Climate change is introducing new risks that will impact a wide range of assets and business models around the world. These include physical risks, such as rising sea levels and extreme weather events, and transition risks, including policy, legal, and market changes related to the transition to a low-carbon economy. Climate risks could introduce new financial fraud risks, particularly in the oil and gas, coal and industrial logging industries, as well as industries that enable them.
The risk of fraud is particularly high in situations where there is a strong motivation, opportunity, and ability to rationalize fraud, factors known as the fraud triangle. Management at companies that have failed to adequately prepare for the energy transition may begin to feel tremendous pressure to meet contradictory goals. With gaps in information and oversight on climate risks, they may see opportunities to hide worsening performance by “cooking the books” or pressuring lower-level employees to “get creative,” encouraging them to rationalize fraud as a necessary step to meet unrealistic expectations.
In June 2020, the National Whistleblower Center published a report, Exposing the Ticking Time Bomb, which described an important pathway to ensure that climate change is properly accounted for: collaborative work by whistleblowers, prosecutors and regulators to enforce anti-fraud laws. Whistleblower-assisted prosecutions could play a major role in revealing complex climate-linked financial schemes. The U.S. Securities and Exchange Commission has increasingly signaled that climate change will be an area of significant focus and emphasized that it will rely on whistleblowers to identify violations.
To report accounting fraud, whistleblowers around the world can use the powerful Dodd-Frank Act to confidentially report securities fraud. Passed in 2010, the Dodd-Frank Act created a whistleblower office at the U.S. Securities and Exchange Commission (SEC). The law has powerful transnational application; whistleblowers from around the world can report violations of the Securities and Exchange Act (SEA), which regulates all trades conducted on U.S. stock exchanges and all stocks sold in the U.S., covering a significant portion of the publicly traded global economy. Whistleblowers who provide original information to the SEC about accounting fraud that leads to a successful prosecution are eligible for a financial reward between 10% and 30% of monetary sanctions that exceed USD 1 million.
This page outlines several types of potential climate-related accounting fraud that whistleblowers could be instrumental in helping to detect and prosecute.
Improper asset valuations
By improperly valuing assets, companies can present an unrealistic portrayal of the company’s financial position. This can involve the improper valuation of inventory, accounts receivable, or fixed or intangible assets. When companies overstate their assets, their net income is overstated as well, which can impact shareholder’s equity and ratios that are crucial for determining financing arrangements. The most famous examples include asset inflation schemes by banks investments banks during the 2008 financial crisis, which whistleblowers were instrumental in revealing.
Climate change is now introducing new physical and transition risks that will directly impact the valuation of assets across a range of industries. The fossil fuel industry is particularly exposed to climate risks, as are industries that depend on fossil fuels, such as petrochemicals or transportation. In the banking and financial services industry, climate change will impact a range of financial assets, including financial assets tied to property or infrastructure threatened by physical risks, financial assets tied to companies with business models impacted by transition risks, and financial assets tied to insurance providers.
Companies could inflate their assets by using inappropriate valuation models, using management estimates that are no longer appropriate due to new climate risks, ignoring climate-related events that should trigger an impairment process, or extending the useful lives of carbon-intensive assets in ways that contradict transition plans. Each of these strategies is discussed in more detail below.
Fossil fuel companies may also be particularly tempted to engage in schemes to make carbon-intensive assets appear more profitable than they really are. For example, in 2020, the Wall Street Journal reported that a whistleblower filed a complaint with the SEC alleging that lower-level employees at Exxon were pressured to use unrealistic drilling assumptions, which overstated Exxon’s oil & gas properties.
A previous SEC enforcement action shows how the SEC addressed a company that overstated assets. In the Matter of Miller Energy Resources, Inc., Et al., the SEC charged Miller Energy and two executives with overstating the value of oil & gas properties. According to the SEC, Miller was required to record the properties at fair value, but instead improperly used the valuation from a reserve report, which did not account for income tax, or asset retirement obligations, or the degree of uncertainty for cash flows. Miller Energy also intentionally understated operating and capital expenses and double-counted USD 110 million in certain fixed assets.
Failing to record an impairment loss
The failure to record an impairment loss is a type of improper expense recognition scheme that allows companies to inflate assets and net income. An impairment test is an accounting procedure that determines whether the economic benefits an asset comprises have dropped significantly. If this is the case, the company must recognize an impairment loss, a non-cash expense. To commit fraud in the impairment process, companies could ignore factors that should trigger an impairment or use inappropriate estimates or assumptions to avoid an impairment.
