be today’s version of the boss in Weber’s cartoon. Yellen recently told Politico, “Both the impact of climate change itself and policies to address it could have major impacts, creating stranded assets, generating large changes in asset prices, credit risks and so forth that could affect the financial system. These are very real risks.” How can those risks be measured?
Both business and investors need an easily comparable way to measure, manage and communicate climate-related financial risk. This article describes a simple and effective approach to assessing climate risk in financial terms and explains the essential role that accountants will play in improving the quality and reliability of the data and analysis needed to guide corporations and investors to net zero.
The International Federation of Accountants’ (IFAC) Professional Accountants in Business Advisory Group recently issued an insightful report on Enabling Purpose Driven Organizations. The report elucidates the through line from qualitative information on climate-related financial risk to accounting judgments on asset valuations and useful lives but finds that climate impacts are mostly not quantified and monetized. The IFAC report concludes that, in the absence of quantification, companies will find it hard to compare climate transition risks against their wider enterprise risks, and investors will be unable to make informed decisions about the allocation of their capital.
Perhaps more worrisome, the IFAC report also found that companies and their investors typically lack robust climate impact insights to understand how it will affect business resilience and long-term value creation. This suggests company managers have failed to pinpoint the principal financial barriers and constraints posed by climate change and the energy transition.
What are the financial barriers and constraints to net zero?
Climate-related financial risk and opportunity both largely arise from the need to retire and replace carbon-intensive assets on an expedited basis.
With the price of renewable energy dropping, the principal economic barrier to reaching net zero by 2050 is that it will require us to prematurely retire much of the world’s vast stock of carbon-intensive assets and either retrofit or replace them with low or zero emission alternatives.
Examples of carbon-intensive assets include everything from oil and gas reserves and coal-fired utility plants to cement and steel factories to jet airplanes and gasoline-powered cars to homes and office buildings. But for climate change, the useful economic lives of these assets might extend well beyond 2050.
Replacing or modifying these assets will require a tremendous amount of capital investment that is not figured into existing business models. It also means that existing and especially new carbon-intensive assets are at high risk of becoming impaired or permanently stranded by the energy transition.
The principal financial constraint is that businesses must navigate the transition to net zero while maintaining an acceptable level of profitability and return on investment.
Companies and investors need a new approach to measuring climate-related financial risk that explicitly recognizes the nexus between greenhouse gas (GHG) emissions and the long-lived tangible assets that produce them – the carbon quotient.
What is carbon quotient?
Carbon quotient (CQ)TM is a new way to help companies, accountants and markets measure climate-related financial risk. By using CQ, corporations and investors have a better chance of achieving net zero on schedule by making informed financial decisions.
CQ is a set of open-source financial equations and ratios every accountant and financial analyst can immediately grasp. CQ doesn’t change the audited financials. Rather, it builds on them. it adjusts the income statement and the balance sheet to reflect a particular “what if” scenario – “what if” this company or this portfolio had to be carbon neutral today, as a matter of law? Would it be profitable? Would it be solvent?
Think of CQ like earnings per share or profit margin. It’s algorithmic, something a computer can process. This means there are no subjective “expert” assumptions or “black box” methodologies. It’s completely transparent. This differentiates CQ from most proprietary carbon metrics.
How does carbon quotient work?
CQ starts by calculating the future emissions embedded in emission-producing long-lived tangible assets over their remaining useful lives. CQ is forward-looking. It captures the future that has already happened.
Unrealized emissions are future GHG emissions that will result from the continued use of a company’s long-lived tangible assets, calculated as current year realized emissions times asset life. Asset life is a measure of the estimated remaining depreciable life of a company’s assets, calculated as property, plant and equipment, at cost, less accumulated depreciation, depletion and amortization (DD&A), divided by current period DD&A expense (see example for Exxon). When applied to assets that are not on the balance sheet of publicly traded corporations, asset life may be estimated using relevant benchmarks, such as IRS Class Lives and Recovery Periods.
CQ then monetizes these unrealized emissions at the estimated cost to remove them from the atmosphere at global scale. A 2019 study from the U.S. National Academies of Sciences, Engineering, and Medicine concluded that a direct removal cost of $100 or less per ton of CO2 is economically feasible.
CQ treats this unrealized carbon expense as a contra asset to property, plant, and equipment (PPE), just like accumulated depreciation. On the flipside, CQ treats avoided costs to offset past emissions as a contingent liability. Think of it like a court award in a lawsuit claiming damages for “unjust enrichment” for a company having profited from harming society.
Finally, CQ enables comparison of different assets, capital projects, companies, or investment portfolios in two ways. First, by comparing net zero-adjusted results of operations and financial condition, for example, carbon-adjusted shareholder’s equity or earnings per share. Second, by comparing the ratio of unrealized carbon expense to the carrying value of PPE on the balance sheet. The carbon quotient ratio is a normalized metric that functions at the asset, capital project, company, portfolio, or even national level.
The carbon quotient ratio can be calculated retroactively and forecasted prospectively. Performance over time can be charted against an asymptotic curve reaching zero by 2050 (or earlier for the energy sector). The gap between targeted and actual performance represents impairment risk. It also reflects potential legal liability and reputational damage for greenwashing and failing to reach net zero commitments as wells as risk of investment loss arising from misallocation of capital. On a macro level, it reflects systemic financial risk.
