Climate risk disclosure will soon be required as part of filings by publicly traded companies, according to Gary Gensler, chairman of the U.S. Securities and Exchange Commission (SEC). This development is unsurprising and is consistent with the increasing importance of climate-related financial information to investors’ decision making. It is vital that all investors are aware of the impact of climate information integration and how it affects the companies in which they choose to invest.
Investors should not only think about reallocating their portfolios to align with climate-related targets but should also consider the reality and costs of climate risk on the financial statements of the shares they hold. Financial filings serve as one of the primary sources of business risk information and should be regarded as incomplete and misleading without the integration of climate risks.
For investors to derive the most value from companies disclosing climate risk, it is imperative that they adhere to the recommendations of the Task Force on Climate-Related Financial Disclosure (TCFD). These principles—identical to those found in established financial disclosure standards—are:
The TCFD recommendations have many advantages. They set adherents on a safe path to compliance, provide guidance on how to approach climate risk disclosure, and establish a viable structure for incorporating scenario analysis. These benefit not only financial participants such as asset owners, asset managers, pensions funds, and insurers, but also publicly traded companies.
Although the wider application of the TCFD recommendations has thus far been for determining the format of climate-related financial disclosure, its most important use can be found in the synthesis of climate scenario analysis throughout an organization, especially related to enterprise risk management processes.
Requiring that companies apply the TCFD’s six-step process for scenario analysis ensures the resulting information is consistent and comparable. The advantage is that investors will be better able to tell which companies present the most risk in their portfolios under certain climate scenarios. Additionally, better estimates of key performance indicators (KPIs) such as emission metrics would allow investors better estimations of their own emissions metrics, such as financed emissions (Scope 3).
For investors, applying the scenario analysis recommendation is crucial for a proper assessment of the transition robustness of their portfolios.
Apart from preparing investors for stringent climate-related regulation, the TCFD provides a consistent, reliable formula to gauge climate risk positioning across time and changing climate-related, socioeconomic developments.
There are several avenues for understanding and integrating climate scenario analysis into the risk management process that will eventually be disclosed in TCFD reports. However, as indicated by the TCFD, the process can be cumbersome and resource intensive. Therefore, to adequately capture all the necessary angles to the scenario analysis and climate risk information integration, third-party specialist technology providers come in very handy to investors.
Climate-related information integration manifests in two ways:
This is demonstrated by the creation of climate goals, strategies, and policies that may include the consideration of climate risks in the general business strategy of an organization. The preliminary integration is mostly qualitative.
Disclosures come in the form of statements on general sustainability and climate. This stage is often fraught with a reproduction of scientific climate findings and offers little financial risk communication, limiting its decision-making value.
By using the recommendations of the TCFD, investors and the companies in which they invest are guided on how to use the various climate scenario information accessible to formulate policies and strategies that present a true and fair view of their business’ prospects.
By following the TCFD recommendations, investors and the companies in their portfolios are guided to explore the appropriate responsibilities for the process, as well as oversight to ensure trustworthiness.
This involves the incorporation of assumptions, estimates, and projections into risk-management activities and the preparation of financial statements.
The climate risk recognized in the preliminary integration is incomplete without the representation of such recognized risks in operational plans and financial reports. Deep integration is mostly quantitative.
For example, a company that recognizes capital assets are at risk of becoming obsolete because of climate risk must disclose this in its financial statements. They also must go further and reflect this in the calculation of the discount rate being applied to the writedowns of such assets.
For investors, information on the various types of risks is critical to developing investment strategies. Company reports have value because they serve as one of the primary sources of business-risk information. It is, therefore, imperative that investors require companies in which they invest to include climate risk parameters in determining the projections used to produce financial statements.
In assessing financial climate risk information, investors and other users must use either preliminary or deep integration. This will help them determine the decision-making value of the disclosed information.
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