Interconnectivity - Climate change impacts on the financial statements

Interconnectivity has become a buzzword lately as investors, regulators, and standard-setting bodies acknowledge the importance of general-purpose financial reports that provide a holistic and comprehensive review of an entity.

What is interconnectivity and why is it important?

The term ‘interconnectivity’ refers to the connectivity between climate-related disclosures provided in the front end of annual reports (often in the strategic report) and the related disclosures in financial statements.

It is generally acknowledged that providing a holistic view where narrative climate-related commentary is clearly linked to the effect in the financial statements improves investor decision-making.

There are clear benefits for companies as well - As EFRAG (European Financial Reporting Advisory Group) noted in its paper “Climate-related risks in the financial statements” many stakeholders anticipate a nudge effect on risk management processes through the enhanced identification of material risks to the financial reporting, as a result of greater coordination and communication across companies’ sustainability and financial reporting departments.

Current practice

Despite these benefits, research shows that connectivity is still lacking in most cases and the quality of climate-related disclosures in financial statements remains low¹.

According to Carbon tracker’s report ‘Flying blind: in a holding pattern’, the majority of companies are still not providing sufficient transparency about the impacts of climate matters in financial statements.

Recognising the growing demand for clarity and examples, the International Accounting Standards Board (IASB) has launched a consultation ‘Climate and other uncertainties in the financial statements’ setting out eight illustrative examples of possible disclosures covering a range of primarily climate-related scenarios.

Common areas of interconnectivity

The table below summarises some common climate risks and the potential impact on financial statements. It also provides some examples of fact patterns where companies may find interconnectivity increasingly relevant for consideration in their financial reporting process. (Note this is not an exhaustive list):

#	Climate risk/opportunity	Possible impact on the financial statements	Relevant for consideration
	Transitional risks
1	Entity’s decarbonisation strategy or transition plans: for example, commitments to replace existing fleet with Electrical Vehicles (‘EVs’) or other net zero commitments.	Useful lives and/or residual values of PPE if these are being phased out and replaced by electrically powered alternatives. Impact on the cost of raw materials, if the company is moving on to ‘greener’ alternatives which may appear to be more expensive. Impact on cost assumptions in management forecasts in relation to additional costs required to decarbonize operations Impairment indicator for non-financial assets and/or impact on assumptions used in impairment calculations. Changes in business models could impact segment and disaggregated revenue disclosures.	Companies with net zero targets and commitments Companies that prepare and disclose detailed transition plans outlining their roadmap and decarbonization activities
2	Government decisions such as the introduction of carbon targets or new policies and legislation to incentivise emissions reductions (e.g., Minimum energy efficiency standards) and waste management.	Useful lives and/or residual values of PPE Impairment indicator for non-financial assets and/or impact on assumptions used in impairment calculations. Impact on estimated costs to complete, expected duration and total contract value for long-term contracts. Provision/contingent liabilities for costs to comply or penalties/fines imposed	Companies operating in jurisdictions with ambitious national net zero targets, supported by implemented regulations and policies to decarbonize the economy
3	Carbon pricing mechanisms Government Emissions trading schemes for high carbon emitting activities, Carbon Border Adjustment mechanisms and Voluntary carbon markets	Impact on management forecasts through additional compliance costs, including the price of emissions allowances purchased by companies on mandatory or voluntary basis Additional costs of key raw materials imported from jurisdictions that fall subject to the Carbon Border adjustments mechanisms, where suppliers can pass this additional cost of carbon on to customers.	Companies operating in jurisdictions with established national Emission Trading schemes. Companies in jurisdictions with established Carbon Border adjustment mechanisms, procuring materials from other jurisdictions. Companies committed to buying voluntary carbon offsets
4	Customer and supplier behaviour Revenue and growth could change as customers' preferences shift to greener/more sustainable goods and services. Similarly, suppliers could be impacted by climate-related risks and pass higher costs up the supply chain	Useful lives and/or residual values of PPE Impairment indicator for non-financial assets and/or impact on assumptions used in impairment calculations. Impact on management forecasts because of changing sales volume/revenue assumptions or cost assumptions	Companies under pressure from growing customer demand for ‘greener’ alternatives Companies reliant on corporate customers with ambitious Scope 3 reduction targets Companies procuring carbon intensive raw materials/energy
5	Macro-economic impacts of physical and transition climate risks	Impact on assumptions and judgements required for expected credit loss (ECL) calculations. Impact on methodology and forecasts for valuations where climate-related factors have significant impact on the valuation assumptions	Companies with significant investments in carbon intensive sectors and/or vulnerable geographical locations Companies that hold significant investment property requiring improvements to meet energy efficiency requirements/targets Companies with longer term receivables such as construction companies and banks with customers that are exposed to significant climate risks.
	Physical risks
5	Extreme weather events and chronic weather patterns	Impairment indicator for PPE Impact on the management forecasts where additional costs need to be incurred on improving assets resilience to accelerating impacts of climate change. Impact on estimate costs to complete, expected duration and total contract value for long-term contracts. Impact on sales and cost assumptions in management forecasts as a result of business disruption caused to supply/distribution as a result of extreme weather events. Impact on going concern and viability assumptions	Companies exposed to extreme weather events and geographical locations highly vulnerable to climate risks, either directly or through their supply /value chain Companies located in areas of extreme heat hazard where investment is needed to maintain appropriate labor conditions

Preparers of financial statements should pay particular attention to reporting the effects of climate-related uncertainties in the financial statements as we move into the reporting cycle for December 2024 year ends.

Determining the right amount and level of disclosures to provide can be challenging. In cases where there is no material impact on the financial statements in the current period, the FRC noted in its thematic review that users of the financial statements may still reasonably expect a transparent explanation to how this conclusion was reached if the companies are exposed to significant climate risks or have disclosed detailed net zero/transition plans in the front end².

The FRC has also cautioned entities against greenwashing,for example by providing undue prominence to minor green initiatives, so preparers still need to consider the overall principle of materiality in applicable financial reporting standards when determining the level of disclosures that should be provided.

For a deeper discussion on this topic, please contact Anthony Appleton.

The UK endorsement board July 2023 research paper titled “ Climate-related matter: Summary of Connectivity Research.”
FRC thematic review on TCFD disclosures and climate in the financial statements