The FRC prompts boards, companies, and auditors to improve responses to climate change challenges through improved governance structure and narrative reporting.
By Paul A. Davies and Michael D. Green
On 10 November 2020, the Financial Reporting Council (FRC) published its findings (the Report) on its thematic review undertaken in 2020, concerning climate-related considerations that various stakeholders take into account. The Report focuses on boards, companies, auditors, professional bodies, and investors, as these actors help drive appropriate reporting to the market and thus ‘play important roles in delivering society’s climate ambitions’.
In 2019, the FRC joined a growing list of regulators in expressing concerns related to the challenges that accelerated climate change poses. The FRC called upon companies to ‘consider their impact on the environment and the likely consequences of any business decisions in the long term’. The FRC encouraged companies to report on their operations’ effects on climate change and demonstrate how they have considered the company business model’s susceptibility to climate risks.
In the Report, the FRC addresses these issues and seeks to assess the extent to which stakeholders actually engage in such reporting and analyses. The FRC’s recommendations are responsive to investors’ need for more accurate and reliable information. The Report notes that investors do support the Task Force on Climate-related Financial Disclosures (TCFD) framework, but ‘also expect to see disclosures regarding the financial implications of climate change’, as investors themselves are facing a changing regulatory framework.
The Report Findings and Recommendations
Boards: The FRC assessed a sample of 60 premium-listed companies’ governance structures and references to climate-related considerations in the context of the UK Corporate Governance Code. The Report acknowledges that it is a board’s responsibility to consider climate-related issues; however, ‘there is little evidence that business models and company strategy are influenced by integrating climate considerations into governance frameworks’.
The FRC advises better board practices including the following:
- A clear explanation of the company’s governance structure and oversight, ideally linked to the TCFD framework.
- Explanations of the process by which the board receives climate-related information and details on the selection process for the climate expert, if the board was advised by one.
- Reporting on examples of specific climate-related issues discussed by relevant bodies, and how those issues could impact the business.
Companies: The FRC further assessed a sample of 24 annual reports and accounts against the provisions of the Companies Act 2006, in addition to the aforementioned listed companies. The main finding in this category is that companies are increasingly providing narrative reporting on climate-related issues. However, although many companies currently set strategic goals, ‘it is unclear from their reporting how progress towards these goals will be achieved, monitored or assured’. The Report further identifies the following shortcomings:
- While many of the disclosure requirements are met, disclosures are often non-specific and lacking in substance and clarity.
- More companies are referencing TCFD, but the reporting level does not yet meet investors’ needs.
- Companies’ discussions of risks and opportunities should be balanced, with companies also being open about their failures. Companies should avoid providing disproportionate focus on ‘good news’.
- There is limited reference to climate change in the financial statements.
To address these issues, the FRC suggests companies take the following steps:
- Include a separately identifiable non-financial information statement in their strategic report, which addresses environmental matters, such as climate change ‘to the extent necessary for an understanding of the company’s development, performance and position and the impact of its activity’. This statement should include significant ‘policies pursued’ with respect to climate change, clear explanations in relation to major commitments, and the most significant outcomes of the policies for the business as a whole.
- Describe the principal risks and uncertainties facing the company, which relate to climate change and any significant impacts on the business model.
- Describe the methodologies used to calculate emissions metrics and the extent of any due diligence or assurance over such methodologies.
Auditors: The Report’s main finding regarding auditors is that ‘the quality of support, training and resources provided to the audit practice varies considerably across firms’. Companies should do more to ensure that the internal quality monitoring includes consideration of climate change issues. Equally, auditors should improve their understanding of climate-related risks when planning and executing audits. The Report recommendations in this respect are as follows:
- A high-level climate change consideration memo for all audits should provide evidence of auditors’ risk assessment considerations and audit response.
- Firms should provide guidance to companies’ audit teams on the TCFD recommendations and the importance of climate-related reporting, such as sharing examples of good disclosures and including climate change subject matter experts within the technical accounting team.
- Audit teams ideally should review management’s process, and ensure the completeness of management’s climate-related issues and disclosures.
What the Future Holds
The FRC also announced that its future work may include the following:
- Encouraging UK public interest entities to report 11 recommended disclosures aligned with the TCFD, and to also use the SASB metrics (with reference to the entity’s sector).
- Assessing professional associations’ approaches to climate change, including within their regulatory functions.
- Incorporating monitoring of climate-related reporting in the FRC’s annual UK Stewardship Code and the UK Corporate Governance Code, with a view to monitoring which climate-related amendments are appropriate for future revisions of these Codes.
- Investigating developing investor expectations and better reporting practice in relation to TCFD and SASB.
Latham & Watkins will continue to monitor developments in this area.
This post was written with the assistance of Sabina Aionesei in the London office of Latham & Watkins.
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