What is the worst that could happen

Zsuzsanna Schiff explains ICAEW’s efforts to bolster financial services firms’ climate-related financial disclosures

Climate change is referred to by leading economists as the greatest market failure in human history. It is said to have potentially disruptive implications on the social wellbeing, economic development and financial stability of current and future generations.

Since the release of its recommendations report in June 2017, the Taskforce on Climate-related Financial Disclosures (TCFD) has worked with global companies, NGOs and industry groups to encourage their implementation. More than 500 public and private sector organisations have now indicated their support for the TCFD recommendations, including banks, governments and even stock exchanges.

One of the key findings of the report was that only a limited number of companies disclose information on the resilience of their corporate strategy to different climate-related scenarios.

Several industry working groups have since been set up to tackle industry-specific implementation challenges. In its latest status report the TCFD deemed this collective effort as critical for “achieving climate-related financial disclosures that provide decision-useful information for investors and others”.

What are the challenges?

To support this engagement, the ICAEW, in collaboration with the Institute of Environmental Management and Assessment (IEMA), hosted its own TCFD workshop on scenario analysis in November 2018. Professionals from a range of sectors including banking, insurance, regulation, civil society and industry attended the half-day event.

The objective was to assess the level of understanding about scenario analysis and the activity of professionals in this area, as well as what help ICAEW should provide to its members. A set of poll questions revealed that 57% found scenario analysis valuable to their organisation, though 70% claimed they knew little about the topic.

Janice Lingwood of Superunion opened the discussion by sharing the results of some recent research. By reviewing the latest annual reports of the FTSE 100 businesses, Lingwood found that only a very small proportion had included climate change related disclosures, including some of the official supporters of the TCFD. More promisingly, she cited several case studies that showed companies are experimenting with different ways of thinking around the subject.

Nick Blyth, policy and engagement lead at IEMA, explained that in a world of uncertainty, scenario analysis is intended to explore alternatives that may significantly alter the basis for business-as-usual assumptions. 

What is scenario analysis?

Paul Pritchard, senior associate at Iken Associates, explained the concept of scenario analysis. This is a “what if” analysis of one potential state of the world under which a low-carbon transition could materialise. It is a plausible hypothetical construct of the future, not a precise forecast or a predictive model.

Pritchard also introduced the United Nations Environment Programme Finance Initiative (UNEP FI) project, in which 16 banks followed a holistic approach for transition risk assessment. They used publicly available and widely referenced scenario sources prepared by the scientific community. Using the transition scenarios, banks estimated changes in credit outcomes at a borrower level, overcoming the problems caused by a lack of available empirical data. The risk assessed this way is then extrapolated to the portfolio level making the approach systematic, repeatable and consistent.

This information is presented in the form of a report, Extending our Horizons, that was published in April 2018 (see tinyurl.com/FS-Extend). There is also a follow-up report from July 2018 and a new project for investment management risk is currently underway.

Jon Wright, sustainable finance reporting manager at HSBC, presented the bank’s latest TCFD strategic report in which it looks at multiple climate scenarios, including a 1.5°C and 2°C increase in temperature. The bank aims to increase its exposure to help clients reach their greenhouse gas reduction goals and work with external experts to develop climate-related scenario analysis and related disclosures.

Scenario analysis in practice

Having explored the purpose and requirements of TCFD, participants analysed the effects of the scenarios on given sectors (the energy sector and the mining/metals industry) and their relative sensitivity or resilience to transition risk. Four distinct pathways were evaluated as a range from high impact to no impact:

1. Direct emissions costs – eg, cap and trade scheme.
2. Indirect emission costs – eg, something in the supply chain, costs of fossil fuels.
3. Incremental low-carbon capital expenditure – eg, to compete in a lower carbon economy, will the segment have to invest in new fixed capital?
4. Change in revenue – eg, could the segment experience decrease in demand due to competition with low-carbon alternatives or an increase in price from a cost pass-through?

Participant groups identified that sensitivities appeared to broadly align with the UNEP FI results. 

Geography/rule of law
Delegates found that answers very much depended on geography and politics. Other delegates queried who the best person within organisations would be to complete this analysis. They felt that banks often have to make assumptions if they don’t have intimate knowledge of a sector and these may not be accurate.

Good/bad regulation
Regulation (eg, punitive vs helpful regulation) might have a huge effect on the time horizon. Unregulated companies are more exposed to market prices but this could represent opportunities too.

Absolute/relative assessments
Individual companies will make absolute assessments (about the climate change effects). But relative assessments of the whole industry will be useful too, although much harder to do.

Investment strategies
Participants confirmed that 77% of firms are considering climate as a risk, with 10% taking a strategic approach to address this, while 60% are doing initial work to see what their exposure might be. They felt it may be useful to think about the extent to which these risks will crystallise over three- to five-year investment strategies (which are relatively short terms). This means governments will need to work with these businesses to support a shift in perspective.

What next?

One of the most important learnings was the value and benefit of putting oneself in the position of decision maker to better understand the risks and to challenge the assumptions. This is the objective of the TCFD recommendations too. Organisations should be ready to question their banks on their assessment.

In planning for future activity we’ll be considering the following feedback:
• Gathering a mixed audience was recognised as a positive – professionals across disciplines working together should be replicated in the workplace.
• An exercise that drills deeper into scenario assumptions and which one is worth further exploration.
• Bringing the understanding and evaluation of risk into a short-term period (one to five years) is important.

Delegates felt that a less experienced audience would benefit from being taken back to basics; allowing people to choose from four examples of different industries and having a short presentation of actual case studies with the 2°C rise scenario to develop better understanding.

If you are interested please contact Zsuzsanna Schiff at zsuzsanna.schiff@icaew.com

About the author

Zsuzsanna Schiff, manager, auditing and reporting, Financial Services Faculty