5026 Understanding the Entity’s Climate-Related Risks

Sep-2022

Industry factors include industry conditions such as the competitive environment, supplier and customer relationships, and technological developments. Entities in certain industries or geographic locations may need to implement changes to allow for continuing business activities in the event of extreme events, such as wildfires or flooding. These measures may require significant expenditures and may increase operating costs. Alternatively, entities in these industries who do not take such actions may face the impacts of business disruptions and property loss.

Longer term technological improvements intended to facilitate a transition to a lower carbon, energy-efficient economy may also have a significant impact on entities. For example, the development and use of technologies such as renewable energy, battery storage, or carbon sequestration may affect the competitiveness of entities utilizing older technology, their production and distribution costs and, ultimately, may impact customer demand for their products or services.

The regulatory environment encompasses, among other matters, the legal and political environment in which an entity operates.

Some entities face uncertainty over future climate policy and regulation. For example, some regulations may create economic disincentives for entities to continue carbon emissions by imposing levies or taxes on high-emissions sources, while other regulations may seek to incentivize entities to adopt specific operating practices, for example, by requiring or promoting a change to lower emission sources of inputs, or more sustainable land-use practices.

Changes in climate regulation or policy may affect a wide range of business inputs and outputs such as energy pricing, carbon taxes, mandatory emission and energy standards and/or industry targets.

The rapid emergence of climate-related legislation in different jurisdictions means that entities need to be aware of any existing or proposed climate-related laws and regulations and the extent to which those laws and regulations may impact the entity’s operations, its existing or potential liabilities, or its planned acquisitions, financing, investment or new projects.

The financial impact of such regulatory or policy changes depends on the nature and timing of the change and needs to be considered for both the entity and its supply and distribution chains.

In some countries, regulators have implemented, or have announced plans to implement, climate-related disclosure requirements. As part of our understanding of the entity and its environment, we need to consider such disclosure requirements so that we can consider these disclosures when assessing risks of material misstatement.

What knowledge and awareness does management have of scientifically forecasted impacts of climate change on their industry, geographical locations, and regulatory and policy changes?

How do the entity’s finance teams work together with those assessing climate impacts to ensure that available scientific data, including scenario analysis, informs the financial information reported?

What background information has management gathered to keep up to date (e.g., regarding regulatory updates, known impacts, how peers are assessing and developing climate risk assessment processes, latest technological developments)?

How are climate change considerations integrated into the existing enterprise risk management and related decision-making processes?

Who within the entity is responsible for the risk assessment process and what resources are available to them?

Do those charged with governance provide oversight of management’s risk assessment activities and plans for mitigation of the risks?

Has management used any subject matter experts to assist in carrying out the risk assessment and, if so, what are their credentials and what level of understanding do those experts have of the entity’s objectives, strategy and business?

Have the purpose and expected output of the risk assessment process been defined?

Have both climate-related risks and climate-related opportunities (e.g., energy transition to low carbon or renewable technology) been considered?

Which types of opportunities have been considered, and on what basis were they selected?

Have both sector-specific and geographically specific factors been considered?

Is the entire value chain, both upstream and downstream, considered?

At what level has the risk assessment been conducted (e.g., at entity level, operating segment level, product/service level, asset or liability class, or asset/liability/transaction level)?

What time horizon has been considered in assessing future impacts?

Have climate impacts on macroeconomic conditions and trends been considered?

How has the risk assessment been conducted (e.g., by whom, when, how, using what sources of information, tools, modelling)?

Which acute and/or chronic climate-related impacts have been considered?

What climate scenarios have been used and what is the source of assumptions used?

How have climate and socioeconomic data been brought together in climate scenarios?

How does management determine that the identified risks are consistent with the scenarios used?

How has management identified new or potential regulatory or policy changes, in all jurisdictions, that may affect the entity?

How has management identified operations, suppliers or markets that may be affected by shifts in consumer preferences toward environmentally friendly alternatives, the transition to low carbon economies, or by the entity, itself, transitioning to low carbon alternatives?

