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Sustainable accounting

David Pitt-Watson, who has been Pembroke Visiting Professor of Finance and Visiting Fellow at Cambridge Judge, talks about a campaign to stop companies benefiting from ‘stranded assets’ that unduly inflate profits.

Digital image of bank notes with pound signs on on an green background.

by David Pitt-Watson

Most people, most governments, and indeed most investors would like companies to commit to a business model which is compatible with climate sustainability. So why have so few companies responded?

One reason is that, until recently, they were able to declare profits as though climate change simply did not exist. They have been allowed to value assets and calculate profits as though there was no climate threat. So an oil well could be valued as though it was still pumping oil and getting $80 a barrel for it in 2050. These assets are known as “stranded assets” that will have to be written down if a stable climate is to be maintained.

In a similar way companies have assumed that the future of a thermal power plant or a fossil fuel engine factory was only limited by its technical life, and unchallenged by climate concerns. That meant annual depreciation was lower, and profits consequently higher.

In most cases they didn’t even tell their investors what climate assumptions underpinned the company’s profits – and the bonuses they paid their executives.

In other words, the way we calculated profit encouraged companies to trade unsustainably. It is this observation that has driven work I have led with colleagues, including those from the Accounting and Finance departments at Cambridge Judge Business School, which aims to put an end to such a myopic approach to calculating profits – and in doing so, help stop the incentive to invest in such stranded assets.

This next bit may seem like nerdy alphabet soup, but bear with me: One critical observation of our work was that the bodies that draw up the rules by which companies calculate profitability have a huge influence. Most of the world uses International Financial Reporting Standards (IFRS), which are established by the International Accounting Standards Board (IASB). The US and some other territories have their own standards, established by the Financial Accounting Standards Board (FASB), on behalf of the Securities and Exchange Commission (SEC). Auditing Standards are established globally by the International Auditing and Assurance Standards Board (IAASB) – in the US, they are applied by the Public Company Accounting Oversight Board (PCAOB).

So here is what has happened. In an interpretation of its existing standards, the IASB has made it clear that accounting rules require climate to be considered where material, and assumptions shown. The IAASB has further clarified that climate must also be part of the audit. In other words, the historic practice of ignoring climate considerations and hiding assumptions must come to an end.

The “Big Six” accounting firms have signed a letter welcoming the interpretations from IASB and IAASB. It is important that they, and the companies they audit, are held to account for following the new guidance.

However, even under the new accounting approach, companies can continue to use assumptions which are incompatible with sustainability, provided these are published. That is why key investor groups have insisted that they want to see IFRS properly applied and also want to know that the assumptions used are aligned with a sustainable world as defined by the Paris Agreement. Links to all these papers and statements can be found on the Principle for Responsible Investment’s website, one of the organisations which has been backing this initiative.

What difference has this made? By some accounts, quite a lot. BP, for example, has written off $16 billion in assets, and cut back its exploration expenditure, citing climate concerns. But there is still a long way to go, and there is a big challenge for companies, for auditors and for regulators. Indeed, the UK regulator has noted the failure of companies to follow the new interpretation. And so far we have only talked about IFRS, the standards that apply outside the US. Rules also need to change in that country.

So there is lots still to do. The IASB, the SEC and the FASB can set standards and interpretations. But they have no power of enforcement. If companies are to be called to account that must be done by their regulators and their investors.

Most people, most governments, and indeed most investors would like companies to commit to a business model which is compatible with climate sustainability. The acid test of that commitment is shown in the company accounts, and in how they calculate their profitability. We have the opportunity to insist that that is done in a way which is consistent with the Paris Agreement.

Indeed we must do so, if we are to support the creation of a sustainable world.