It’s been four years since the Task Force on Climate-related Financial Disclosures released its draft recommendations (TCFDs) but getting to grips with the finer details remains a significant challenge for a lot of companies.
The TCFDs were developed to allow investors to understand how climate change will affect a company’s current and future financial viability. They are now the default reporting mechanism for climate disclosure and provide a much-needed central framework. However, they fall short of providing a uniform and comparable disclosure approach, which can leave organisations second-guessing what investors want. If companies are to adequately illustrate the effectiveness of their climate risk management practices and provide investors with the comparable information they need to price in climate risk and navigate the energy transition, it is up to them to bridge this gap.
To do this, companies must cross three interrelated TCFD obstacles. If they get these right, they will be on their way to a more unified and meaningful climate disclosure approach that will satisfy investors and keep them ahead of the dynamic climate change regulatory environment.
1. Quantify existing and future financial impact
The unfortunate truth is that companies are behind the curve in measuring and reporting the current and future financial impact of climate change on their operations. As such, investors are left to make ill-informed decisions on how to price climate risk and where to invest. This market failure could prove to be catastrophic for our planet, unless it is swiftly accounted for.
Companies need to show how future profit and capital could be affected by the physical impacts of climate change and the shift to a low carbon economy. This includes incorporating equity-accounted emissions and their movement over time, revenue splits for their operations (which communicate the variability of future earning prospects), and other markers of adaptive response – such as performance on climate targets to date. While some of these parameters may be easier to capture than others, and subject to varying degrees of commercial sensitivity, their transparent disclosure would do a lot to align corporate reporting with the TCFD recommendations and align climate risk management with the goals of the Paris agreement.
2. Crack open the black box of scenario analysis
One of the most critical tools institutions can use to understand how climate change drives financial impact is scenario analysis. This is the TCFD element companies struggle with the most though.
With over ten different scenarios identified by the Institutional Investors Group on Climate Change (IIGCC), companies risk picking one which may not satisfy investors. Furthermore, details of the assumptions used to model these scenarios tend to be a ‘black box’ made up of multiple discrete factors, all with varying sensitivities across portfolios, geographies, sectors and time horizons.
We argue that it is in the interest of regulators and the financial industry as a whole to develop a set of central scenarios which are tested by all, and where impacts are disclosed over consistent time periods. These scenarios must be appropriately granular (for example including commodity prices by region) and appropriately holistic (including physical and transition risk). Such scenarios currently sit in the academic domain, with companies appearing reticent to adopt them. Similarly, disclosing the impacts of scenarios using consistent metrics – such as impact on the present value of the business, specific assets or specific projects – would be highly beneficial. Where these are not achievable, the disclosure of impacts according to relevant financial metrics used by the company (such as revenue growth) would still offer insight to investors.
3. Challenge the traditional stress-testing approach
While scenario planning and stress-testing are methodologically identical, stress-testing is designed to establish the resilience of a business under the most ‘extreme’ scenarios. Traditional stress-testing exercises, however, consider backward-looking market information and gradual future shifts that are not representative of climate risk, which is characterised by deep future uncertainty and non-linearity.
Companies, therefore, need to be bold in how they imagine ‘extreme’ scenarios, where almost nothing is too unexpected or ridiculous to consider. All kinds of risks must be put to the test and integrated with other corporate scenario planning – from compliance and legal risks to full-bore crisis. Only by building a stress-testing capability can a company know where to focus its efforts for climate resilience – a cornerstone of the TCFD recommendations.
Get ahead to stay ahead
It is clear that for the TCFD recommendations to drive effective action, they need to produce more informative outputs. To get ahead, companies need to transition quickly to a more sophisticated climate risk evaluation and disclosure approach. Failing to do so will expose them to wavering investor confidence and to potential non-compliance with the sea-changes in climate change legislation coming our way. The TCFD recommendations aren’t just about disclosure; they’re prescribing a framework to ensure the longevity of businesses far and wide. It is up to companies to make sure they take the right steps to get that framework right.