A shake-up in company reports and accounts to consider companies’ environmental impact could radically alter the way they are assessed, argues the influential political economist and accountant.

The need to address the environmental emergency head on is absorbing many professionals. They include Richard Murphy, professor of accounting at Sheffield University Management School and founder of the Corporate Accountability Network, a non-governmental organisation established in 2019 to target “the weaknesses in the accounting disclosure of all companies” so they meet the needs of all stakeholders, not just those providing their capital.

There is a need for a new approach

Murphy, a former adviser to the Labour Party in the UK, believes there is a need for a new approach – one that brings the cost of transitioning to a low-carbon economy directly onto the balance sheet of large companies.

In an interview with AIQ, Murphy explains why he believes ‘sustainable cost accounting’ could change corporate decision-making and revolutionise how a company’s prospects are assessed.   

What is the problem with the way accounts are prepared now?

The International Financial Reporting Standards (IFRS) suggest published accounts are primarily for the benefit of investors. Implicit within that assumption is a capital maintenance concept that suggests maintaining financial capital is all a company is about. IFRS accounts look at the amount of financial capital in the business this year and compare it to last year – that increase or decrease is all that matters. The making of profit to create new financial capital is the priority.

The Venn diagram for financial reporting should be a subsidiary of the Venn diagram for sustainability reporting

That's inconsistent with the world we live in, which should have the maintenance of environmental capital as its primary goal. While financial capital is important, it's secondary compared to the requirement for businesses to operate within the environmental constraints imposed upon them by the greater goal of achieving sustainability, aligned with the Paris Agreement.

The problem is that the IFRS view – and its singularity of purpose for financial accounting – is contributing to an environment where there is one set of rules for financial accounting, and another for sustainability reporting, mainly based on the framework set out by the Task Force on Climate-related Financial Disclosures (TCFD). If we draw a Venn diagram of this, the two would not heavily overlap (see Figure 1).

In my view, the Venn diagram for financial reporting should be a subsidiary of the Venn diagram for sustainability reporting. That’s because the purpose of a capital maintenance concept is to explain whether a company is successful as a going concern or not. I believe a company cannot now be a going concern if it is not able to undertake its activities within the constraints of net-zero carbon, to constrain temperature growth.

Figure 1: Accounting systems as windows on the world1
Accounting systems as windows on the world
Source: Tax Research UK, December 8, 2020

How does sustainable cost accounting address it?

The idea of sustainable cost accounting came about after a discussion when two academic colleagues (Professor Aled Jones, director of the Global Sustainability Institute at Anglia Ruskin University and Dr. Rupert Read, associate professor of philosophy at the University of East Anglia) asked me if it would be possible to merge the two capital maintenance concepts we have with the aim of putting climate change directly onto the balance sheet.

We would have to take a different approach to climate reporting

I believe this can be done, but we would have to take a different approach to climate reporting. The existing approaches appear to say: ‘We have a problem; we need to appraise it’. That seems the fundamental objective of TCFD guidelines. They essentially report that an organisation is aware climate change is an issue it is starting to address. What the TCFD does not require is that the reporting entity adapts to the constraints within which it must now live if it wishes to continue to be a going concern.

That is because the TCFD, and other standards, focus largely on the measurement of carbon through the lens of scopes one, two and, sometimes, three carbon emissions. The last, especially, worries me. TCFD guidelines suggest scope 3 emissions may be immaterial, and an entity may not need to measure them, but frankly, for all businesses that have macro significance I find that hard to imagine.

The consequence of this approach is that we end up with some absurd claims, like Gatwick Airport suggesting it's a carbon neutral airport. Yes, of course other people run the planes down its runways, but it has chosen to take a deeply micro view of the issue and is ignoring the consequences. It facilitates those emissions: it has a responsibility for them.

How we bring this into accounting is about trying to reconcile this macro-micro conflict. There is a real problem with accounting for carbon, in my view, because carbon pricing is beyond the control of the company. The carbon market is a wholly artificial market, created for regulatory purposes, not a natural market as such. That means it is hard to use as a real measure in accounting.

This also leads to a question as to whether there might be different criteria that might be used to bring the decision-making process around carbon within the scope of the general ledger, the accounting environment where we record income and expenditure, profit and loss, assets and liabilities and so on.

What we are aiming for is an organisation that does not create a something harmful to the environment

My view is there is, but it should not be about measuring the amount of carbon the company creates. Instead, what we can measure is the cost of eliminating carbon production processes within the structures of the organisation. After all, what we are aiming for is an organisation that does not create a something harmful to the environment and need a measure aligned with that goal.

From the perspective of an accountant, this suggests processes that are not very different to those we are already accustomed to. If anything, it might simplify things by bringing carbon onto the balance sheet, in line with other established accounting concepts.

For example, we understand there are events that require a company to make a provision. This is important; it is implicit in the accounting standards on provision-making that there must be an event which requires action. In my view, the government has created that event by demanding we have a net-zero carbon economy. This requires a company to make a provision for the cost of achieving this goal.

