When it comes to climate disclosures, do you prefer Paleo or a McDiet?

In today’s essay, I’m going to try to sketch out my views on the ideal design of climate-related financial disclosures.  I’m going to do so mainly by describing the motivation, and criticizing the design, of expected loss accounting procedures that have recently been introduced around the world.  

For readers with a banking risk background, this discussion will be very familiar and hopefully quite interesting.  My views on IFRS 9 and CECL are slightly outside the mainstream – something that will become immediately apparent later on.

For those solely interested in climate risk, I urge you to stick with it – I’ll try to make the discussion as accessible as I possibly can.  Unfortunately, to form a view on issues related to accounting you need a bit of background (ugh), which means studying some accounting.  But I think you’ll soon find that the design of these new expected loss methods overlaps quite a bit with the approach regulators are taking in the development of climate related disclosures.

A brief history

Up until quite recently, distressed loans were only recorded in a company’s financial statements when some sort of adverse event had been observed.  If a borrower missed a payment or declared bankruptcy, the accountants would recognize the impairment.  If nothing bad happened, the accountants would record nothing.  This method was known as “incurred loss” (IL).