Description of how climate change factors have been taken into account in judgements and estimates

Rolls-Royce Holdings plc – Annual report – 31 December 2021

Industry: aerospace

1 ACCOUNTING POLICIES (extract)

Climate change

In preparing the Consolidated Financial Statements the Directors have considered the potential impact of climate change, particularly in the context of the disclosures included in the Strategic Report this year and the stated decarbonisation commitments. Based on the Taskforce for Climate-related Financial Disclosures (TCFD) recommendations, the Group assesses the potential impact of climate-related risks which cover both transition risks and physical risks. The transition risks may include extensive policy, legal, technological, and market changes and physical risks could include direct damage to assets and supply chain disruption.

The Group has set decarbonisation commitments and identified longer-term considerations in response to the climate challenge and is engaging proactively with external stakeholders to advocate for the conditions that society needs to achieve its net zero target. The Group’s main short- and longer-term priorities include the following:

  • achieving net zero greenhouse gas (GHG) emissions by 2030 from all energy purchased and consumed in the operation of the buildings, facilities and manufacturing processes (with the exception of product testing and development). This will be met through continued investment in onsite renewable energy installations; the procurement of renewable energy; and continued investment in energy efficiency improvements to reduce the Group’s overall energy demands and operating costs. The investment required to meet these scope 1 and 2 emission improvements is included in the forecasts that support these Financial Statements. The Group expects the Bristol, UK, manufacturing site to be its first site to achieve net zero carbon operations during 2022.
  • pioneering breakthrough new technologies, including investment in hybrid-electric solutions in Power Systems, continued development of the more efficient UltraFan aero engine, testing of sustainable aviation fuels, small modular reactors (SMRs) and hybrid and fully electric propulsion. New products will be compatible with net zero operation by 2030 and all products will be compatible with net zero operation by 2050. In the year, R&D costs of £(68)m within New Markets included design development to ready the SMRs to enter the UK GDA process and investment in electrical propulsion technology. Future investment required to deliver these technologies is included in the forecasts that support the Financial Statements.

Climate change scenarios have been prepared to assess the viability of our business strategy, decarbonisation plans and approach to managing climate-related risk. There is inherent uncertainty over the assumptions used within these and how they will impact the Group’s business operations, cash flows and profit projections. The Directors assess the assumptions on a regular basis to ensure that they are consistent with the risk management activities and the commitments made to investors and other stakeholders.

Assumptions used within the Financial Statements in relation to areas such as revenue recognition for long-term contracts, impairment reviews of non-current assets and the carrying amount of deferred tax assets consider the findings from the climate scenarios prepared. Key variables include carbon prices based on the IEA Net Zero scenario, which assumes an increase from $47 per tonne of carbon in 2022 to $250 per tonne in 2050, commodity price trends derived from the climate scenarios set out by the Intergovernmental Panel on Climate Change (IPCC RCP1.9), temperature rises from the (IPCC SSP1-19) scenario, and GDP information from the Oxford Economics Net Zero model.

As details of what specific future intervention measures will be taken by governments are not yet available, carbon pricing has been used to quantify the potential impact of future policy changes on the Group. To ensure revenue recognition or the carrying value of assets is not overstated it has cautiously been assumed that the impact of carbon pricing predominantly falls on the cost base of the domestic facilities and external supply chain, rather than directly on customers or consumers. The Group will be able to mitigate an element of the financial impact as it reduces the scope 1 and 2 emissions from its buildings, facilities and manufacturing processes and this is expected to decline. However, no account has been made of expected mitigations from decarbonisation in the external supply chain (who the Group is working with, whilst acknowledging in its financial modelling that this is complex and will therefore take some time). The financial modelling performed recognises the extent to which the Group’s current supplier contracts offer protection from cost increases in the short to medium term where pricing is fixed or subject to capped escalation clauses. The Group has made a cautious assessment of whether higher costs would be passed on to customers in the short and medium term that considers the markets operated in and the pricing mechanisms in place. For example, in Civil Aerospace it is recognised that escalation caps within a number of its LTSA contracts would be triggered, meaning additional costs could remain within the business under current commercial arrangements until the end of existing contract periods.