So, you believe this could be straightforward to implement?

In effect this means closing the current carbon producing activity a company has, with a few exceptions for activities regarded as socially necessary. Any business that decides to close an activity will make a provision for that, plus the cost of opening the new carbon-neutral replacement. The cost of transitioning to become a sustainable business does, in my view, require this provision. It is simply a requirement to make a true and fair disclosure to say: ‘This is the cost of the decision we have made to become sustainable.’

This measure won't be perfect; it will, for example, be necessary to refine the estimated costs of achieving this goal annually. That cost may go up or down, because of changes in circumstance. In the meantime, money can be spent, and will need to be accounted for against the provision to demonstrate the commitment to achieving the goal. This is a new form of reporting.

What is essential is that the provision be a realised reserve on the balance sheet

The provision would not necessarily have to go through the income statement in the year it is made. It could be a statement expressed through comprehensive income or changes in equity, but that debate is still to be had. But what is essential is that the provision be a realised reserve on the balance sheet, reducing the reserve available for distribution.

I'm not pretending sustainable cost accounting wouldn't have a significant impact on dividend distributions as a result. But can companies afford to pay dividends unless they can demonstrate how they can also address the issue of climate change? This is a going concern issue. If they can put forward a plausible plan to raise capital to fund the transition, then they can carry on paying dividends. If not, they will have to constrain distributions.

If they cannot show a plausible route to pay for the costs of transition, I suggest the idea of carbon insolvency, because some businesses will not survive. I suggest carbon insolvent businesses will have to cease to trade by the end of the transition period to net-zero carbon. 

This is a massive issue for investors. All investment managers have a responsibility to those who depend upon them for good decision making. Those people depend on investment managers to have a view on who might not survive the carbon transition. It seems to me this is the most important question you can ask any company now.  Sustainable cost accounting is designed to inform that decision making.

Where does offsetting tie in with this approach?

I admit I make carbon insolvency harder for a company to achieve by suggesting external carbon offsets should not be allowed. I am comfortable with offsetting within the entity itself because that is an issue on the same balance sheet. This is now called insetting (read more on offsets and insets, here)2. But it is not reasonable to rely on external offsets, because there will be a scarcity of resources available for offsetting. That's part of a growing narrative within the environmental movement, particularly in the extractive industries.

The other concept I put forward is that the precautionary principle should apply. In other words, if a company claims it's going to achieve net-zero via new technologies like carbon capture and storage (learn more about CCS, here)3, it, and the investors in it, needs to be comfortable the technology will work. I am comfortable the costs for developing these technologies could be included in the provisions for climate change that need to be made. But it is only when they are proven to work that the benefit can be claimed, a profit can be taken (in effect, by reducing the provision) and investors can feel secure.

This system of accounting does in that case create the need for a direct narrative about how to achieve an explicit outcome. Something like CCS cannot be something spoken about in vague terms, because ultimately it impacts the bottom line. The details must be given. Importantly though, this introduces the incentive to invest heavily now. That’s worth a lot more than investment in the future when the problem is much worse. When it comes to the climate issue normal investment criteria are reversed. Sustainable cost accounting encourages that. It’s aligned with climate goals.

What does this mean for organisations who have already adopted TCFD guidelines?

I'm not here to overthrow TCFD guidelines. I welcome the idea we're moving towards a single standard; I think its beneficial. I welcome its discussions around strategy and risk assessments; they are very important. But I'm worried about the implied metrics and targets because we need to do much more than just disclose what greenhouse gas emissions are, and more than describe the targets used to appraise risks. We need to meet those challenges positively on the balance sheet and doing so would enhance the TCFD process by integrating the issues into the existing financial reporting framework.

Sustainable cost accounting delivers the accounting metric within the TCFD framework

What I'm suggesting is that sustainable cost accounting delivers the accounting metric within the TCFD framework. This is not radical; it just recognises the moment has come when all public interest entities need to make a provision for their cost of transition to the economy. They must be a part of it if they are to be a going concern.

The accounting is not hard either: it recognises real market risk, and applying the precautionary principle is nothing more than prudence. That should come as no surprise to an auditor; if something is not proven, then we should not be relying upon it, just as no one should claim an offset they cannot prove they can make.

Have you discussed your concept with Mark Carney, UN Special Envoy on Climate Action and Finance?

I would welcome the opportunity, but it has not happened so far.

Is anyone else working on themes like this?

There is one group of academics in France that has attempted what I am trying to achieve, but has not gone as far in developing a deliverable methodology.

The Institute of Chartered Accountants in England and Wales (ICAEW) has been supportive of my work and suggests it is a break from what has gone before. But do I see it as revolutionary or evolutionary? It’s evolutionary, in my view. 

Mark Carney is signalling he does not think the market can solve climate change by itself, and I agree. He seems to be moving from a position of supporting voluntary standards to advocating mandatory standards and has indicated that, if those mandatory standards are not moving quickly enough, there may need to be more regulatory intervention.

This is an issue where major investors are pivotal in wanting to understand the risks. It would be good to discuss this issue with all involved, as soon as possible.

