Financial disclosures continue to be a key concern for climate risk management. Sonia Shah looks at recent developments in the legislative and regulatory landscape.
Last week, the government unveiled its 10-point plan to achieve net zero carbon emissions by 2050. Heralding a ‘green industrial revolution’, the plan includes a shift in energy provision, more efficient homes and a new deadline for the sale of electric cars.
The plan aims to actively incorporate green finance and climate change into the COVID-19 recovery plan, creating hundreds of thousands of jobs by 2030. Achieving this depends on matching public investments to emerging technologies and innovative practices. This, in turn, relies on appropriate disclosures to help investors identify opportunities.
Factoring climate change into the coronavirus recovery plan is a sentiment echoed by the Bank of England. In a recent speech, Andrew Bailey stressed the importance of improving the UK financial system’s resilience to the impact of climate change, and the need for rapid action.
This includes making use of all available data to develop good metrics and make climate-related disclosures. The delayed Biennial Exploratory Scenario on climate risk will now take place in June 2021, and should develop a clear picture of climate risk in the UK.
Mandatory climate risk disclosures before 2025
In line with Supervisory Statement 3/19, banks, building societies and insurers have a deadline of 2021 to establish appropriate governance, risk management, scenario planning tools and a taskforce for climate risk-related financial disclosures (TCFD) with aligned disclosure practices.
The Prudential Regulation Authority (PRA) had not originally given a deadline for this, but updated its expectations with a Dear CEO letter in the summer to increase the pace of change. HM Treasury evidently felt the same and introduced mandatory disclosures for firms operating in the UK, noting that a voluntary approach will not have the desired effect.
Once again, timing is crucial as the Treasury encourages a green recovery and emphasises the need for greater transparency to support capital allocation, inform pricing and drive sustainable change.
Some firms will fall under multiple categories, reflecting transparency for clients and investors as the top priority, with broader disclosures following further along the timeline. Using TCFD’s guidelines as the gold standard, the treasury urges firms to start work on disclosures and refine their processes over time as new tools and metrics emerge.
Building transparency, trust and tools for climate risk
In a speech at the Green Horizon Summit, the newly appointed CEO of the FCA, Nikhil Rathi, emphasised the importance of transparency and trust when transitioning to a low-carbon economy.
Greater transparency can be achieved through TCFD-aligned disclosures at every step of the investment chain. Consultation paper 20/3 supports this approach and requires UK premium-listed companies to disclose climate risk or explain the decision not to. It will be adopted for reporting periods from 1 January 2021.
Building trust in green investments is also a challenge. Standardising definitions of green products in terms of design and delivery will offer assurance that investments are truly sustainable and help prevent greenwashing. To achieve this, the FCA supports plans for a Sustainability Standards Board with increased use of climate related disclosures.
In turn, insightful disclosures depend on better use of tools to develop metrics and methodologies. Good market collaboration will establish best practice, including the PRA and Financial Conduct Authority (FCA) co-chaired Climate Financial Risk Forum.
In the first half of 2021, the FCA will also publish proposals for disclosures for life insurers, asset manager and pension providers.
The European Central Bank (ECB) has also developed supervisory expectations and consultation recently closed for its ‘Guide on climate-related and environmental risks’. The guide focuses on climate and environmental factors on prudential management under Capital Requirements Directives and Requirements (CRD/CRR), including the potential impact on capital requirements and buffers.
Material risks must be reported in the Internal Capital Adequacy Assessment Process (ICAAP) and the ECB reminds banks that information cannot be excluded because it’s difficult to measure or express. Developing basic tools and standardised taxonomies will lay a foundation for more-sophisticated techniques over time.
Once again, the ability to make appropriate disclosures is a key concern. Disclosure processes should include all business lines and portfolios, key performance indicators, key risk indicators and the ability to track progress.
The ECB expects material risks to be reported, in line with the European Commission’s supplementary guidelines on non-financial reporting (as a minimum) and TCFD, to be accompanied by clear criteria, definitions and methodologies. If risks are seen as immaterial, reasoning should be provided, included quantitative and qualitative information. Groups should also report greenhouse gas emissions and all firms should explicitly consider any wider information for inclusion.
The use of metrics to effectively track progress against preset targets is a common problem with disclosures, as reflected in the Financial Reporting Council’s (FRC) Climate Thematic’ review.
While companies generally meet the minimum disclosure requirements, they don’t go far enough against investor needs. Reports often focus on opportunities rather than risks, and where risks are discussed it’s provided as a narrative description and not reflected in the financial statement.
Where risks are identified, they are not clearly fed into strategy, business models and other decision-making processes, and the FRC stresses the role of the board to achieve this. Audit firms also have a role to play, through consistent audit methodology, templates, quality assurance processes and input from specialist teams.
Climate risk and financial risk
Making the link between climate risk and the financial impact is crucial, especially around the risk of material misstatement in financial statements. Many professional bodies and regulators are working on training programmes, and sector approaches to help embed climate risk governance and strategy.
The TCFD paints a similar picture around the current quality of disclosures, with its 2020 Status Report noting the need for further work, despite significant progress to date.
Key concerns include making the connection between climate risk and financial risk, and the impact on resilience. Investors are predominantly interested in the impact of climate change on business and strategy, and TCFD urges disclosers to focus on these areas.
The focus on disclosures highlights the continued need for greater transparency around climate risk management. As the UK focuses on a green recovery after coronavirus, connecting investors to genuinely sustainable projects and companies will be more important than ever.