How financial disclosure can combat climate risk

We need greater tranparency from companies and investors about the impacts of climate-related risks and opportunities and how they can affect revenues, expenditures, estimates of future cash flows, assets and liabilities. Mainstream financial disclosures, made via a standardized voluntary framework, is the best way to make that transparency accessible to a wide variety of market participants.

The Financial Stability Board’s (FSB) Task Force on Climate-related Disclosures has just released its draft recommendations for such a framework. The goal of these disclosures — designed to apply to organizations in all sectors — is to provide relevant, forward-looking information to investors, lenders and insurance underwriters on the potential financial impacts of climate-related risks and opportunities, as well as their management.

Adopting these recommendations will require organizations to link issues around climate with corporate and investment strategy, risk and opportunity analysis — a timely development, given the recent close of the COP22 climate meeting in Marrakesh.

The new guidelines stem from a concern among FSB members (which include G20 finance ministers and Central Bank governors) about the potentially disruptive effect of the transition to a low-carbon economy on the stability of global financial systems. Recent speeches by Bank of England Governor and FSB Chair Mark Carney clearly articulate this.

Streamlining disclosure

Numerous climate disclosure frameworks already exist, such as CDP’s global disclosure platform, which captures climate data for more than 6,000 companies worldwide. The Task Force’s vision is that these frameworks will align their core disclosure requests with its recommended disclosures. CDP and others already have committed to do this. CDP’s will assimilate the Task Force’s recommendations into its climate questionnaires in 2017, ready for the 2018 cycle.

This is key, as the Task Force did not seek to introduce yet another framework for voluntary reporting, but rather to be a catalyst for consistent provision of climate-related financial disclosures. This should increase the accuracy and volume of information available to users while reducing the reporting burden for preparers. The Task Force recommendations reinforce existing reporting requirements in most G20 jurisdictions for companies with public debt or equity disclosure material risks in their financial filings, including material climate-related risks. Introducing a standardized framework for consistent climate-related financial disclosures should support these requirements.

Wide-ranging applications

The Task Force’s job was to create recommendations for voluntary financial disclosures that can apply to companies and investors globally. While initial attention has focused on organizations in countries from the FSB’s constituency (such as the G20), the recommendations themselves are widely applicable and suitable for adoption worldwide.

Listed issuers (financial and non-financial), asset owners (pension funds, insurance companies, endowments and foundations) and asset managers are particularly encouraged to disclose. The report also encourages private companies to adopt the disclosure framework in communicating their oversight of climate-related risks and opportunities. There is no specific size threshold, and the Task Force suggests that existing relevant reporting thresholds be extended to these disclosures.

Supplementary guidance for reporting is provided in an annex to the main report. For example, guidance is provided for companies in sectors such as energy, transportation, materials and building and agriculture. These sectors may be most affected by the physical or transition impacts of climate change such as water scarcity, shifts in energy supply or use or extreme weather events.

Examining the impacts

The voluntary recommendations are built around four thematic areas, shown in the infographic below. Their application will have implications for boards of directors, senior executives, chief investment officers, chief risk officers and risk leaders, and require the same level of oversight and management as other aspects of financial reporting. 

There are a few core elements of the recommended climate-related financial disclosures. One is the organization’s governance around climate-related risks and opportunities: Climate impact will need to be integrated into organizations’ overall processes, including strategy setting and risk management.

Another element is the actual and potential impact of climate-related risks and opportunities on the organization’s businesses, strategy and financial planning. This may include assessment of how various future climate scenarios (including a 2-degree scenario consistent with the Paris Climate Change Agreement) could affect the organization’s operations and performance. In order to integrate climate strategy, CFOs and CIOs will have to become much more familiar with the impacts of climate-related risks and require increased usage of scenario planning.

Risk management, or the organization’s process of identifying, assessing and managing climate-related risks, is another element. Organizations should identify these climate risks and opportunities in the short-, medium- and long-term.

Lastly, the organization should use metrics and targets to assess and manage climate-related risks and opportunities. For example, asset owners and asset managers could include the investment portfolio carbon footprint and a discussion of other climate-risk metrics or targets in their investment decision-making and monitoring.

The Task Force grouped climate-related risks and opportunities into three categories:

  • Transition risks related to the move to a lower-carbon economy, including policy and legal risks, technology risks, market risk and reputation risks;

  • Physical risks relating to acute risks such as extreme weather events and chronic risks associated with long-term shifts in climate patterns with impacts on water availability, sourcing and quality and factors impacting organization’s operations, supply chain and transportation needs; and
  • Climate-related opportunities, including opportunities to improve resource efficiency, manage energy costs, develop new products and services, capture new markets and improve organizational resiliency.

Benefits of increased transparency

A standardized disclosure framework should benefit multiple market participants in a variety of ways. Companies understand what financial markets want from disclosure in order to measure and respond to climate change risks, and they can align disclosures with investors’ needs. Wider and consistent disclosure also allows companies to more effectively measure and evaluate their own risks and those of their suppliers and competitors, and streamlines reporting burden. 

Institutional investors, banks and insurers receive additional relevant information supporting more informed investment, credit and insurance underwriting decisions about reporting companies. It is hoped they can improve market efficiency and economic resiliency.

Meanwhile, individual investors, such as pension fund members or beneficiaries and mutual fund holders, have access to information about the management of climate-related risks and opportunities undertaken on their behalf.

And regulators are better positioned to assess the concentrations of carbon-related assets in the financial sector and the financial system’s exposures to and management of climate-related risks.

Task Force recommendations likely will be accepted by the market as a starting point for climate-related disclosures by companies and investors. Those that have made progress on climate-related intellectual capital will become leaders in this space. 

What now?

First, organizations and their advisers, along with credit rating agencies, stock exchanges, the analyst community and other stakeholders, should review the Task Force’s report and draft recommendations and provide feedback to the online consultation, open until Feb. 12.

Next, companies and investors — and their boards — should take the opportunity in 2017 to consider how well-positioned they are to provide the recommended, voluntary disclosures to stakeholders. Is there a thoughtful approach to considering climate risk and opportunity and the associated financial implications? If not, how will it be developed?

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