As fossil fuel companies face the energy transition, there is a strong likelihood that fossil fuel assets could not only lose value but become obsolete. As the risk of stranded assets grows, so does the risk that some companies will attempt to fraudulently conceal worthless assets.
Companies could hide stranded assets by failing to account for new changes in the impairment process, such as lower demand or higher carbon taxes, or claiming that long-term changes due to climate change are only temporary changes and therefore do not require an impairment charge. The Massachusetts Attorney General’s lawsuit against Exxon, for example, alleges that Exxon misrepresented its use of a proxy cost for carbon in its impairment process for marginally economic assets.
A lawsuit against Rio Tinto shows how the SEC has previously addressed a company that allegedly failed to impair a coal mining asset. In SEC v. Rio Tinto plc et al., the SEC charged mining company Rio Tinto with concealing negative developments related to a coal mining project that, if revealed, would have triggered an impairment analysis on coal assets the company acquired for USD 3.7 billion and sold a few years later for USD 50 million. After the acquisition, the company found that there was less high-value coal than the company had predicted and no feasible method for transporting it, factors that should have triggered an impairment process. By failing to properly impair the coal assets, Rio Tinto overstated the value of the coal assets by billions and allegedly overstated its net earnings by 50% at the half year 2012.
Overstating fossil fuel reserves
Although they are not recorded like other assets on the balance sheet, oil, gas and coal reserves are often considered the most valuable “assets” fossil fuel companies own. Estimates of a company’s reserves play a major role in determining the company’s valuation and the company’s ability to obtain credit. In addition to attracting investors and obtaining financing, fossil fuel reserve estimates also determine key performance metrics like reserve replacement ratios. The SEC requires fossil fuel companies are required to disclose information about their reserves as supplemental information to the financial statement, as well as information about their process for estimating their reserves.
The energy transition will put particular pressure on oil, gas and coal companies. Without sufficient oversight and proper auditing, fossil fuel companies could engage in fraudulent schemes to inflate their reserves in order to appear more attractive to investors or to obtain financing.
Companies could do so through inaccurate estimates or assumptions, including estimates of the quantity or quality of the reserves, the speed or cost of extraction, the company’s ability to transport it, or whether it has contracts to sell it. For example, whistleblower complaint from Lea Frye, a former employee at Anadarko Petroleum (now owned by Occidental Petroleum) alleges that Anadarko Petroleum hid a multibillion-dollar exaggeration about the value of a new oil field ahead of the merger with Occidental.
A previous enforcement action shows how the SEC has addressed the overstatement of oil and gas reserves. In the Matter of Royal Dutch Petroleum Company and The “Shell” Transport and Trading Co., p.l.c., the SEC alleged that Shell overstated the company’s proved reserves by using excessively permissive booking practices for reserves. As the problem grew worse, the company attempted to hide the problem by attempting to delay de-booking reserves until they could be replaced by new reserves. In 2004, Shell announced a reduction to proved reserves of nearly 5 billion barrels of oil equivalent, amounting to one-fifth of the company’s global reserves. Shell agreed to settle claims with the U.S. Securities and Exchange Commission and the Financial Services Administration in the United Kingdom for USD 150 million.
Fraudulent management estimates and assumptions
Management estimates are often based on subjective factors, for which management may rely on past experience or particular expertise. The imprecise nature of these estimates, and a lack of disclosure about key estimates, can create a high risk of manipulation that, if left unchecked by auditors, could create opportunities for significant financial fraud.
As companies face new climate risks or make transition plans, they will need to adjust certain estimates and assumptions that underlie their accounting and determine how sensitive those estimates are to variation. There is a risk that companies could hide the impacts of climate change on their assets or business model by using assumptions that are no longer realistic in light of new climate risks or recently announced plans for the energy transition.
In 2018, global investment manager Sarasin & Partners warned the oil & gas companies could use unrealistic long-term oil price assumptions based on unrealistic projections of future demand in their accounting, which would have a ripple effect on the rest of their accounting, including their valuation of oil and gas assets, the impairment process, revenue recognition, and the timing of asset retirement obligations. These concerns were reflected by BP’s auditor in a critical audit matter in March 2020, that noted the portion of BP’s cash-generating units that were “most at risk of a material impairment as a result of a reasonably possible change in the key assumptions, particularly the oil and gas price assumptions.” The auditor identified this as a significant audit risk.
