Article:

COP26 renewed impetus for action on climate change - what does this mean for Heads of Internal Audit?

15 December 2021

COP26 came to a close in mid-November 2021 with renewed commitments by made governments to reduce emissions by 2030 with the goal of achieving net zero by 2050. The UK Government had already introduced legislation including a commitment to achieve the 2050 net zero goal and to reduce greenhouse gas emissions by 78% by 2035 compared with 1990 levels. A key feature of Government legislation to date has been to progressively require the largest companies to disclose their emissions and energy use. The focus has now shifted towards climate-related risk disclosures.

Current emissions disclosure requirements

Since 2013, premium-listed companies have been required to report greenhouse gas (GHG) emissions in their directors’ reports and to report on environmental matters (including the impact of their activities on the environment) to the extent it is necessary for an understanding of the company’s business within their annual report.

Following on from this the Streamlined Energy and Carbon Reporting (SECR) framework was introduced from April 2019:

  • All quoted companies are required to report their global GHG emissions and an intensity ratio through their annual reports.
     
  • Large unquoted companies and Limited Liability Partnerships (LLPs) are required to disclose their UK energy use as a minimum relating to gas, electricity and transport, as well as their total emissions from UK energy use, an intensity ratio and information relating to energy efficiency action, through their annual reports.

Introducing climate-related risk disclosures

At COP21 in Paris in 2015, important gaps in corporate climate risk reporting were noted. Following on from this, the Task Force on Climate-related Financial Disclosures (TCFD) was set up. In 2017, the TCFD recommended 11 disclosures in the four key areas of governance, strategy, risk management and metrics and targets.

In 2019, the UK Government set out its intention that all listed companies and large asset owners would disclose in line with the TCFD recommendations by 2022.  Until now the TCFD disclosures have not been mandatory. Some companies have already begun to make disclosures on a voluntary basis. However, recent reviews undertaken by ClientEarth and the Financial Reporting Council (FRC) have indicated that the disclosures made to date vary in terms of quality, completeness and consistency.

What is new for 2021 and beyond?

In December 2020, the Financial Conduct Authority (FCA) introduced a listing rule applicable to premium-listed companies for periods beginning on or after 1 January 2021 - requiring them to disclose in their annual report, whether they have provided climate-related disclosures consistent with the recommendations of the TCFD on a ‘comply or explain’ basis.

This was followed up by a consultation undertaken by the Department for Business, Energy & Industrial Strategy (BEIS) to extend TCFD-aligned disclosures to a wider scope of listed and regulated entities and to make the disclosures mandatory. The UK Government mandated the disclosures to all large companies and LLPs in October 2021. The regulations will come into force on 6 April 2022, subject to parliamentary approval.

At this stage no changes are proposed to the existing SECR requirements. However, BEIS has confirmed that further consultation and review is to take place covering the alignment of SECR with the TCFD recommendations and the potential extension of other disclosures. The aim is to introduce any further amendments by 2023.

Smaller entities have so far been excluded from the UK disclosure requirements.  However, as a joint report by ACCA, the International Chamber of Commerce and Sage- Think Small First - recently noted, many such entities are already being requested to provide data to large corporates to support their disclosures. As disclosure requirements are extended, the pressure on smaller entities to maintain more granular records of energy and emissions is only likely to increase.

There is also more to come from the UK Government. At COP26, the Chancellor announced that the UK will mandate UK financial institutions and listed companies to disclose their transition plans towards achieving net zero emissions by 2050. It is proposed that a new Transition Plan Taskforce will be established to develop the disclosure requirements during 2022. When the requirements have been specified, the mandated organisations will need to respond to these too.

More generally, ESG is also driving significant changes in reporting. There is currently a plethora of diverse reporting frameworks. These are generally voluntary, without a requirement for the independent verification of reporting numbers. This has invariably led to questions on the integrity of some numbers alongside the perceived (and real) risk that organisations focus on metrics that portray them in a positive light, leading to suggestions of ‘greenwashing’.  At COP26 the formation of the International Sustainability Standards Board was announced.  This body will have the remit to develop a comprehensive global baseline of sustainability disclosure standards.  It is likely that once these standards have been established that they will begin to be introduced into UK corporate reporting.

How should organisations respond?

For those large companies that have already begun to make TCFD disclosures, the new requirements should not present a challenge.  These companies will already have deployed resources and established the mechanisms to collect the information necessary to support the disclosures. However, they need to consider whether their disclosures are sufficient. Key areas of focus highlighted by the FRC include:

  • Specificity on the impact of climate on the business model and strategy
  • Quality of disclosures of risks and opportunities arising from climate change and how the strategy may be adapted
  • Detail of potential climate change scenarios
  • Sharper definition of net zero commitments and indicators
  • Clarity over the scope and basis for the calculation of metrics.

