How Will Climate Change Impact Net Asset Values?

Net assets recorded on the balance sheet are frequently material to disputes – either as a liability issue or in the assessment of damages. For example, net assets are often central to disputes regarding:

• Asset impairment testing (particularly stranded assets) – A plaintiff may argue that the reported carrying value of assets has diminished, resulting in a financial statement failure. 
• M&A – A plaintiff may challenge the truth and fairness of a balance sheet provided for a corporate transaction.
• Solvency – net asset value may be the critical input into a solvency ratio or capital adequacy ratio, triggering contractual provisions or regulatory actions.
• Valuations – where a business is valued using balance sheet metrics, such as Price / Book Value multiples or by reference to net asset value metrics.

Resolving such disputes increasingly requires consideration of climate change issues, particularly in sectors facing high transition risks like fossil fuels, construction or financial services.

Physical risks and transition risks can lead to impairments of assets, write-downs or changes in valuation that affect the carrying amounts of assets such as property, equipment and inventory. Liabilities might also increase due to potential fines, compliance costs and remediation expenses associated with environmental issues.

Such factors underpin many disputes. In this article, we explore the potential impact that climate change on asset and liability balances in an entity’s financial statements.

Property, plant and equipment (PPE)

Physical risks (e.g., bush fires and floods) may result in damage to property, plant and equipment or business interruption losses. Business is impacted if such losses are uninsurable – or insurable only at increasing cost. Ultimately, businesses may not be able to operate in certain locations. For example, certain farmland may become commercially unviable due to physical risks. 

Transition risks often change the economics of assets: shortening an asset’s useful life; reducing the residual value from the sale of the asset at the end of its life; or requiring capital expenditure to upgrade or repurpose the asset. These are often described as “stranded asset” risks, where an asset becomes obsolete and is reduced to scrap value. For example, the economic life of a coal mine may be shorter than expected when mining began, and its related equipment may become obsolete.

Investment properties

The risks relating to investment properties are similar to those for PPE. Profitability may be impacted by the cost of mitigating against physical climate risks (such as protecting or insuring a building on a flood plain) or transition risks (such as tenants preferring properties with lower carbon footprints). In turn, reduced profitability will impact the properties’ carrying value.

Inventory

Also like PPE, inventory is subject to physical risks like extreme weather events. Transition risks include stock obsolescence, where products become unsaleable. For example, an inventory of diesel motors may need to be written down as decarbonising economies transition to electric powered vehicles.

Goodwill and intangibles

Goodwill is recorded in financial statements when one business is acquired by another for more than the fair value of its net assets. Goodwill is periodically reviewed to consider whether its value has been impaired. If so, it is written down to its recoverable amount (effectively fair value). The recoverable amount will depend on the anticipated earning capacity of the business, which may be impacted by transition risks. Goodwill associated with investments in carbon-intensive entities may require impairment.

Where brand values are recorded in financial statements, similar risks may be present. For example, brand values associated with carbon-intensive activities may be written down.

Provisions

Climate change may result in reinstatement / rectification costs being brought forward. For example, oil and gas assets may incur rectification costs sooner than previously forecast. The provision for these costs would be calculated by discounting the future costs reinstatement / rectification costs at an appropriate discount rate to reflect the delay in the costs being incurred. However, if climate transition means that these costs will need to be incurred sooner, the period of discounting will be reduced and the recorded costs will be higher.

Additionally, certain contracts may become onerous contracts. For example, an entity may have a contract to supply electricity at a fixed price that is below the current cost. On this basis, the entity would need to recognise a provision for the onerous contract.

Consistency with sustainability reporting

Companies need to be mindful that climate risks are addressed consistently in both sustainability reports and financial statements. For example, if a company discloses sensitivities and potential impacts on asset values in its sustainability reporting but does not address the same matters as part of impairment testing in its financial statements, this may give rise to disputes.

Addressing climate risk in expert evidence

In any dispute hinging on net asset values, courts and tribunals will expect experts and parties to address the impact of climate risks in their assessments of damages. Entities should be aware of what such assessments will take into account.