Subsequent write-downs from major companies including BP and Total showed that, at these companies, lowering long-term price assumptions required major write downs. Many US companies do not disclose their price assumptions, creating a risk that companies could get away with avoiding write-downs or low liability estimates through unrealistic internal price assumptions.
Many companies are also increasingly making bold claims about their “net-zero” ambitions. These claims will need to be integrated with accounting assumptions, particularly regarding estimates for the useful lives of assets, depreciation expenses, and claims about future uses for carbon-intensive assets. In 2020, the auditor for the U.K. utilities company National Grid noted concerns in a critical audit matter about a potential contradiction between the company’s net zero claims and its estimates for the useful lives of assets. Without sufficient oversight, companies could attempt to defraud investors by making bold public claims that are contradicted by their own internal accounting assumptions.
A previous enforcement action shows how the SEC has addressed fraudulent management estimates. In the Matter of Computer Sciences Corporation et al., the SEC charged Computer Sciences Corporation and several of its executives with manipulating financial results and concealing significant problems about the company’s largest and most high-profile contract. According to the complaint, the Finance Director for the company’s largest contract used “made-up assumptions” to avoid a negative hit to CSC’s earnings. In 2015, Computer Sciences Corporation agreed to pay USD 190 million to settle the charges.
Eliminating or deferring current period expenses
Eliminating or deferring current period expenses refers to a type of improper expense recognition schemes that occurs when companies push costs to future periods, allowing them to inflate their net income in that period.
Companies could defer expenses by fraudulently extending the useful lives of carbon-intensive assets through inaccurate accounting estimates or through strategies like idling oil and gas wells as a way to avoid retiring them. In doing so, companies could avoid depreciation expenses and postpone asset retirement obligation expenses. Companies could also make unrealistic claims about future uses for these assets negatively impacted by climate change, to justify otherwise unsupported increases to salvage values.
A previous SEC enforcement action shows how the SEC has addressed fraud related to deferred expenses. In SEC v. Dean Buntrock et al., the SEC charged several high-ranking officers at Waste Management engaged in a massive scheme to inflate earnings by improperly eliminating and deferring current period expense, ultimately leading the company to overstate profits by USD 1.7 billion. Among other types of fraud, the company avoided depreciation expenses by extending the useful lives of the company’s garbage trucks while, at the same time, making unsupported increases to the truck’s salvages values. The defendants also failed to record expenses for decreases in the value of landfills as they were filled with waste and failed to record expenses necessary to write off the costs of impaired and abandoned landfill development projects. The officers agreed to settle the charges for USD 30 million dollars.
Failing to record or improperly lowering liability estimates
In addition to overstating their assets, companies can also impact their balance sheet by understating their liabilities. Schemes can include executives altering estimates for environmental remediation or pension obligations, omitting relevant costs or applicable sites, or disclosing to estimates to investors that differ from internal estimates. Liability estimates often rely on management assumptions and discretion; without strong internal controls and rigorous auditing, liability estimates could become an area vulnerable to manipulation.
Assumptions that underpin these evaluations could become even more significant as climate risks lead to shorter lives for carbon-intensive assets and the risks of bankruptcy or layoffs increases. For example, National Grid’s independent auditor highlighted in a critical audit matter key estimates and assumptions about the company’s environmental remediation costs and the company’s assumptions about pension obligations.
Oil, gas, coal, and petrochemical companies have historically evaded environmental remediation and asset retirement liabilities through optimistically low liability estimates. In a common pattern, companies understate liabilities before spinning them off into a separate, undercapitalized company, ultimately shifting the burden to the public. As American coal companies have struggled with the energy transition, several have been able to shed billions in liabilities through inaccurate estimates. Similar schemes could allow oil and gas companies to do the same.
A previous SEC enforcement action shows how the Commission has addressed improper liability estimates. In the Matter of Ashland Inc. And William Olasin, the SEC found that William Olasin, Ashland Inc.’s former Director of Environmental Remediation, had improperly reduced Ashland’s cost estimates for remediating environmental contamination at dozens of chemical and refinery sites for which Ashland had responsibility. By improperly reducing the cost estimates, the company understated its environmental reserve and overstated net income.
Misleading non-GAAP measures and key performance indicators and metrics
In addition to information that is standardized by GAAP principles, companies are increasingly using non-GAAP measures and key performance metrics to provide investors with additional information about a company’s performance. While these metrics provide additional insight, they can also be ripe for abuse and used to manipulate uninformed investors. Schemes to mislead investors through KPIs have been increasingly targeted by the SEC for enforcement.
