European Commission paves way for green accounting standards

Companies and auditors must build Paris agreement into financial accounts

Large-scale changes in accounting standards and systems are an essential prerequisite for building sustainable economies – and for ensuring the success of the European Union’s ‘green deal’.

With its 21 April proposals for a directive on corporate sustainability reporting (CSRD), the Commission has paved the way for a new system of accounting on environmental, social and governance factors. For the first time, reporting obligations will apply to all large non-listed companies. Especially in countries like Germany and Italy with multiple moderately large companies in key sectors, these changes will usher in new standards of transparency on firms’ environmental impact as well as on their business models and strategies.

To highlight how German companies – both stock market-quoted and privately owned – are responding to the CSRD challenges, OMFIF and other partners have started a major polling exercise of the corporate sector in Europe’s biggest economy. Results are due in June.

The EU plan for a 55% reduction in member states’ CO2 emissions by 2030 will require estimated investments of €350bn. To mobilise private capital on this scale, top-down regulation by itself will not suffice. Businesses need incentives to switch priorities towards sustainable processes. This means governments must work to change market mechanisms. The Commission’s moves to widen and tighten reporting requirements are central to this necessary shift in company accounts, requiring assessment of qualitative (non-financial) as well as financial indicators measuring corporate sustainability. All this should promote allocation of capital to companies and activities that adequately address social, health and environmental problems.

Companies will be expected to publish their plans for transitioning to sustainable business practices in line with the 2015 Paris agreement. Minimum standards are needed to switch policies away from those promoting today’s growth at the cost of tomorrow’s penury. Transparent structures are required to make businesses pay the price for external effects of non-sustainable corporate activity. Tax incentives are vital for promoting sustainable business practices, helping compensate for higher production costs.

Financial reporting systems at present appear to make non-sustainable economic activities pay acceptable returns. In fact the opposite is often true. Existing systems don’t require sufficient disclosure of key financial indicators of corporate sustainability. This information deficiency obscures businesses’ long-term financial risks and fails to incentivise to achieve benefits from timely adjustments. A supplier to the petrochemical industry, for example, may build its long-term business model on the assumption that world governments will not sufficiently support the Paris targets. If the Paris accords prove to be binding, the company faces substantial risks of overvaluing assets that become stranded and will face serious shortfalls in funding its liabilities.

A strong push is coming from the US. President Joe Biden’s ‘Made in America Tax Plan Report’ contains climate-related commitments that would remove the subsidies for global fossil fuel producers and substantially expand tax incentives for clean energy. External costs of fossil fuels are addressed as implicit non-market subsidies. This is one more reason why corporates and auditors can no longer ignore the Paris agreement in financial accounts.

Companies are increasingly promising net-zero carbon emissions by 2050, without setting serious plans for implementation. These pledges will be realistic only if companies adjust their financial data towards Paris-aligned accounting – requiring them to disclose possible losses in the transformation process.

Under the present system, companies’ accounts do not include the external costs (as well as possible benefits) of their economic activities. Greenhouse gas emissions can impose costs on nature, society and other economic players, which then reverberate on the companies. Consumers will not be able to switch towards sustainable purchasing unless they carry out and disclose systematic, auditable assessment of externalities as ‘true costs’.

Necessary market-wide transparency and comparability will come only through changes in legislation. Balance sheets as presently constituted fail to give a holistic, true and fair view of economic performance. Moreover, efforts to raise long-term sustainability impact negatively on financial ratios and credit ratings. Bank loans become more expensive or inaccessible. This reason alone justifies the European Commission’s proposed ‘green supporting factor’ for capital adequacy.

Next steps after the Commission’s CSRD must encompass a root-and-branch improvement of accounting procedures to include the Paris transformation processes. Combined efforts are needed to overcome present deficiencies. Only then will Europe’s green deal achieve its ambitious objectives.

Janine von Wolfersdorff, a Berlin-based tax adviser to companies and official institutions, is a policy fellow at the Hamburg-based The New Institute and a member of the OMFIF Advisory Council.

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