What’s the impact on the discount rate used in testing non-current assets for impairment?

What’s the issue?

Getting into more detail

The rate applied to discount the cash flows is based on the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those of the asset or CGU. In other words, the discount rate is based on a market participant’s view of the asset or CGU. This is true for both a calculation of the recoverable amount based on value in use (VIU) and on fair value less costs of disposal (FVLCD). [IAS 36.55-56, A16, IFRS 13.B14(a)]

Where should climate-related matters be reflected – in the cash flows or in the discount rate?

In our experience, the preferred approach in valuation practice is generally to reflect the impact of climate-related matters in the cash flows, rather than in the discount rate, whenever possible. This may not be possible when cash flow projections relate to circumstances or events outside the company’s control and there is no data or evidence to support them. [IFRS 13.61, B12]

If sufficient data is not available, or it is not possible to reliably quantify the impact of climate-related matters on the cash flows, adjustments to the discount rate may need to be considered. These adjustments may be made if they can be supported. Methods that may be used to support such adjustments include:

• looking to market multiples for comparable quoted companies for a potential adjustment factor. Comparable transactions may also provide some support; and
• calculating the implied adjustments to cash flows that would be consistent with the proposed adjustment to the discount rate.

It can be very challenging to quantify the adjustment necessary to reflect climate-related risks in the discount rate.

For more information on how climate-related matters might affect cash flow projections, see our article What’s the impact on cash flow projections used for impairment testing of non-current assets?

How should climate-related matters be reflected in the discount rate?

In our experience, the most common approach to estimating an appropriate discount rate is to use the weighted average cost of capital (WACC) formula. One of the components of the WACC is the cost of equity. Companies typically use the Capital Asset Pricing Model to estimate the cost of equity as follows.

Climate-related matters may affect two inputs that are typically used to calculate the cost of equity – the alpha and the beta factors. [IAS 36.A17(a), Insights 3.10.300.30].

The effect of climate-related matters on the beta factor

The beta factor reflects the risk of the industry or sector in which the CGU operates, relative to the market risk as a whole (systematic risk).

The beta factor is typically estimated based on comparable companies’ betas in the relevant industry/sector, even if the company subject to the impairment test is listed. Estimating the beta requires identifying sufficiently comparable listed companies in the industry/sector. If climate-related matters are significant, they should be considered when identifying comparable companies.

The risk profile of companies in an industry can be very different because of their exposure to climate-related risks and opportunities. This could be due to:

• different geographic locations,
• significant differences in legislation by jurisdiction; and
• the companies’ strategy (some companies are proactive; others are not).

For example, in some jurisdictions, large public oil and gas companies are increasingly diversifying away from purely extractive activities and selling assets that emit high levels of greenhouse gases, whereas small private companies are not as likely to do so. This needs to be considered when identifying comparable companies. Furthermore, the mix of comparable companies may change over time. Large public oil and gas companies may become less relevant over time for determining the beta of a small extraction-only company.

If climate-related matters are industry-wide (rather than CGU-specific) and significant, they may be reflected in the beta. This will depend on whether climate-related matters are priced by the market and the time span of the beta. Beta is a medium-term measure – it is typically based on historical data over a two- to five-year time span.

Where changes affecting an industry have been introduced recently, these may not be fully reflected in older data. A five-year beta may not reflect climate-related matters – for example, in markets where companies have only recently started providing climate-related information it is unlikely that stock prices over the preceding five-year period reflected the impact of climate-related matters.

The effect of climate-related matters on the alpha factor

An alpha factor reflects a CGU-specific risk premium that may need to be added to the cost of equity when a CGU is determined to carry additional risk – i.e. risk that cannot be attributed to market risk (unsystematic risk).

If a CGU is exposed to a particular climate-related risk or a distinctive climate-related strategy which is significantly different from those of the comparable companies identified, then – after reflecting the impact in the cash flows – it is necessary to consider whether the discount rate reflects the return required by a market participant.

If it is not possible to find an appropriate beta of comparable companies with a similar climate-related risk, then reflecting the risk through the alpha factor is appropriate if it can be supported. Incorporating such adjustments should be carefully considered to avoid double counting for risks that are already reflected in the cash flow projections or in other components of the WACC and should be supported by sufficient data.

For example, if the company is significantly exposed to physical risks (e.g. storms, flooding, etc.) which the group of comparable companies is not, and if these risks can be reflected in the cash flow projection, then:

• the cash flow projection needs to be adjusted to reflect these risks, and
• the discount rate should reflect these risks to arrive at the rate of return required by a market participant to the extent that any adjustments to the alpha factor can be supported.

How might double counting for climate-related matters be avoided?

It is important to carefully assess whether a proposed adjustment to the discount rate for climate-related matters is already reflected, directly or indirectly, in the cash flows or in other components of the discount rate, to avoid double counting. [IAS 36.A15, IFRS 13.B14(b)]

Significant climate-related matters that are industry-wide may be reflected in the beta. For example, the automotive industry is significantly impacted by climate-related risks and opportunities due to the influx of hybrid and electric vehicle competitors. The industry beta may at least partly reflect this. If climate-related matters are reflected in the industry beta, then adjusting the alpha factor for the same climate-related matters would result in double counting.

Another example is when the alpha factor contains a premium for size risk. This premium considers smaller companies to be more risky than larger ones – for example, because they are less likely to have the resources and expertise to mitigate climate-related risks or to take advantage of climate-related opportunities. As such, size premiums may implicitly account for some climate-related matters.

Disclosures

IAS 36 Impairment of Assets specifically requires companies to disclose the discount rate used to estimate the recoverable amount (both VIU and FVLCD) when:

• an impairment loss has been recognised or reversed for an individual asset or CGU; or
• the impairment test is for a CGU (or group of CGUs) with a significant carrying amount of goodwill or intangible assets with indefinite useful lives. [IAS 36.130(f)(iii), (g), IAS 36.134(d)(v), e(v)]

Generally, the discount rate is a key assumption when estimating the recoverable amount under the DCF technique. Therefore, the following IAS 36 disclosure requirements related to key assumptions also apply when estimating the recoverable amount of a CGU (or group of CGUs) with a significant carrying amount of goodwill or intangible assets with indefinite useful lives:

• a description of management’s approach to determining the value assigned to the discount rate [IAS 36.134(d)(ii), (e)(ii)]
• sensitivity disclosures if a reasonably possible change in the discount rate would result in the CGU’s carrying amount exceeding its recoverable amount. [IAS 36.134(f)].

In other cases, disclosure of key assumptions is encouraged. [IAS 36.132]

Regulatory expectations

Climate-related information is a key area of focus for many regulators. For example, the European regulator ESMA¹ has published a report on climate-related disclosures included in the 2022 annual financial statements of selected European companies. The report contains examples of disclosures of the impact of climate-related matters on impairment of non-current assets together with explanations of why such disclosures may be useful to users of financial statements. ESMA expects companies to consider these examples when assessing and disclosing the degree to which climate-related matters play a role in the preparation of the financial statements. For example, the report states that issuers should consider disclosing how climate-related matters were considered in the estimation of discount rates.

For more guidance on disclosures and regulatory expectations see Have you disclosed the impacts of climate-related matters clearly?

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