03 March 2023
Our previous blog outlined the inevitability of climate change and global warming and the risks not only to the world’s financial system but also to individual organisations.
Whilst that blog focused on the consequences of global warming and the reasons for burning less fossil fuels, it didn’t state the obvious, which is that Climate Change is here to stay (at least in our lifetime), all we can do is reduce the impact and consequences of future changes in emissions.
Investors now need to know whether your business is climate change ready so that they can invest in the right types of business. Financial markets are expected to appropriately price risk to ensure efficient capital allocations, but in comparison to other risk factors the approach to accurately assessing climate-related risks is still in its relative infancy. The Financial Stability Board is an international body that monitors and makes recommendations about the global financial system. The Board took the lead in 2015 in establishing the Taskforce for Climate Related Financial Disclosures (TCFD) to develop consistent climate-related financial risk disclosures for use by companies, banks, and investors in providing information to stakeholders.
Disclosure & Transparency
The Board’s main guiding principle was that disclosure was needed for better decision-making which will enable more stable, resilient markets with less abrupt price adjustments, and facilitate a smoother transition to a low-carbon economy. The UK was the first G20 economy to enshrine the TCFD principles into national law.
This can seem like a complex set of new reporting requirements. In essence, TCFD describes how risks can largely be categorised into those that are transitional or physical:
However, whilst the potential impacts of climate change pose massive risks and uncertainties, there are also opportunities that need to be considered. These can manifest themselves as:
Each of these risks and opportunities can have material financial impacts on both an organisation’s, profit and loss account and its balance sheet.
The reporting requirements are structured around four core elements – Governance, Strategy, Risk Management and Metrics and Targets – and within these core elements are the eleven recommended disclosures
The eleven recommended disclosures are inevitably interconnected and when viewed together should provide a holistic picture.
The importance of scenario analysis
The important next stage that delivers real value is to undertake some scenario analysis. This is the process for identifying and assessing the potential implications of a range of plausible future states under conditions of uncertainty. Scenarios are hypothetical constructs and are not designed to deliver precise outcomes or forecasts. Instead, scenarios provide a way for organizations to consider how the future might look if certain trends continue or certain conditions are met.
The assumptions organisations make about future climate trajectories are crucial when completing a scenario analysis. Generally, transition risks are greater when the transition to a low-carbon economy is rapid. This will see significant changes in the energy mix and associated infrastructure, as well as progressive green regulation and legislation, which will require organisations to move faster.
Whereas in warmer scenarios, organisations will have to face much more extreme physical impacts directly. In either case, a warming world will bring with it inevitable risks and associated costs – and it is up to organisations to prepare to face this the best they can.
Far more than box ticking
Disclosing climate-related information in the mainstream annual financial filing should also ensure that this information is treated with the same rigour and internal controls as used for financial information. It also helps connect climate information to financial information and allows companies to provide a holistic picture of the entire organisation.
As with other areas of mandatory energy and carbon reporting, viewing them as an opportunity to demonstrate the sophistication of the organisation approach rather than a “box ticking” exercise can provide the opportunity to create a competitive advantage and a greater probability of retaining and attracting investment towards the new low carbon economy.