What time horizon has management used to consider the climate-related risks, including variability in transition timing for different elements of the entity’s operations or value chain?

Has management considered any past actions by the entity that may present climate-related risk, for example, potential environmental clean-up costs, or potential litigation or claims as a result of past actions?

Have a range of risk management responses been considered, by whom, and on the basis of what information?

How are risk management responses prioritized and selected from the range of possible responses? How will climate-related risks be integrated into the monitoring process, what will be monitored, by whom and how often?

How have the financial impacts of the identified risks been assessed and incorporated into existing financial budgeting and financial reporting processes?

What is the role of those charged with governance in monitoring the entity’s risk assessment processes, including climate-related risks?

What has management done to ensure that emerging regulations or expectations on disclosures have been followed, and that there is a reasonable basis for information presented or disclosed in its annual report?

• Declining demand for products and services resulting in decreasing revenues. For example, demand may decline if an entity needs to increase selling prices to address increased input costs resulting from carbon pricing mechanisms implemented to regulate emissions, or demand may decline due to consumer perception and preference for alternative products or services with lower environmental impact.
• Revenues decrease as a result of extreme events, e.g., loss of production facilities due to wildfires or flooding.

• Write-offs or shortened economic useful lives of existing assets, for example, as a result of policy changes requiring new production technologies or as a result of earlier disposal or abandonment of property and/or fixed assets in high-risk locations.
• Impairments of non-financial and financial assets. Climate-related matters may give rise to indications that an asset (or a group of assets) is impaired.
• Declining asset fair values such as fossil-fuel reserves, land valuations, securities valuations.
• New or increased accruals or provisions, for example, to recognize obligations related to changes in regulatory requirements to remediate environmental disturbance or recognize provisions for onerous contracts due to uneconomic supply contracts or lease terminations. Similarly, disclosures related to increasing likelihood or magnitude of contingent liabilities arising from fines and penalties levied for non-compliance with climate standards or regulations.

The impacts of climate change may cause increases in an entity’s operating costs and capital expenditures which can have a broad range of financial reporting and compliance implications. For example, lower current and future profitability and cash flows can give rise to declining asset values and impairments, loan covenant violations and may even challenge an entity’s ability to continue as a going concern.

Examples of how climate change may increase an entity’s costs and expenditures include, but are not limited to, the following:

• Increased capital expenditures needed to acquire and implement new and alternative technologies, resulting in higher operating costs.
• Increased costs of repairing or implementing protective measures to manage the increased likelihood of severe climate-related events.
• Increased production and distribution costs resulting from increased input costs (e.g., water, energy, upstream supply chain inputs, transportation).
• Increased cost of labor, for example, resulting from additional employee and health and safety measures implemented by the entity to protect them from extreme weather events.
• Increased insurance premiums or potential for reduced availability of insurance in high-risk industries or locations.
• Increased costs resulting from new regulatory compliance requirements.

The impacts of climate change may make access to capital more challenging for some entities and may also make compliance with contractual covenants more difficult. If an entity’s profitability and cash flows are declining it is typically more difficult or costly to attract debt or equity financing and can be more difficult to comply with existing loan covenants. Some investors and lenders have also begun to consider climate-related impacts of an entity’s business and/or the entity’s climate-related commitments to reduce their impact on climate when making decisions and setting terms. An inability to obtain sufficient capital or violation of loan covenants can, among other things, challenge an entity’s ability to continue as a going concern. Examples of how climate change impacts may make it more difficult for an entity to obtain capital and financing or to comply with related covenants include, but are not limited to, the following:

• Inability to attract sufficient capital to sustain or grow the business because the business is in an industry known for high greenhouse gas emission levels.
• Non-compliance with loan covenants related to the entity’s achievement of climate-related targets.
• Decrease in borrowing capacity due to a decline in the value of the available collateral, for example as a result of asset impairments or becoming uninsurable.