When determining the amount of cumulative revenue recognised on long-term contracts, and the obligation in relation to onerous contracts, the assumptions above have been used to reflect the climate uncertainties. This has resulted in a revenue catch-up of £(17)m and an increase in contract loss provisions of £(20)m in the year from increased costs over the term of the current contracts of around 1%. A sensitivity is presented within the key sources of estimation uncertainty (page 129) to disclose the impact of a further 1% cost increase that might arise from further unmitigated increases in carbon and/or commodity pricing.

Impairment testing of non-current assets including goodwill, programme assets and deferred tax assets has considered the above risks as well as assessing how the Group’s 1.5oC scenario may change the demand for products over the medium and longer term. To assess the carrying value of assets where there is more potential for impairment, the Directors have modelled downside risks specific to those products. This included consideration of lower OE volumes or a shorter in-service life that generates lower aftermarket volumes, together with higher costs in Civil Aerospace. Power Systems is a shorter-cycle business with scope to re-assess contractual terms to reflect the cost of carbon. Whilst the Defence programmes cover a longer period, the nature of the largest customers and the typical contractual arrangements mean that the Group expects future contracts to reflect the cost of carbon. Further information is provided in notes 5 and 9.

Deferred tax assets are recognised to the extent it is probable that future taxable profits will be available, against which the unused tax losses and deductible temporary difference can be utilised. In addition to the weighted downside forecast (see note 5), the climate-related estimates and assumptions above have also been considered when assessing the recoverability of the deferred tax assets. Recognising the longer term over which these assets will be recovered, the Group has also considered the impact on OE and aftermarket sales if new, more efficient, civil aircraft or new engine options enter the market earlier than assumed in its most likely estimates. Under this scenario some older products would see a reduction in profits but additional opportunities exist for newer products such as the Trent XWB. Whilst carbon pricing illustrates pressure on costs, decarbonisation and new supplier and customer contracts offer the opportunity to receive value for more efficient and sustainable products. Further details are included in note 5 together with sensitivity analysis in the key sources of estimation uncertainty section below.

The climate-related estimates and assumptions that have been considered to be key areas of judgement or sources of estimation uncertainty for the year ended 31 December 2021 are those relating to the recoverable amount of non-current assets including goodwill, capitalised development costs, recovery of deferred tax assets, recognition and measurement of provisions and recognition of revenue on long-term contracts. These items are included within the key areas of judgement and key sources of estimation uncertainty summarised on page 119 and 120 and explained in detail throughout the significant accounting policies.

Items that may be impacted by climate-related risks, but which are not considered to be key areas of judgements or sources of estimation uncertainty in the current financial year are outlined below:

Useful lives of assets – The useful lives of assets could be reduced by climate-related matters, for example as a result of physical risks, obsolescence or legal restrictions. The change in useful lives would have a direct impact on the amount of depreciation or amortisation recognised each year from the date of reassessment. The Directors’ review of useful lives has taken into consideration the impacts of the Group’s decarbonisation commitments and has not had a material impact on the results for the year.

Inventory valuation – Climate-related matters may affect the value of inventories as they could become obsolete as a result of a decline in selling prices or a reduction in demand. After consideration of the typical stock-turns of the inventory in relation to the rate of change in the market the Directors consider that inventory is appropriately valued.

Recoverability of trade receivables and contract assets – The impact of climate-related matters could have an impact on the Group’s customers in the future, especially those customers in the Civil Aerospace business. No material climate-related issues have arisen during the year that have impacted our assessment of the recoverability of receivables. The Group’s ECL provision uses credit ratings which inherently will include the market’s assessment of the climate change impact on credit risk of the counter parties. Given the maturity time of trade receivables and the majority of contract assets, climate change is unlikely to have a material increase on counter party credit risk in that time.

Share-based payments – Executive leadership remuneration packages will be impacted and measured against a new sustainability metric from the 2023 financial year. This could impact the future amount and timing of the recognition of the share-based payment expense in the income statement once these metrics are included within the performance condition criteria of the share-based payment plans. This change has had no impact on the 2021 financial statements.

Defined benefit pension plans – Climate-related risks could affect the financial position of defined benefit pension plans. As a result, this could have implications on the expected return on plan assets and measurement of defined benefit liabilities in future years.