Every step in the CQ process involves accounting and accounting professionals.
What is the role of accounting in estimating emissions?
Along with audited financial data, reliable emissions data are a necessary input to CQ.
Assumptions about emissions affect accounting estimates and asset values. Realized and unrealized emissions create financial risk and close off financial opportunities. It is time for corporate accountants and auditors to treat them as such.
There are generally accepted accounting principles for GHGs. The GHG Protocol is a comprehensive, widely used global standardized framework to measure emissions.
The GHG Protocol’s Corporate Accounting and Reporting Standard sets the process to prepare a corporate-level GHG emissions inventory. It includes direct emissions from operations owned or controlled by the company (Scope 1) as well as from sources owned or controlled by another company, such as purchased electricity (Scope 2) and emissions in a company’s value chain (Scope 3), including its supply chain and emissions associated with use of its products.
CDP, formerly known as the Carbon Disclosure Project, has been collecting emissions data from companies for years through its annual climate change questionnaire. More than ninety percent of Fortune 500 companies that respond to CDP use the GHG Protocol to report on their GHG emissions. These reports are in turn used by the companies’ stakeholders, including investors, who rely on the data for investment decisions, corporate governance engagement and proxy voting.
Banks and other financial institutions also use GHG emissions data to calculate Scope 3 financed emissions. In November 2020, the Partnership for Carbon Accounting Financials (PCAF) launched the Global GHG Accounting and Reporting Standard, based on the GHG Protocol. The PCAF is a partnership of 118 financial institutions, representing more than $2.9 trillion in assets, that have committed to measure and disclose financed emissions in a harmonized way, to help financial institutions align their portfolios with the Paris Agreement.
The PCAF’s new standard sets forth a methodology for financial institutions to measure financed emissions across six asset classes: listed equity and corporate bonds, business loans and unlisted equity, project finance, commercial real estate, mortgages and motor vehicle loans. It requires measurement and reporting on emissions associated with all companies in member institutions’ portfolios, based on the GHG Protocol. The PCAF standard, and more broadly, financial institutions’ climate pledges, stand to significantly constrain high-emitting companies’ liquidity and access to financing for high-emitting activities. Reliable calculation and reporting on emissions is thus a critical finance function.
The problem is that the voluntary corporate sustainability reports that investors and lenders rely on inevitably are susceptible to greenwashing. Many companies essentially customize their emissions disclosures, by reporting only portions of their emissions and omitting other portions that may be material. In financial accounting, this would be called a scope limitation. But given the voluntary nature of GHG reporting, investors and banks must act on incomplete information. Thus, the PCAF standard says, “Limited data is often the main challenge in calculating financed emissions.” To address the data problem in the immediate term, PCAF established a data scoring system. Longer term, we believe that capital providers will cut off companies that do not provide full data sets.
Addressing the data quality challenge will require calling in the accountants, sooner rather than later. As with any other accounting estimate, emissions data are estimates that require an effective system of internal control over their preparation. Emissions data should also be subject to investor-grade assurance.
Many companies today do obtain some level of assurance. This may be motivated by CDP’s questionnaire, which asks whether reported emissions have been verified. But the quality of the assurance obtained varies widely and may not be provided by an accounting firm. Moreover, in most cases, the assurance is by its terms “limited,” which means that nothing came to the assurance provider’s attention that the reported information is wrong. Unlike in a financial audit, the assurance provider does not opine on the effectiveness of the reporting process or the fairness of the estimate.
How can CQ improve internal financial planning and external financial reporting?
Because a carbon pricing scheme is not a reality today, CQ measures a latent threat to uncertain future cash flows. Nonetheless, as illustrated in Figure 1 (reproduced from the recommendations of the Task Force on Climate-related Financial Disclosures), climate-related impacts on expected future cash flows can have immediate consequences on both internal financial planning and external financial reporting.
Climate transition risks and opportunities feed into today’s risk management and strategic planning decisions that will determine tomorrow’s financial outcomes. CQ helps companies identify, assess and manage the risks associated with the transition to net zero and decide how to compete in a low carbon economy.
The significant assumptions underlying a company’s internal financial planning should then flow into its external financial reporting.
Under U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), forward-looking expectations can adversely affect a company’s balance sheet – e.g., through asset impairments, accelerated asset retirement obligations, and contingent liabilities.
For example, as one of us explained in Accounting for Climate Change: From Scenario Analysis to Fraud in Three Easy Steps, internal carbon pricing assumptions should flow through to estimated cash flows used in impairment testing.
CQ analysis produced by accountants provides a concrete link between financial performance and narrative disclosures on climate strategy and risk management.
Every accountant knows that measurement lies at the heart of accountability. Net zero ambitions will remain illusory until policy makers, corporate managers, and investors start measuring the right things in the right way. Without audited, transparent and objective financial measures of carbon risk, there can be no accountability for net zero. Without accountability, there will be no results. Time is running out, and we are still looking for a clock. The only thing that can save us is an accounting breakthrough.