For premium-listed companies that have not already made disclosures on a voluntary basis - if work has not begun already towards meeting the requirements - it needs to start now. 

Firstly, to meet the listing rule requirements, premium-listed companies need to be ready make the TCFD disclosures for accounting periods that began on or after January 2021 or to explain why they have not done so. For accounting periods beginning on or after 6 April 2022 the TCFD disclosures will be mandatory. All other listed entities and large AIM-listed or private companies and LLPs also need to begin to consider this, since the TCFD disclosures will be mandatory for them too.

This is a major exercise. It is important that the Board and management invest sufficient time and resources to ensure an effective response. It may be useful to establish a steering group to develop a roadmap towards the TCFD disclosure deadline and oversee its delivery.  The key elements that need to be considered are set out below.

Governance

As a starting point, the Board need to be provided with training in this area so that they are up to date with the requirements and climate change impacts on the business. In view of its importance a Board member (typically the Chief executive) needs to lead on climate change. Mechanisms for reporting to the Board also need to be re-aligned and the Board committee structure reviewed to provide for sufficient focus on climate risk.

Risk management arrangements also need to be reviewed.  Existing Risk Committees may have sufficient capacity to include this within their workload.  However, in view of the scale of the work involved, it may be appropriate to establish a separate TCFD risk sub-committee to oversee the development of risk management for climate risk.

Strategy and risk management

Business risk registers may need to be redesigned to capture climate risks and opportunities. Some businesses have introduced a separate climate risk category.  Others have included it with a wider category covering sustainability or ESG. A different approach will also need to be adopted for evaluating climate change risks and opportunities. The risk horizon considered needs to be longer term with exposures in 5-10 years’ time evaluated as well as the more immediate impacts.

Underpinning the risk assessment, climate change scenarios need to be assessed. These need to include physical risks (severe weather, chronic climate changes with resulting damage to assets and disruption to supply chains) and transitional risks (Government policy, regulatory, technology, market risks) as the UK transitions to a lower-carbon economy. Workshops are a useful means of exploring the impact of scenarios with key business stakeholders and devising effective mitigations. 

Metrics and targets

Since all large UK entities are required to report under SECR, they will have already established the mechanisms to collect and report data on energy use and emissions. However, to meet the TCFD requirements, the metrics to be produced go beyond reporting GHG emissions or energy usage and will now also need to include measures specific to the impact of climate risk on the business (e.g. percentage of assets or activities undertaken in a location with high risk of flood). Some of these matters may require new and potentially complex data to be collected.

Although smaller entities currently remain exempt from the mandatory disclosure regime, climate change is real and will have an impact on their business models and strategies. It is important that these entities also look to strengthen their risk management to ensure that they better understand their exposure to the climate risks that are likely to emerge.

Net zero

Since the guidance on net zero transition plans has still to be developed, there is little detailed work that organisations can do to respond to this in the short term. However, for some this will mean fundamental change to operational models and they need to begin to consider this at a strategic level, since its impact could be profound.

What this means for Heads of Internal Audit

At the IIA UK Conference in November 2021, there were several presentations on climate-related issues and the role of internal auditors. In addition, in collaboration with the British Standards Institute (BSI) the IIA published Harnessing Internal Audit against Climate Change Risk in October 2021. This guide for Audit Committees and directors sets out the value and support that Internal Audit can bring to companies as they seek to respond to climate challenges.

If they have not already engaged with management about this matter, Heads of Internal Audit need to begin this process, to understand the impact of climate change on the business and the steps being taken in response. If little progress has been made, Internal Audit can play a useful advisory role in helping establish the structures necessary to develop risk management and disclosures. Their experience in risk management may also be helpful in supporting any workshops or risk discussions as the business seeks to identify and evaluate its exposure.

Where the business has already taken some steps, some Heads of Internal Audit have already undertaken a climate risk review within their annual plans for 2021. The benefit of this is to highlight at an early stage any gaps in process or approach so that they can be remediated before the TCFD disclosure deadline.

The climate change information reported is likely to attract increasing interest from investors, lenders and other stakeholders as they seek to meet their own commitments in respect of ESG. Heads of Internal Audit may therefore be asked to provide assurance in respect of the data disclosed (or commission a specialist to conduct this review) on a regular basis going forward. The involvement of Heads of Internal Audit is only likely to grow as ESG reporting requirements become increasingly standardised.

For net zero transition, the key focus will be upon the feasibility of the transition plans and whether the impacts and opportunities have been identified adequately, with the potential risks factored into management activity throughout the business. Internal audit support to the business can be integrated within the work on climate risk referred to above. The transition plans will require disclosure. Once the Government has defined the requirements, Heads of Internal Audit could play a useful role by reviewing the systems and controls underpinning the disclosure to ensure that the information required is collected efficiently and reported accurately.