What are your main concerns with TCFD guidelines?

If I have a concern, it is that they do not require the logical steps required to ensure the nature of business is changed to meet environmental constraints that flow from the reporting. I think accounting should promote change. Let's build climate change into the general ledger and make what counts, count.

Businesses can perpetuate the idea they are viable going concerns, when implicitly they are not

At the moment, the cost of eliminating carbon is uncounted, which means businesses can perpetuate the idea they are viable going concerns, when implicitly they are not. Will budget airlines be going concerns in the long run? Why would I invest in companies that may not be able to deliver products consistent with climate targets? These are questions we need to address.

In a sense, the reason for doing this is to force climate change into decision-making criteria in a way that wouldn't be possible if it didn't hit the bottom line. Accounting professionals and investors have a professional duty to address this head on.

Where are the greatest tensions between what companies are saying and what they are doing?

Many of the climate claims within the extractive industries are open to serious challenge. A number of steelmakers also say they will become net-zero steel producers, but I am not aware they have mapped the pathways to achieving that. And yet, by saying this they have now crystallised an event requiring change, and a provision for its costs. But that has not happened.

This is what I see repeatedly. Businesses are claiming X and promising Y, but there is a missing component Z – which is needed to reconcile the two. Z is the cost of the transition process to make things happen. It’s that demand on capital we now need to know about.

Retailers are also in a difficult position. Many of them are working around their scope one emissions quite well. They are talking about packaging, but that's not the big issue. The big issue is the scope three emissions they are enabling, and how are they going to change their decisions on product mix. Where is the sustainability in that? This is fundamental. If I was a major food retailer and wanted to cut scope 3 emissions, I could stop selling petrol, but that will change my cash flows, risk appraisals and ultimately the cost of capital. These are accounting issues. Where is that being reported?

What role will accountants play in the climate transition? 

The question here is whether accounting is a neutral subject. I believe not. Accounting is not just about the passive disclosure of what has already happened; it is about active requirements to create reporting systems that themselves incentivise the change that we wish to see. Accountants are about changing the world. Accountancy genuinely has an opportunity to play a role to leverage change.

Today, we have a backward-looking concept of capital, into which vast amounts of money have been invested on the assumption the status quo will be maintained. On this basis, we have a resource and the expectation of a sustainable income stream based upon past performance. We ignore the fact past performance is not a good indicator of future outcomes despite the fact we know we are at a point where past performance is not a good indicator of future outcomes because of an externality, and that is climate change.

There is a need to change the way investors allocate capital

There is a need to change the way investors allocate capital. They need to ask if companies are investing in real activity that will deliver a sustainable income stream beyond the next few years.

I hope the accounting system I have proposed could generate provisions that will reflect the cost of building sustainable business entities. There will be negatives and positives. The negative is: ‘We have to spend an awful lot to achieve that goal.’ The positive is: ‘We know we can raise the capital to do it.’

The role of investors in all this is to not allocate capital based on the existing assumption of a financial return, but to look to each underlying activity and its sustainability now and, where appropriate, to allocate to that.

Allocation criteria will change. You will need to be convinced by the accounts and reporting criteria that returns can be made from assets which deliver sustainable, long-term income streams. Capital investment decisions will be transformed by this, and soon.

Could there be a role for a ‘bad bank’ to absorb organisations that are unable to fund and manage their own transformation?

I like the idea. There will be organisations that fail, and there will also be activities that are socially useful that we cannot make carbon neutral. We may choose to allow them to continue, making limited offsets available. There could be a role for unconventional capital here, just as we have had unconventional monetary policy, with the government working in partnership with other organisations where no other sources of capital are available. But that requires intervention and a bad bank, acting as a regulator of carbon capital, may support that.

Where do you go next in your research and what kind of timeline are you working towards?

Our initial research has prompted interest from the property and construction sector, including major commercial landlords but, so far, we have not had reactions from people in extractive industries or retail. We are building relationships now, which will be built into case studies for a joint UK/Danish project being run with Copenhagen Business School. The timeline is three years – that is comparatively slow, bearing in mind the environmental consequences of this.

There are many businesses where adaptation is not going to be so easy

Bluntly, some companies will find this quite easy to navigate. I can see why builders and professional landlords might think that is the case, if they install heat pumps, appropriate insulation and so on. They can start to address scope three outputs and illustrate how they are progressing towards net zero. You can see how it might give them a competitive edge. But there are many businesses where adaptation is not going to be so easy.

The job is to build reporting that helps all achieve the essential goal of transition. That is what I am working towards.

Want more content like this?

Sign up to receive our AIQ thought leadership content.

Please enable javascript in your browser in order to see this content.

I acknowledge that I qualify as a professional client or institutional/qualified investor. By submitting these details, I confirm that I would like to receive thought leadership email updates from Aviva Investors, in addition to any other email subscription I may have with Aviva Investors. You can unsubscribe or tailor your email preferences at any time.

For more information, please visit our privacy notice.

Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.