Climate change, disclosures and financial materiality
With rules around climate-related disclosures likely to be tightened this year, how do companies plan and prepare for a very different future?
By Anj Chadha – Chief Executive – ESG360°
Companies have historically pursued corporate social responsibility (CSR) strategies and disclosed impacts on external stakeholders because of compliance requirements, such as the Non-Financial Reporting Directive (NFRD), which is currently being revised by the EU and will become the Corporate Sustainability Reporting Directive (CSRD). The NFRD included disclosures on issues such as human rights, diversity and the environment, explaining any material impacts that the company’s activities had in these areas.
The Task Force on Climate-related Financial Disclosures (TCFD) became the first methodology that requires companies to carry out scenario planning to understand the impacts of climate change on their business; and in doing so, consider how climate issues had a bearing on financial materiality, especially in the medium to long-term, which goes beyond the usual planning horizons of three to five years.
Companies need to construct alternative, plausible futures and narratives to understand the strategic and financial materiality of these issues. This requires a reasonable organisational effort, given the level of uncertainties involved, making this process challenging but extremely valuable and relevant. To that end, the Financial Reporting Council (FRC) is currently undertaking a survey of FTSE 350 companies with a specific focus on scenario planning. It recognises this is one of the key gaps in companies’ skillsets, which may prevent them from producing meaningful metrics and targets for climate risks and opportunities.
The climate issues faced are also incredibly dynamic, so it’s imperative they are embedded within companies’ strategic and operational risk management processes and part of business-as-usual activity. For this purpose, it’s advisable for companies to integrate climate-related matters within enterprise risk nanagement (ERM) and other governance processes, such as performance metrics and targets.
The audit and risk committees need to play an important role to ensure that material climate risks and opportunities are discussed at the board table and governance structures must reflect this new reality to operationalise climate matters.
Climate change is about more than simply disclosure
While the typical reaction from most companies has been to treat climate issues as compliance, corporate social responsibility (CSR) and reporting matters, there is a rather important reason boards need to consider things differently. This is the concept of ‘non-stationarity’ – when the past is a poor prediction of the future. Due to the increasing amount of CO2 in the atmosphere, currently around 415 parts per million (ppm), and the subsequent warming and biodiversity loss beyond the planetary boundaries, it cannot be assumed the past is a reliable guide.
These planetary changes are likely to create immense physical risks in a non-linear fashion globally, which will challenge the business-as-usual assumptions.
“The climate issues faced are incredibly dynamic, so it’s imperative they are embedded within companies’ strategic and operational risk management processes and part of business-as-usual activity”
The risks are already starting to manifest themselves, for example with the UK Met Office issuing its first ever extreme heat warning, or the floods in Western Europe. This in turn will accelerate the race to net zero, which may result in disorderly transition to a low-carbon world, creating significant transition risks and opportunities for the private sector.
Questions boards need to ask themselves
Financial statements don’t fully account for the financial implications of non-financial factors, so they don’t reflect future risks and liabilities arising in the next five to 15 years. As these so-called non-financial factors become increasingly financially material, institutional investors, such as pension funds, are likely to challenge the efficacy of capital asset pricing models (CAPMs) and reorient them to factor in these future externalities (which may greatly impact future cash-flows). This reorientation is very likely to impact their investment decision-making and cost of capital. In many cases it already is, given the hot topic of ‘stranded assets’, for example coal mines or gas power plants, losing value as a result of the low-carbon transition.
Some of the critical questions boards need to consider include:
Is the company’s strategy robust for the biggest structural shift the market has ever experienced?
Will the company be able to operate under the same assumptions it has in the past, and, if so, for how long?
What are the impacts of these transition, physical and legal risks on the business? Are there any opportunities for the company to capture in this new environment?
Without substantial changes to its business model, will the company be able to raise capital in a new world that is driven by sustainable finance, for how long, and what would be the likely cost of capital?
Scenario planning as a strategic tool
These are very complex questions and require rigorous analysis. Scenario planning is a tool that can be used as an iterative process, which provides an avenue to analyse these complex matters. Scenarios are not predictions or forecasts, but they allow companies to test their current strategic assumptions in a range of plausible narratives.
It is a learning exercise for the board and management at various levels, which greatly helps in collective understanding of major trends and their implications on a company’s business beyond the usual three to five years planning horizon of companies. Scenario planning also helps build a roadmap to track these key developments and allows for strategic planning of new options.
TCFD is maturing as a methodology and becoming a gold standard
The IFRS Foundation has recently announced it will be establishing an International Sustainability Standards Board (ISSB) at COP26 Glasgow in November, alongside the International Accounting Standards Board (IASB). This new board will focus on climate change as the first ESG issue in scope to create guidelines based on TCFD methodology to account financially for material climate issues in annual reports, which will bring enterprise value in focus.
