Heating up the debate
Youri Lie and Doug Johnston discuss developments in climate-related disclosures and the challenges ahead.
There is a growing understanding that climate change presents risks to the global economy. Limiting the increase in global temperatures to below 2°C, in line with the Paris Agreement, is a challenge that requires urgent and sustained action for all sectors if we are to avoid catastrophic consequences for society and economies, including financial markets.
The degree to which companies report on how they manage these risks varies considerably and, in many cases, disclosures are limited. However, as understanding of climate risk becomes more widespread, investors are increasingly dissatisfied with the lack of quality disclosure.
This has led to an explosion of voluntary and mandatory regulatory and industry developments relating to the management and reporting of climate-related risks. The most prominent are the recommendations of the Financial Stability Board’s (FSB’s) Task Force on Climate-related Financial Disclosures (TCFD). The TCFD recommendations seek to establish a framework for an organisation’s disclosures “that will help financial market participants understand their climate risks”. Issued in June 2017, the recommendations give organisations the opportunity to apply a more rigorous and consistent approach to assessing and disclosing the financial impact of climate risks in their financial filings.
Central to the recommendations are two types of risk: physical and transition risk. Physical risk focuses on the risk of damage to land, buildings, stock or infrastructure owing to physical effects of climate-related factors, such as heat waves, drought, sea levels, ocean acidification or flooding. Transition risk includes policy, legal, technology, reputational and market changes to address mitigation and adaptation requirements related to climate change.
The recommendations set out to disclose four groupings of information:
- Governance: The organisation’s governance around climate-related risks and opportunities.
- Strategy: The actual and potential impacts of climate-related risks, and opportunities for the organisation’s businesses, strategy and financial planning, including through scenario analysis.
- Risk management: The processes used to identify, assess and manage climate-related risks.
- Metrics and targets: The metrics and targets used to assess and manage relevant climate- related risks and opportunities.
Despite application of the TCFD recommendations being voluntary, EY saw widespread adoption during the 2018 reporting season and expects further take up in the future. We also expect to see further enhancement of the recommendations in the coming years.
What did we see in 2018 reporting?
Last year, EY published its first global assessment of companies’ TCFD disclosures in its Global Climate Risk Disclosure Barometer 2018 report which examined the disclosures made by 350 companies globally against the TCFD recommendations. The key findings are outlined below.
Many companies disclose, few disclose well
Two-thirds of companies assessed now report on climate-related risk. However, the quality of these disclosures was relatively low with, on average, only 31% of the TCFD recommendations being fully addressed. This is a clear indication that organisations are at the beginning of their TCFD reporting journey and leaves plenty of room for improvement in future years.
Regional differences prevail
The responsiveness to the recommendations differs significantly between countries, with countries in Europe generally being relatively advanced in their TCFD disclosure, but countries in Asia being less transparent. This can be attributed to the fact that the ambition and action to mitigate climate change still relies on country-led initiatives and in some cases, regional-level efforts. For example, The European Commission’s action plan on sustainable finance has provided a regulatory dynamic on climate finance within the EU, with many TCFD elements reflected in the legislative proposal that are generating debate and awareness of the recommendations within the finance sector. Similarly in the UK, two key financial sector regulators are increasingly demanding of the firms that they regulate in relation to the management of climate risk. In the US, a number of large investment funds have supported shareholder resolutions targeted at improving the climate risk disclosures of US companies operating in fossil fuel sectors.
Disclosing in the annual report or in the sustainability report
The TCFD recommendations ask for disclosures to be made in financial filings, alongside other disclosures. While some companies did include their TCFD disclosures within the annual report, the overwhelming majority reported within non-financial reports such as sustainability reports. There are a number of reasons why companies have not included disclosures in their annual reports. The relative immaturity of processes to capture and report on climate change risks is likely one reason. It can also be difficult to translate these risks into financial implications.
Scenario analysis is not yet evolved
Scenario analysis was mentioned in the disclosures of many of the larger companies but mostly in the context that they expected to conduct the analysis in the future. In other cases, no detail was given around the scenarios analysed or the results of the modelling. Several organisations disclosed their support for a 2°C future, but did not state how their business aligned with such an economy. Additionally, where companies had undertaken detailed scenario analysis, the scenarios generally only dealt with transition risks.
Challenges for 2019 reporting and beyond
As companies get ready for the 2019 reporting season, a number of challenges to better addressing the recommendations both now and in the future prevail.
Ownership within an organisation
Who should be responsible for climate risk has been a constant debate as it becomes increasingly embedded in the mandates of a wider range of executives. Traditionally climate risk has been the responsibility of a chief sustainability officer (or equivalent), but the financial nature of the TCFD recommendations has meant that many are now debating whether responsibility should, at least partially, be held by risk, strategy, finance, or other functions. Accountability to different board committees is also changing, as reporting on climate to committees such as the audit and/or risk committees has increased.
Creating the right control environment
As interest in climate disclosure increases, companies are becoming more mindful of the need to design enhanced control environments surrounding TCFD disclosures. Finance and internal audit functions in particular are taking larger roles in organisations’ responses to climate change than in previous years and we expect this to increase in the future.
Evolving practice in scenario analysis
Confusion around how best to conduct scenario analysis is frequently highlighted as industry-wide approaches do not often exist. Whilst some industries are more advanced than others, the methods for quantifying climate risk and understanding its financial implications remains an area of development. It is often stressed that industries would benefit from alignment of the scenarios being used for modelling, the risks identified for the sector and the modelling techniques.
Setting appropriate targets and metrics
Many organisations struggle to set meaningful targets and metrics. Whilst environmental and commercial targets such as reductions in carbon emissions and sales growth of ‘green’ products often exist, considering the way in which they interact with each other is often more difficult to do.
The road ahead
While we have highlighted the challenges that remain, climate-related reporting has developed at an exceptional pace. With the current attention that climate change receives in the boardroom, it is hard to remember that, for many companies, a few years ago the topic was not even on their radar. As we expect the quality of disclosure to enhance rapidly over the next few years, we also expect
investors to become more sophisticated in the way they use the information when making
investment decisions. Ultimately, this should allow them to enhance the value of their investments and in so doing, protect the most valuable asset of all: our planet.
About the authors
Youri Lie is a senior manager and Doug Johnston is a partner, at EY