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Better Climate Risk Reporting an Opportunity for Business

Mark Carney, Governor of the Bank of England, recently spoke at the Task Force on Climate-Related Financial Disclosures (TCFD) Summit 2019, and highlighted that over the past five years, global carbon emissions have risen by 20% and sea levels by over 3.3mm per year. As a result of this, global temperatures are on course to increase by 3.4°C by 2100.

Changes in climate policies, new technologies and growing physical risks will prompt reassessments of the values of virtually every financial asset, Carney asserted in his address. In his opinion, in order to bring climate risks and resilience into the heart of financial decision-making, climate disclosure must become comprehensive, climate risk management must be transformed, and investing for sustainability must go mainstream.

“The development of this new sustainable finance is not moving fast enough for the world to reach net zero carbon emissions,” Carney said. “The current process of disclosure by the users of capital, reaction by the suppliers of capital, and adjustment of these standards will be critical to ensure that the TCFD standards are as comparable, efficient and as decision-useful as possible.”

The providers of capital – banks, insurers, asset managers and those who supervise them – all need to improve their understanding and management of climate-related financial risks. Changes in climate policies, new technologies and growing physical risks will prompt reassessments of the values of virtually every financial asset. Firms that align their business models to the transition to a net zero world will be rewarded handsomely. Those that fail to adapt will cease to exist. The longer meaningful adjustment is delayed, the greater the disruption will be, according to the Bank of England Governor.

Banks have reportedly begun considering the most immediate physical risks to their business models – from the exposure of mortgage books to flood risk and the impact of extreme weather events on sovereign risk. Banks have also started to assess exposures to transition risks in anticipation of climate action. This includes exposures to carbon-intensive sectors, consumer loans secured on diesel vehicles, and buy-to-let lending given new energy efficiency requirements.

On the supply side: 80 percent of the top 1100 global companies are now disclosing climate-related financial risks in line with some of the TCFD recommendations. In addition, 75 percent of investors are said to be now using TCFD disclosures when investing and the same percentage report a marked improvement in the quality of climate disclosures. These investors control balance sheets totalling $120 trillion and include the world’s top banks, asset managers, pension funds, insurers, credit rating agencies, accounting firms and shareholder advisory services.

Strategic Approach

As the volume of disclosures has increased, so has their sophistication. Companies, financial firms and policymakers increasingly recognise that disclosures must go beyond the static to the strategic. Climate risks have several distinctive elements, which, in combination, require a strategic approach.

These include their:
· Breadth, as climate risks affect multiple lines of business, sectors and geographies;
· Magnitude, as the full impacts of climate risks are large, potentially non-linear and irreversible;
· Foreseeable nature;
· Dependency on short-term actions given that the size of future impacts will, at least in part, be determined by the actions taken today; and
· Uncertain time horizon, which may stretch beyond traditional business planning cycles.

The nature of these risks means that the biggest challenge in climate risk management is in assessing the resilience of firms’ strategies to transition risks.

Good News

Markets need information to assess which companies can seize the opportunities in a low carbon economy and which are strategically resilient to the physical and transition risks associated with climate change. The good news is that half the companies that participated in a TCFD survey are using scenario analysis to assess the resilience of their strategies. Financial firms are at the forefront of these assessments.

The Bank of England’s supervisory body – the Prudential Regulation Authority (PRA) – surveyed banks in the UK last year and found that almost three quarters are starting to treat the risks from climate change like other financial risks – rather than viewing them simply as a corporate social responsibility issue.

In South Africa, some of the biggest banks, including ABSA, Standard Bank and FirstRand are making strides in developing policies that would help them decide how to employ their enormous balance sheets to finance activities that could positively contribute to, or mitigate against, climate change.

Path Ahead

Although the private sector has made rapid progress on reporting and risk management, more is required. Carney stated that for adequate progress to be achieved over the next few years, companies, their banks, insurers and investors must:
1. Increase the quantity and quality of disclosures;
2. Refine disclosure metrics to determine which ones are most decision-useful;
3. Spread knowledge on how to assess strategic resilience; and
4. Consider how to disclose the extent to which portfolios are ready for the transition to net zero.

Better TCFD disclosure is an opportunity, Carney suggested. “Research by the Bank of England and PwC has found a positive correlation between companies’ stock price and the number of TCFD disclosures that firms make,” he said. “This could be because investors reward companies that are leaders in managing climate-related risks or simply because TCFD adoption identifies companies that are more naturally disposed to longer-term strategic thinking and planning. As the transition gains traction, it is likely that both ESG and mainstream investors will increasingly focus on companies’ strategic resilience to climate change.”

The TCFD provides the necessary foundation for the financial sector’s role in the transition to net zero that the planet needs and that citizens demand, according to Carney. “So, whether the TCFD is used to manage the growing physical and transition risks from climate change or to finance the enormous opportunities to develop more resilient and sustainable economies, the work that is being done to develop the TCFD and spread its adoption is vital,” he said.

NOTE: The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) is a market-driven initiative, set up to develop a set of recommendations for voluntary and consistent climate-related financial risk disclosures in mainstream filings.