Climate change and preventing the next global financial crisis

When it comes to climate change many businesses deserve credit. But they don’t necessarily deserve investment.  Corporates have largely woken up to the challenge of climate change over the past two decades. They freely admit that it will affect their long-term interests. They collectively call for stronger government action. And they have made good progress in reducing their own emissions.

However, businesses are still systematically failing to properly report on how they will be affected by a warmer environment. In many cases this is because they themselves do not fully grasp impacts and implications. So although some companies do indeed deserve praise for taking a positive position on climate change issues, this does not always go hand-in-hand with a positive increase in value.

The problem is that few companies are currently providing specific details on their climate risks and opportunities, taking plausible positions supported by science. This lack of information harms the ability of investors, analysts, insurers and regulators to correctly determine prices and value assets. In turn, this undermines the efficiency of markets, creating the conditions for economic shocks over the longer term.

The task at hand: Task Force for Climate related Financial Disclosures recommendations

To address this challenge, the Financial Stability Board, an international body composed of central bankers and finance ministers from the G20 and European Commission convened the Task Force for Climate related Financial Disclosures. Chaired by Michael Bloomberg, a philanthropist, the task force has now released its initial recommendations, with a final version following consultation inputs expected by June 2017.

The development of these recommendations has been supported by a number of highly influential organisations. These include some of the world’s biggest companies and investors, such as JPMorgan, the Industrial and Commercial Bank of China, Tata Steel, Dow Chemical, BHP Billiton and Aviva Investors. It also includes the Big Four accounting firms, as well as the credit rating agencies Moody’s and Standard and Poor’s.

At the heart of the recommendations is the guidance that businesses should provide a much clearer picture of the risks they face from climate change, as well as their opportunities they could seize in the shift to a sustainable, low carbon economy.

The view from the task force is that in most advanced economies this is already a legal requirement under existing disclosure rules, where companies should report on all material opportunities and risks. It is just seen as something that is currently being done badly.

Institutional investors that consider longer time horizons – such as pension funds, insurers and asset managers – have been the strongest advocates for improving disclosure to date. Many of them now also consider themselves bound to take into account environmental factors as a part of their broader fiduciary or regulatory duties, as they will impact performance and returns.

Being accountable

These institutions are putting increasing pressure on companies to improve disclose. For example, Blackrock, the world’s largest asset manager with over US$5tn under management, has made climate change one of its top engagement priorities with company leaders over the coming year. What all this means is that it is no longer enough to just write platitudes about recognising the challenge of climate change. Nor is it sufficient to simply improve operational efficiency and reduce emissions, without fully taking into account the impacts of the transition to a sustainable, low carbon economy.

Reporting needs to be in the language investors would expect to see, providing verifiable data based on commonly-used metrics, alongside a clear narrative of risks and opportunities. This will enable them to assess a company’s performance and prospects, comparing it against competitors in the marketplace. To do this, businesses will need to learn how to properly assess their value-at-stake. This involves working through plausible climate change scenarios, taking into account factors such as the impact of regulatory change and carbon pricing across key geographies, alongside concurrent technology breakthroughs and shifts in consumer behaviour. It is also very important to consider the physical impacts of climate change, such as the operational and supply chain disruptions that may occur from more frequent incidents of drought and flooding.

A variable forecast

Of course predicting the future is challenging. Small differences in assumptions today can create huge gaps in expectations a few years down the line. The oil majors have been pioneers in the art of scenario planning, but still come to wildly different conclusions from one another. Shell projects that global oil demand could peak within the next decade, whereas Exxon expects continued growth through to 2040.

But over time scenarios are likely to become increasingly standardised. This will occur through a combination of better science, clearer technology pathways and greater climate policy certainly. Helpfully, there is now a growing list of highly authoritative sources which can be used to help companies make meaningful assessments. These include assessment reports from the Intergovernmental Panel on Climate Change and energy transition scenarios from the International Energy Agency.

These landmark reports are already being used to help companies set their own science-based targets compatible with maintaining global warming below 2 degrees. Assumptions can also be based on the nationally determined contributions submitted by individual countries as part of the Paris Agreement.

Contextual information will sometimes need to be presented alongside detailed, primary data collected from within a business, to reveal the specific extent to which companies are exposed to wider risks and opportunities. However, in other cases the key requirement will be demonstrating sound judgement in understanding where simple estimated data could be sufficient, or excluding areas that are not materially relevant.

The important thing with disclosures is not to come to the same conclusions as everyone else. After all, everyone will be implementing different strategies to outperform their competitors. But companies do need to stand on some common ground when going through the exercise of assessing their climate-related risks and opportunities. Then, so long as they are transparent about the assumptions they used, others will be able to independently judge their credibility.

At the same time, companies need to outline how they will respond to these risks and opportunities. This will include integrating them into their overall strategy, governance mechanisms, risk management processes, and broader metrics and targets. This improved reporting is not a matter of advocating one particular course of action on climate change. Investors will make their own assessment of what is likely to happen with climate change, looking at how this will affect the value of markets and companies. As Mark Carney and Michael Bloomberg said in a joint article about the launch of the draft recommendations, “the right information will allow optimists and pessimists, sceptics and evangelists, to back their convictions with their capital.” But without the right information they run a serious risk of getting things wrong, with potentially catastrophic consequences.

Equally as importantly, companies also need to use this process as an opportunity to ensure that their boards and senior management are properly informed about the potential impact of climate change on the business. Making disclosures should not be seen as an end in itself, but a fundamental part of setting an effective strategy for long-term success.