The 2016 edition of the World Economic Forum’s annual Global Risks Report lists “failure of climate-change mitigation and adaptation” as the greatest risk facing the world over the next 10 years. That was the collective judgment of 742 surveyed experts and decision makers drawn from business, academia, civil society and the public sector.
Last year’s international climate conference in Paris saw 195 countries agree to keep the global temperature rise below 2 degrees Celsius. To see this through, governments are required to produce Intended Nationally Determined Contributions (INDCs) every five years to review their progress in reducing emissions and their plans for the following five years.
For that reason, governments and multilateral actors are mobilising to decarbonise a heavily fossil fuel-dependent economy. In the course of this process, it is becoming increasingly evident that many fossil fuel reserves will have to be left untouched if this target is to be met – thus removing their value. The relevance of this to the financial sector is its exposure, from investment firms to pension funds and insurance policy holders, to the value of these assets, hereon called climate-related financial risk (or climate risk for short).
While opinions on mitigating climate risk have been wide-ranging and diverse, most financial actors agree on the necessity of a clear method for disclosing a firm’s exposure to a low carbon economy transition (e.g., those assets which may become ‘stranded’ in this scenario). This article reviews where demand for this disclosure is coming from and the current progress in making such disclosures accurate and effective.
A March 2016 report by the European Systemic Risk Board (ESRB), ‘Too late, too sudden’ contributed to a growing weight of evidence that the time for firms to act on climate risk is imminent. If coordinated action is not taken immediately to steadily transition away from fossil fuels, an abrupt transition will inevitably occur in the future; with a sudden repricing of carbon-intensive assets and a strong hit to the financial sector and the global economy. Indeed, a recent report from the Grantham Institute indicated that firms that fail to plan for this climate risk could face bankruptcy.
The ESRB report stated that the implications for systemic risk depend on the exposure levels of entities – highly leveraged financial institutions in particular – to carbon-intensive assets and the specific form of emission abatement policies chosen by governments, both of which are highly uncertain. It was thus suggested that making these risks transparent through disclosure and stress testing will be central to addressing the resilience of the financial sector in a low-carbon transition. In fact, bankers present at the Paris Agreement in December argued in favour of regulations to compel financial firms to declare their exposure to holdings that might lose value due to climate change.
We can, therefore, expect a significant increase in climate-related financial legislation soon – aimed at risk disclosure. In fact, this is already starting to happen, a good example of this is the EU’s non-financial information directive, due to come into effect on the 1 January 2017. It is designed to raise the transparency levels of the social and environmental information provided by organisations in all sectors across all EU Member States. The commission has cited the directive as a “continuous endeavour” that will likely encounter more onerous requirements down the road.
Likewise, France has introduced mandatory reporting of the annual contribution to, and risk from, climate change for finance companies, while Singapore has launched a sustainability initiative which requires similar disclosure from the country’s stock exchanges. It is probable we will see many more of these national initiatives as the Paris Agreement’s INDCs begin to bite. Sensing the future, the big four Australian Banks have established a working group to agree on a consistent and comparable method for measuring and disclosing climate performance. Firms that look ahead like this will have the upper hand when the mood begins to change.
Yet, to actually be effective, disclosures would need to be consistent and comparable across the global financial sector and, thus, rely on a common method for measuring climate risk. In this case, it is best to follow the mantra of Michael Bloomberg, who is heavily involved in the climate-finance debate, that “if you can measure it, you can manage it”!
A framework for managing climate risk
Achieving effective disclosure for capital reallocation and stress testing requires the relevant data, yet current risk reporting is not advanced enough to assess carbon risk with any degree of clarity. Existing disclosure regimes, such as IFRS 9, are too quantitative for risks that will be based heavily on judgement; currently mandated sustainability reporting often employs boilerplate language of no use to investors and some 400 voluntary regimes for climate risk reporting provide an environment incredibly difficult to navigate for consistence.
Progress is being made by the Task Force for Climate-Related Financial Disclosures (TCFD), established by the Financial Stability Board last December. Its high level objectives, as set out in the June phase 1 report, are to develop a common reporting framework for climate risk – one that is consistent, comparable, reliable, clear and efficient. This principle-based framework would consider elements of climate risk with potential impacts over the short, medium and long terms, encourage reporting that addresses both risks and opportunities and, perhaps most importantly, could be applied consistently across all countries.
It is clear the Task Force has a very difficult challenge on their hands in designing a concise and focused framework for disclosing material climate risks, which have to be measured at asset level if they are to be granular and detailed enough to inform each investment decision. In December, we will see the phase two report published, expected to include a set of disclosure principles and detailed recommendations and a number of best practice examples from company disclosures.
Following the greater uptake of common disclosures, it won’t be long before firms can expect to see the introduction of climate risk to bank stress testing. The ESRB report recommended incorporating a hard landing scenario into the regular European Supervisory Authorities stress tests, while the Basel Committee is already coming under pressure to include the environment in its normative framework and to improve the total loss absorbency capacity to accommodate climate risk. With the recent strengthening of the EU emissions trading scheme, and over 40 countries and 500 companies putting a price on carbon, climate change will soon be a risk that’s central to day-to-day decision making.
It seems certain that the coming years will increasingly see climate risk related legislation affecting investment firms, as countries come under increasing political pressure to set tough standards. The FSB have recently reiterated that the TCFD is one of their 2016 priorities and with regulators increasingly publishing their intentions there is still time and space for the industry to play a crucial role in setting and aligning the regulatory agenda. Given the misalignment and general chaos of other reporting regimes globally, for instance transaction reporting, the case for firms to do just that is clear.