The UK has endorsed recommendations for financial reporting of climate risks – but are voluntary guidelines enough?

Climate change risk disclosure is making headlines in the financial press.

Last month investors of the Australian Commonwealth Bank launched a landmark lawsuit saying that the bank had failed to adequately disclose its exposure to climate change risk in its 2016 annual report. Earlier this month a new survey by HSBC showed that two-thirds of institutional investors are planning to increase their climate-friendly investments but half of those surveyed lacked adequate information on climate risk. And last week, a coalition of institutional investors representing $1tn in assets has sent letters to 60 of the world’s largest banks demanding more information about their exposure to climate-related risks.

These investors add to the group of voices seeking increased financial disclosure from companies hot on the heels of the recommendations of the Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures (TCFD).  Published at the end of June, the recommendations outlined voluntary guidelines for how private companies should report to their investors on climate-change related risks.

Yesterday, BEIS minister Claire Perry announced the creation of a new Green Finance Taskforce, as part of her announcement she confirmed that the UK is officially endorsing the voluntary recommendations of the TCFD.

However, encouraging voluntary disclosure may not be enough.

Disclosure needs to be consistent, relevant, and widespread across companies, which will likely require making these disclosures a mandatory part of existing financial disclosure rules.

The TCFD recommendations are designed to help companies understand and manage their climate change risks

The Financial Stability Board, an international body under the G20 that monitors the global financial system, created the TCFD in 2015 in light of growing concerns about how companies might be affected by climate change risk.

These include transition risks from moving away from high-carbon high emissions fuels and processes, for example coal companies’ stock prices may be affected by technological or policy change that reduces demand for coal; liability risks such as companies being held legally responsible for the impact of their greenhouse gas emissions; and physical risks from the impacts of climate change, for example insurance companies facing higher claims for damages as a result of more frequent extreme weather events.

The TCFD, which was led by private companies, spent a year designing the guidelines to advise companies on which climate risks they should consider reporting and how to go about it.

The TCFD recommendations show how much the discussion on climate change financial risk has evolved―however there are questions about their implementation

Crucially, the recommendations are voluntary. Without external pressure from their investors or regulators, like the pressure applied to CommBank by its shareholders, companies could choose to disclose very little or only favourable information.

Investors need complete and consistent disclosure across firms in order to make informed decisions about the riskiness of their investments and how best to allocate their capital.

If the TCFD’s voluntary guidelines on disclosure became mandatory, this could at least increase the information available to investors.  However, reporting requirements are implemented differently across different countries, which would make it challenging for all countries to impose single set of guidelines. For example, France introduced a new piece of legislation in 2015 that strengthened existing carbon disclosure requirements for listed companies and introduced it for institutional investors as well.

In the UK, as well as now an official endorsement of the Taskforce’s voluntary disclosure guidelines, there is some mandatory disclosure of environmental factors affecting firms’ operations, but it could be applied both more generally (requiring more firms to disclose) and uniformly (standardising the disclosures).

Companies listed on the stock exchange in the UK are already required to disclose environmental, social and governance (ESG) considerations under the UK Companies Act, and non-listed companies above 500 employees will also be required to make disclosures in 2017 for the first time under the EU Non-Financial Reporting Directive. However, there are considerable company-level differences in what they report and how this is integrated into principal risks and key performance indicators. This suggests that guidelines could be further refined to encourage more uniform and useful disclosure, for example by making them more detailed.

Details from the Task Force recommendation need ironing out, and investors should also be aware of the limitations of the information provided by disclosure

When policy-makers are considering how to make these voluntary guidelines into mandatory requirements, they will also need to ensure disclosures are useful to investors and comparable across companies. The current TCFD recommendations give leeway in some areas where more detail will be needed for consistency, for example, in the use of scenario analysis.

Our institutional response to the TCFDs initial recommendations in spring 2016 stressed the importance of forward-looking analysis, which the TCFD included in its next draft.

The TCFD suggests that companies not only assess their current and historical performance but also consider how their business would fare under a suite of possible scenarios encompassing “a reasonable variety of future outcomes, both favourable and unfavourable” including a 2 degree warming scenario, to be consistent with the upper target set under the Paris Agreement (but not the more ambitious 1.5°C target).

For investors to compare companies on a like-for-like basis, it will be necessary to have at least one common scenario. However, investors and firms will also keep in mind the limitations of scenario analysis. As the TCFD points out, these scenarios are “hypothetical constructs and not designed to deliver precise outcomes”.

For example, the International Energy Agency provides forecasts that are widely used and mentioned repeatedly in the Recommendation, but looking backwards at the reliability of their forecasts shows that they have repeatedly underestimated how quickly renewables would be deployed.

With climate change risk as unfamiliar territory for many firms and investors, there may be a temptation to rely on the ‘map’ provided by scenario analysis. While these models can help companies think through different scenarios, operational and investment decisions will need to take into account the inherently unpredictable nature of future developments and prepare as best they can for that uncertainty

Disclosure shouldn’t be promotional; it’s a tool to help understand risk.

Companies may need to shift their thinking to seeing climate change risk disclosure not as something companies do to promote an image of themselves as environmentally friendly, or to technically fulfil a requirement, but as a necessary part of their overall risk analysis to identify emerging threats and opportunities. Similarly, analytical tools like the Transition Pathway Initiative, and increased disclosure from companies can help provide data, but ultimately investors must use this information to broaden their understanding of the risks facing their own unique portfolios.

Overall, the TCFD’s recommendations are a good start, but the challenge will be implementation.  There are no shortcuts to such an approach. This will likely require the formalisation of the voluntary disclosures into financial disclosing requirements, which will have to be applied on a national level. But just as important will be the shift in culture and discourse puts climate change risk firmly within the mainstream: considering it not as an environmental or PR issue, but as part of good management practice.