Disclosing climate-related risk

There is growing recognition that climate change poses a significant threat to business. Laura King takes a look at what is in the pipeline for disclosing climate-related risk.

Business risks relating to climate change fall into two distinct categories. Physical risks, such as those caused by flooding, drought or severe storms, and so-called transition risks. The latter are the risks and opportunities related to new technologies, policies and attitudes that are likely to manifest as we shift to a low-carbon world in line with the Paris Agreement.

Climate change disclosure involves organisations sharing information on both of these risks as part of their mainstream annual reporting. It is not a new concept and has long been championed by organisations such as the Carbon Disclosure Project. However, there is a growing call for better and more consistent analysis to help businesses prepare for any climate-related challenges that lie ahead, as well as to enable investors to make informed decisions.

How significant is the risk of climate change?

Recent studies show that climate change poses a sizable risk. A high-profile report by the Economist Intelligence Unit (EIU) found that the average global value of risk was at least US$4.2 trillion by the end of the century. With higher temperatures comes further risk and in a scenario where temperatures rise by 6°C, the value of risk increases to US$13.8 trillion for private investors and a shocking US$43 trillion for governments and public bodies.

These figures are staggering. To put them into perspective, the GDP of the UK was a mere US$2.6 trillion in 2016, and the value of the global stock market is around US$70 trillion — assuming the modelling holds even partially true, climate change undoubtedly has the potential to result in significant losses for investors.

How does climate change fit into standard disclosure rules?

At the moment, most large companies are required to provide information on both global emissions and environmental risks that are deemed financially material. In principle, these elements could be extended to cover broader reporting requirements for climate change, but there are some challenges.

First, to enable proper reporting, there needs to be a clear framework as to what constitutes full disclosure and associated monitoring and enforcement. Whether the UK is set up to do this is a matter of some debate. Since the implementation of the current reporting requirements, ClientEarth has submitted complaints to the Financial Reporting Council (FRC) about several major companies that have not adequately disclosed environmental risks, leaving questions as to how seriously companies take their obligations as well as how robust the mechanisms are for checking compliance and enforcing malpractice.

Second, climate-related risks are global, long term, and can be difficult to anticipate. For example, the speed of technological development and changes in emission levels can throw even the best-made prediction out. Factors like these make climate change a complicated threat to anticipate, let alone incorporate into business models that, for the most part, will rarely look decades into the future.

What is the Task Force on Climate-related Financial Disclosures?

Helping to improve the difficulties around disclosure is where the work of the Task Force on Climate-related Financial Disclosure (TCFD) comes in.

The TCFD was established by the G20 Financial Stability Board (FSB) to improve visibility around climate-related risk and to help companies understand what financial markets need from disclosure. The task force is industry-led and well-respected with global members from a mix of sectors including banks, insurance companies, asset managers and large non-financial companies.

In June 2017, it published a series of recommendations that provided a voluntary method for disclosure that would give investors what they needed to understand material risk.

The framework identified four areas for disclosure in public financial filings.

  1. Governance — how an organisation incorporates climate-related risk into its overall management.

  2. Strategy — what the actual risks are and how these are incorporated into the company’s financial, strategic and business planning.

  3. Risk — the process by which the risk is assessed and managed.

  4. Metrics and targets — how risk is measured and what goals are in place to measure achievement.

Why is the work important?

The TCFD is influential with hard-hitting members, so its recommendations are not to be taken lightly. It is also the first effort by industry leaders to create a framework that firmly embeds the risks around climate change into public reporting requirements. As such, it creates both a common standard for reporting and raises the profile of climate change as a financial risk.

The last point is particularly important. For too long, many companies have seen climate change as something of a problem for the future and not directly relevant to decisions made today. This attitude is slowly changing, especially with the realisation that the risks and opportunities associated with the low-carbon transition are likely to affect most economies and sectors.

Giving evidence to the Environmental Audit Committee in February this year, Sarah Breeden, Executive Director, Bank of England summarised: “climate change has moved from the corporate and social responsibility box into the financial risk box. It is not complete — the transition is underway, and some are ahead of others — but I think it is now very clearly recognised as being more a financial risk than a ‘nice to have’ corporate social responsibility issue”.

Should reporting be mandatory?

Although the current focus is on sectors such as banking, investment and large organisations in vulnerable areas (such as energy production), it is likely that disclosure will become more commonplace and perhaps even mandatory.

This is certainly the recommendation of the Environmental Audit Committee, which in June 2018 urged the Government to take advantage of momentum behind the TCFD recommendations to make reporting compulsory for listed companies as well as pension and investment managers by 2022. Notably, it does not believe that a voluntary approach will be effective over the medium term, calling on the Government to reiterate that the requirements for disclosing environmental risks should include climate change, and to eventually use the current reporting framework to apply the TCFD recommendations on a “comply or explain” basis.

What next?

Whether the Government fully adopts these suggestions remains to be seen. However, for those looking to take a leading role, the next challenge is working out how to implement the TCFD recommendations. To help this, the TCFD is planning on producing a report by the end of the year that will identify best practice.

Undoubtedly, some parts of the framework will be within reach, whereas other steps will be harder and may take several years to develop. For instance, it is relatively easy to communicate facts, but much harder to disclose scenario analyses that align with future risks and opportunities.

As a starting point, companies intending to publicise information on climate change risks should begin to look at where their reporting requirements match those of the TCFD, and where more needs to be done by:

  • undertaking a gap analysis

  • engaging key stakeholders

  • creating an action plan for capturing the additional data to be disclosed

  • defining and setting targets.

There is a growing consensus that the work of the TCFD has the potential to generate true momentum and create real change, and with the weight of industry and Government behind it, there has never been a better time to adopt its way of thinking. Acting now will not only steer a course towards a lower carbon future, but might also help organisations reap the benefits.