by Cydney Posner
The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has recently issued its exhaustive final report—Recommendations of the Task Force on Climate-related Financial Disclosures—and supporting materials, designed to provide a standardized framework and detailed guidance for “voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders.” To develop its recommendations, the task force spent 18 months consulting with a wide range of business and financial leaders. According to the press release, “[o]ver 100 business leaders and their companies with a combined market cap of around $3.5tn and financial institutions responsible for assets of about $25tn have publicly committed to support the recommendations.” The disclosure recommendations are organized around four core elements—governance, strategy, risk management and metrics and targets. The Task Force also developed supplemental guidance for financial industries along with companies in energy, transportation, materials and building and agriculture food and forest products. This type of information is expected to enable markets to better “price risk” and allow investors to make more informed decisions. The task force urged companies to include this information as part of their annual SEC or comparable filings to ensure the application of adequate governance processes. Although there is no specific timeframe for adoption, the task force encouraged companies to adopt as soon as possible, keeping in mind that climate reporting will certainly evolve over time.
According to the Report, the 2008 financial crisis reminded investors of the potential adverse impact of weak corporate governance and risk management practices; climate change is one of the “most significant, and perhaps most misunderstood, risks that organizations face today,” especially in light of the uncertainties associated with the exact timing and severity of physical effects of climate change. These challenges have led many companies to “incorrectly perceive the implications of climate change to be long term and, therefore, not necessarily relevant to decisions made today. The potential impacts of climate change on organizations, however, are not only physical and do not manifest only in the long term.” Although obviously, the movement away from fossil fuels will have “significant, near-term financial implications” for coal, oil and gas companies, “climate-related risks and the expected transition to a lower-carbon economy [will] affect most economic sectors and industries.” As a result of the expected disruptive changes across economic sectors and industries in the near term, the transition will also have “implications for the global financial system, especially in terms of avoiding financial dislocations and sudden losses in asset values.” A key goal of the task force was to improve disclosure of the financial impact of climate-related risks and opportunities.
Core Elements and Related Disclosure Recommendations
In developing recommendations, the task force sought to balance the needs of the users of disclosures with the challenges faced by the preparers. Set forth below are summaries of some of the disclosures recommended by the task force for the core elements:
- Governance: The organization’s governance around climate-related risks and opportunities
a) The board’s oversight of climate-related risks and opportunities, including processes related to, and frequency of, advising the board regarding climate issues, whether the board considers climate change when reviewing strategy, plans and objectives, and the nature of board oversight of progress toward goals
b) The management’s role in assessing and managing climate-related risks and opportunities, including whether a management-level employee has responsibility for climate issues, reporting to the board, and monitoring by management.
- Strategy: The actual and potential impacts of climate-related risks and opportunities on the organization’s businesses, strategy and financial planning
a) Climate-related risks and opportunities the organization has identified over the short, medium and long term, including the duration of the those time horizons, a description of the climate issues for each timeframe and of the process used to determine which risks and opportunities will have financial impact.
b) The impact of climate-related risks and opportunities (including any climate scenarios) on the organization’s businesses, strategy, and financial planning, such as the impact on products, R&D and operations, and how climate risks and opportunities are factors in financial planning, providing a “holistic picture of the interdependencies among the factors that affect their ability to create value over time.”
c) The resilience of the company’s strategy, taking into consideration different climate-related scenarios, including a 2°C or lower scenario, along with a description of where strategies may be affected by climate, how strategies might change in response and the scenarios and time horizons considered.
- Risk Management: The processes used by the company to identify, assess, and manage climate-related risks, including how the significance of climate risk is assessed relative to other risk
a) The company’s processes for identifying and assessing climate-related risks, such as applicable and expected regulatory requirements, processes for assessing size and scope and definitions of risk terminology.
b) The company’s processes for managing climate-related risks, including how decisions are made and prioritized to mitigate or accept risks.
c) How processes for identifying, assessing and managing climate-related risks are integrated into the organization’s overall risk management.
- Metrics and Targets: The metrics and targets used to assess and manage relevant climate-related risks and opportunities
a) The metrics and methodologies used by the company to assess climate-related risks and opportunities in line with its strategy and risk management process, such as, where relevant, metrics associated with water, energy, land use and waste management, internal carbon prices, revenue from products and services designed for low-carbon uses, with each presented for historical periods to allow trend analysis.
b) Scope 1, Scope 2 and, if appropriate, Scope 3 greenhouse gas (GHG) emissions, and the related risks, calculated in accordance with GHG Protocol methodology and presented for historical periods to allow trend analysis.
c) Key targets used by the company to manage climate-related risks and opportunities, as well as performance against targets, such as those related to GHG emissions, water and energy usage relative to expected regulatory requirements, market constraints, efficiency or financial goals or other goals. Descriptions of targets could include whether the target is absolute or intensity-based, time frames, base year and key performance indicators and methodologies.
The recommended disclosures related to “strategy” and “metrics and targets” are subject to materiality assessments.