Key performance indicators and metrics (KPIs) have been a central focus for investors interested in sustainability information, and companies have responded by increasingly voluntarily disclosing environmental KPIs. These KPIs will also likely have a significant impact on how companies report their progress on net zero goals. However, this also creates a new risk of fraud, as companies could take advantage of knowledge gaps to manipulate investor perspectives on how they are meeting these performance targets. Companies have particularly focused on KPIs related to emissions, and there is a risk that companies could use complex schemes to misrepresent emissions reductions.
A previous enforcement action shows how the SEC has addressed misleading key performance indicators and metrics. In the Matter of Wells Fargo & Company, the SEC charged Wells Fargo for misleading investors about the source of its core business strategy. According to the SEC, between 2012 and 2016, Wells Fargo sought to induce investors to rely on its “cross-sell” metric for selling new products to existing customers, even though this metric was inflated by millions of accounts that were unauthorized or inflated. In February 2020, Wells Fargo agreed to pay a USD 500 million to settle charges, as part of a USD 3 billion settlement with the SEC and the Department of Justice.
Inadequate internal controls over financial reporting
Weak internal controls can enable various types of financial fraud. For example, the failure to maintain internal controls was cited as a factor in the SEC complaints mentioned previously, regarding Shell, Rio Tinto, Ashland, and Computer Sciences Corporation.
As companies face new climate risks, they will need to ensure that internal controls adequately account for new risks and risk management. In 2019, the World Economic Forum published guidance on how companies can create strong “climate governance,” which includes recommendations on board oversight of climate risks, the design of risk assessments, proper incentives structures for executives, and the need for transparent disclosures of climate-related risks.
With new standards just emerging, there is a risk that companies will fail to integrate climate considerations into their internal controls. Growing financial pressure on companies with carbon-intensive business models will also lead to new challenges for internal controls. Financially challenged companies may struggle to maintain a separation of duties or ensure that employees are adequately trained, increasing the risk of that internal controls could break down.
Two previous enforcement actions show how the SEC has addressed inadequate internal controls:
- In the Matter of Petroleo Brasileiro S.A. – Petrobras – the SEC charged Petrobras with misleading investors by filing false financial statements that concealed a massive bribery and bid-rigging scheme. According to the complaint, in order to enable their bribery scheme, executives failed to implement internal controls, exploited deficiencies in those controls, and submitted false certifications in connection with Petrobras’s internal process for preparing SEC filings.
- In the Matter of BHP Billiton Ltd. And BHP Billiton Plc, the SEC charged mining company BHP with violating the Foreign Corrupt Practices Act when it sponsored the attendance of foreign government officials at the Summer Olympics. The SEC investigation found that BHP Billiton had failed to devise and maintain sufficient internal controls over its global hospitality program. BHP Billiton agreed to pay a USD 25 million penalty to settle the SEC’s charges.
Auditors play a crucial role as gatekeepers for the financial system. A recent report from the Center for American Progress highlights that auditors could play a pivotal role in addressing climate-related accounting risks, and critical audit matters on climate risks highlight the types of issues that auditors may increasingly identify in financial statements.
In particular, auditors are responsible for assessing the appropriateness of accounting estimates and their sensitivity to change, as well as addressing potential issues related to internal controls. Failing to consider climate risks could lead auditors to miss internal control issues, inappropriate accounting estimates, and improper valuation models or impairment processes, among other problems.
Two previous enforcement actions show how the SEC has addressed auditor misconduct:
- In the Matter of KPMG LLP and John Riordan, CPA, the SEC charged KPMG and engagement partner John Riordan with failing to properly audit the financial statements of an oil and gas company, resulting investors being misinformed that properties bought for USD 5 million were worth a half-billion dollars. According to the SEC, despite the requirement that auditors must fully comprehend the industries of their client, KPMG did not grasp how the company valued its oil and gas properties and did not properly staff the audit.
- In the Matter of KPMG LLP, the SEC charged KPMG with altering past audit work after receiving stolen information about inspections of the firm that would be conducted by the Public Company Accounting Oversight Board (PCAOB). The SEC’s order also found that numerous KPMG audit professional cheated on internal training exams by improperly sharing answers and manipulating test results. KPMG agreed to pay USD 50 million to settle the charges.