Many organizations routinely disclose the impacts of their activities on the environment to answer questions about the company’s impact on the environment. For example, 6,500 companies routinely do so in CDP’s annual disclosure cycle.
The right question to ask, however, is “How are climate risks impacting your company?” This question is being asked with greater frequency as the direct physical impacts of climate change expose businesses to new and unpredictable strategic and operational risks. The indirect and transition impacts of climate change, such as changing regulatory requirements toward a low-carbon economy or evolving customer demands, are also creating new risks and opportunities.
In response, stakeholders and investors are looking for greater clarity and transparency on the impacts of climate on organizations’ current and future financial performance. A recent survey found that 17 percent of European pension schemes consider the financial impact of climate change in their investments, up from 5 percent in 2017.
The push to enhance climate risk disclosure is seen in the recommendations of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD). The TCFD sets out a framework for voluntary, consistent disclosures that consider the physical, liability and transition risks and opportunities associated with climate change. In short, it’s a framework that enables companies to disclose their climate risk profile and integrate that into mainstream financial filings. This provides investors with decision-useful climate-related risk information to better understand the risks they are running and steward capital allocation and financial investments more effectively.
Where are we one year after the TCFD recommendations?
The TCFD recommendations are receiving broadening and accelerating support. More than 250 organizations, including investors, associations, policymakers and companies with a market cap of over $6.6 trillion, publicly have expressed support for or committed to adopt the recommendations.
However, as companies start to dig deeper into the framework, questions around how to implement the recommendations are growing. Research by CDP and Marsh & McLennan Companies’ Global Risk Center (PDF) has identified that companies struggle with three key challenges:
- Securing leadership support for a wider approach to climate risks
- Overcoming siloed risk-management processes
- Limited experience with climate change scenario analyses.
1. Securing leadership support
The TCFD recommendations call for enhanced governance by boards of directors and management of climate risk and opportunities to properly define the impact of climate change on financial performance.
To meet these requirements effectively, many boards will need to expand their horizons around how they consider climate issues. Research undertaken by CDP and its sister organization, the Climate Disclosure Standards Board (CDSB) (PDF), suggests that more than eight in 10 companies report oversight of climate change issues at the board level. However, the global research also found that only 10 percent of companies actually incentivize boards to prioritize climate risks. Looking at U.S.-specific data, according to recent NACD data, only 6 percent of boards view climate change as a top-five issue affecting their company in the next year and only 9 percent over five years. Contrast this with the findings of the World Economic Forum’s annual Global Risks Report 2018, which ranks climate- and environment-related threats as the most likely and most damaging over the next decade.
Boards and leadership may primarily use the reputational lens to consider climate risks associated with the company’s potential impact on the environment and not fully factoring in short- and long-term direct links to financial performance. Company-wide strategies, driven top-down and supported by strong leadership and governance, will be essential to shift the corporate dial. As one company’s executive aptly noted, “Climate resilience has to start from the top; if nobody is measured by it, who cares?”
2. Siloed risk-management processes
Most businesses understand how to mitigate conventional risks, which can be relatively easily isolated and addressed with standard risk-management approaches. But when it comes to complex risks embedded in interconnected systems, such as those related to climate risks and the changes associated with a transition to a low-carbon economy, standard approaches don’t work.
For example, recent CDP research to assess companies’ readiness for TCFD implementation found that of the over 1,500 respondent companies, only 34 and 28 percent, respectively, are considering physical risks and regulatory and transition risks associated with climate change beyond six years.
Limited, short-term climate risk analyses will not be sufficient to provide organizations, investors and other stakeholders with a mid- or long-term view of the potential direct physical and transitional impacts of climate risks and opportunities.
Other research has shown how climate risk assessments are affected by a lack of clarity on risk definitions, the identified risks and which function “owns” them. Managing climate risk cannot be the sole responsibility of a siloed individual or group within an organization, such as the sustainability team. As one sustainability leader noted, “I may be just one of two people in the organization who have heard of the TCFD recommendations.” Responding to the TCFD will require broad ownership and understanding of climate risks and opportunities and the financial impacts and input from across the organization.
3. Limited experience with climate change scenario analysis
The TCFD calls on organizations to “describe the potential impact of different climate scenarios, including a 2-degree Celsius scenario, on the organization’s businesses, strategy, and financial planning.”
Organizations face a variety of challenges and potential roadblocks in translating climate scenarios to integrated, meaningful financial analysis. Differing types of climate scenarios and widely varied outcomes (even across the most authoritative models) introduce uncertainty on which climate scenarios are appropriate to use. The next step is to translate these climate-economic scenarios into financial impacts. Most existing climate scenario models were developed for economic and academic use cases, not financial ones. Existing scenarios are not just a “plug and play” exercise and require thought and input from experts across the organization. As one company summed up the challenge: “In some sense, the process involves a lot of very educated guesswork, but not everyone guesses in the same way.”
Companies also will need to make decisions on how to integrate this analysis into ongoing strategy and scenario planning or risk assessment. Finally, companies will need to link scenario impacts to future business performance. A general lack of historical and empirical data links climate and economic impacts to financial outputs.
Adopting the recommendations fully to the point of integration with mainstream financial disclosures will likely be a staged effort that takes place over time. Interim steps include CDP’s integration of the TCFD recommendations into its sustainability reporting framework. As companies move forward in their efforts, there is a huge need for practical guidance on “what works,” for example, knowledge hubs, such as those powered by CDSB. Equally important will be initiatives to support peer learning and case studies such as the initiative by MMC Global Risk Center and CDP.
The long-term horizons of climate impacts typically extend beyond the scope of business planning. Business — and especially finance — works on a very short-term cycle, with quarterly financial reports being the norm. The horizon for monetary policy extends out to three years. For financial stability, the horizon is extended, but typically only to the outer boundaries of the credit cycle — about a decade. In other words, once climate change becomes a defining issue for financial stability or robust corporate performance, it already may be too late unless significant action is taken now to measure and disclose climate-related factors.
The shift to assessing and reporting climate resilience is challenging, but offers real gains for companies in surfacing latent risks and opportunities. Companies that can embrace this new world order, ask the right questions and learn fast will gain competitive edge and secure long-term sustainable growth.