With regard to strategic resilience, the Report highlights the importance of forward-looking disclosures, and, in light of the uncertainty of the timing and magnitude of climate effects, recommends the use of hypothetical scenario analysis—“a process for identifying and assessing the potential implications of a range of plausible future states under conditions of uncertainty.” The Report acknowledges that, while scenario analysis is a well-established method for developing more flexible strategic plans, it has only recently been applied to assessing potential business applications. The exercise may be either quantitative or qualitative, and should cover a reasonable variety of future outcomes, both favorable and unfavorable. The Report recommends that companies with more significant exposure consider disclosing key aspects of the analysis, such as the scenarios used, critical inputs, assumptions and analytical choices, time frames used and information about resiliency of the company’s strategy and its implications, such as direction, capital allocations, R&D, and material financial implications. The Report viewed the use of these scenarios as key to understanding the implications of climate change for the organization, including its vulnerabilities, and useful “for considering and enhancing resiliency and flexibility of strategic plans.” One commonly used scenario, the “2°C Scenario” is a common reference point that is generally aligned with the objectives of the Paris Agreement. It refers to warming above 2° Celsius (2°C), relative to the pre-industrial period, which, it is widely believed could lead to catastrophic economic and social consequences. The Report includes a technical supplement that further explores the use of scenario analyses in these disclosures.
Climate-related Risks and Opportunities
The recommendations emphasize risks and opportunities related to climate change and the transition to a lower-carbon economy. The risks were divided into two categories: risks related to the transition to a lower-carbon environment and the physical risks that may result from climate change. After assessing its exposure to risks and opportunities, a company would then need to determine its response, which could include, for example, risk management activities, capital expenditures or R&D expenses.
Transition-related risks, which are especially relevant for resource-intensive companies:
- Policy and Legal, including policy actions that attempt to constrain activities that contribute to the adverse effects of climate change and policy actions that seek to promote adaptation to climate change, as well as litigation risks. These might include increased pricing of GHG emissions, enhanced emissions-reporting obligations, increased regulation of existing products and services and exposure to litigation.
- Technology risks, such as new technology that displaces old systems and disrupts some parts of the existing economic system, including substitution of existing products and services with lower emissions options, unsuccessful investment in new technologies and costs to transition to lower emissions technology
- Markets risks, such as risks resulting from shifts in supply and demand for certain commodities, products and services as climate-related risks and opportunities are increasingly taken into account. These might include changes in customer behavior, market uncertainties and increased cost of raw materials.
- Reputation risk arising out of changing customer or community perceptions of a company’s receptiveness or resistance to transition to a lower-carbon economy, including shifts in consumer preferences, sector stigmatization and increased stakeholder concern or negative feedback.
Physical Risks, which could affect any company, but are especially relevant for companies with long-lived fixed assets, locations in climate-sensitive regions or that rely on availability of water or have “value chains” exposed to any of the above:
- Acute risks refer to event-driven risks, including increased severity of extreme weather events such as hurricanes and floods
- Chronic risks refer to longer-term shifts in climate patterns, such as changes in precipitation patterns, extreme variability in weather patterns, and rising average temperatures and sea levels.
- Resource Efficiency, particularly in relation to energy efficiency but also including broader materials, water and waste management, such as use of more efficient modes of transport, production or distribution processes, use of recycling, more efficient buildings and reduced water usage and consumption.
- Energy Source, including savings from use of low-emission energy alternatives such as wind, solar, wave, tidal, hydro, geothermal, nuclear, biofuels and carbon capture and storage, as well as use of supportive policy incentives and new technologies, participation in the carbon market and shifts toward decentralized energy generation.
- Products and Services that are innovative new low-emission products and services may improve competitive position and capitalize on shifting consumer and producer preferences. These could also include development of climate adaptation and insurance risk solutions, and new products or services through R&D and innovation. Benefits could also include possible diversification and responses to shifts in consumer preferences.
- New Markets, whether accessed through collaborating with governments by taking advantage of public-sector incentives or development banks, small-scale local entrepreneurs or community groups in developed and developing countries, may offer opportunities to diversify activities and be better positioned for the transition to a lower-carbon economy.
- Resilience involves developing adaptive capacity to respond to climate change to better manage the associated risks and leverage opportunities, including the ability to respond to transition risks and physical risks. Resilience may be available through participation in renewable energy programs and adoption of energy-efficiency measures, as well as resource substitution or diversification.
The Report outlines areas of potential financial impact related to various climate-related risk and opportunities. For example, climate-related transition risks could result in increased operating costs (e.g., compliance or insurance costs), write-offs, asset impairment and early retirement of existing assets as a result of policy changes, reduced demand for products and services as a result of a shift in consumer preferences, increased R&D expenditures, increased capital expenditures in new technologies and related costs to deploy, and shifts in energy costs. Physical risks could lead to reduced revenue from decreased production capacity, write-offs of assets due to property damage, negative effects on the workforce resulting in higher labor costs, increased operating costs and capital expenditures related to facilities damage, and increased insurance costs.
On the other hand, climate-related opportunities could lead to reduced operating costs through efficiency gains, increased revenues as a result of increased production capacity or new product solutions or access to new markets, increased value of assets due to energy-efficient buildings and resilience planning, workforce benefits, reduced exposure to fossil fuel price increases, returns on investment in low-carbon technologies, increased availability of capital and reputational benefits, improved competitive position, and increased diversification of assets.