There are currently no universally adopted standards for how companies should measure and report on their climate risks & this is a major impediment to harnessing capital markets' power in accelerating the transition to a net-zero economy. Fortunately, this might all be about to change.
What can financial disclosures achieve?
Lord Adair Turner addressed this question in his keynote talk. The first goal of disclosures is in providing investors with accurate information on companies' CO2 emissions. Comprehensively measuring emissions is not straightforward, particularly so-called "Scope 3" emissions, which capture information such as business travel and emissions created by users of the reporting company's products (see here for an explanation).
There is also the issue of how investors should use this information. It would make no sense, Lord Turner argued, to penalise companies based on their current emissions. Some firms – bus companies, for example – have high current emissions but in a wider context, are vital in reducing society’s overall emissions. Moreover, the world will continue to require steel, cement, and other carbon-emitting industries for some time to come, so any ranking needs to be relative and forward-looking, calculated at the sector/industry level.
The second area where consistent disclosures can be useful is in providing clarity about the reserves and resources of fossil fuel producers. Around two-thirds of known fossil fuel reserves will need to be left in the ground if we are to have more than a coin toss chance of keeping average warming below 2 degrees Celsius. This will inevitably mean large write-downs on some oil and gas companies' books and losses for investors financing these companies. These stranded assets extend beyond fossil fuel reserves: many other assets are close to being effectively worthless, including internal combustion engine factories and blast furnaces.
Third, disclosure standards can be a powerful disciplining device in ensuring that firms follow through on their net-zero commitments. To fulfil this role, disclosure standards need to allow investors to interrogate firms’ strategies. An important issue here is whether the scope of standard setters’ efforts should extend to the text commentary in the front-end of firms’ accounts, which describe forward-looking judgements about strategy. A particularly pressing issue is the need for clearer information about firms’ assumptions on carbon offsets, an area of huge potential vagueness. The need for greater clarity over strategies and commitments also extends to financial firms. Here the complexity is compounded as investors must assess the credibility of individual firms’ strategies and that of their overall portfolios.
Disclosures as a tool for triggering behavioural and cultural change within firms
Morgan Slebos, Megan Bowman and Paul Fisher discussed the high-level objectives of a disclosure regime for climate risks. A key theme was the emphasis on disclosures as a tool for triggering behavioural and cultural change within firms. To disclose their risk, firms’ boards will first need to work out what those risks are. Any company thinking they are not exposed to climate risks has not thought hard enough about the issue. Once the risks are understood, firms’ boards will attempt to mitigate them, enabling them to report a good story. There is substantial evidence that financial reporting constrains risk-taking in this way, albeit imperfectly.
Another theme of their discussion was the inherent difficulty in measuring climate risks: historical data are of limited value, and we are in the domain of “what if” scenario analysis. Those designing disclosure standards need to be wary of the risk of being overly precise, focusing on risks that can be measured quantitatively rather than those that matter most.
The need for forward-looking, dynamic information on firms’ strategies for managing climate risk
Martin Weale, Morgan Despres and Luba Nikolina considered consumers' needs on firms' climate exposures and the challenges they face. A theme of their discussion was the need for forward-looking, dynamic information on firms’ strategies for managing climate risk.
There has been a real wake-up call in the investment community on climate risks over the past year. This is now viewed as a genuine financial risk, rather than a moral consideration or regulatory requirement. An asset owner wishing to decarbonise her portfolio has three broad options. She can divest from carbon-intensive assets and shift towards a carbon-neutral portfolio. While feasible, such a portfolio would be highly concentrated and financially risky, and in macro terms, it would simply shift the risk elsewhere in the system. Another option is to invest in positive carbon solutions, such as renewables, carbon capture and storage technologies and reforestation, but at present, this cannot be done at sufficient scale. The only viable option is to engage with underlying businesses and their long-term climate strategies via her asset managers. The opacity of information on firms’ strategies is a significant barrier to doing so effectively.
Data quality is also a challenge for regulators in assessing the systemic risk implications of climate change. The Network for Greening the Financial System – a coalition of central banks and regulators working on this issue – has established a working group to better articulate regulators’ needs.
What are the practical barriers faced by information providers in their climate disclosures?
Richard Monks, Spencer Dale and Wim Bartels discussed the practical barriers faced by information providers in their climate disclosures.
Many companies continue to find disclosing their own emissions challenging, let alone their strategy and commitments 5-10 years ahead. Picking up a theme of the earlier discussion, text commentary is vitally important – publishing data is worthless if firms don’t explain what it means. This is an area where auditors can help, assisting firms with making their processes and controls robust, challenging models, and identifying anomalies in assumptions made. For instance, there is an intrinsic inconsistency if a company claims to be on a pathway to 2 degrees while also valuing its assets on a business as usual basis.
There remains confusion in the investment community over materiality. While all investors care about financial risks of climate change to the reporting company, different investors will care to different degrees about the impact a company’s activities might have on the climate or its contribution to wider sustainability goals. The work of the IFRS Foundation can provide useful clarity here.
The excellent recent work of the NGFS on climate scenarios has highlighted the great uncertainties involved in such calculations. Even if we knew precise carbon pathways, the impact on the energy system would remain hugely uncertain, and any scenario chosen would be arbitrary. An alternative and simpler approach for the IFRS Foundation to consider could focus on confidence bounds for future energy prices. Companies could be asked to assess their viability across this price band. This would provide investors with a simple metric, which it would be straightforward to extend if alternative price assumptions were of interest.
How should the IFRS proceed?
Frans Berkhout, Lucrezia Reichlin, Clara Barby and Sheldon Mills closed the forum by discussing how the IFRS Foundation should proceed in this area.
A big strategic question is whether to take a globally coordinated approach to develop climate reporting standards from the outset or to embrace regional competition for a period. Panellists saw clear benefits in starting with a global approach – this ultimately has a better chance of meeting investors' needs for a global reporting system. There was strong support for the IFRS Foundation in leading this process, drawing on other stakeholders' guidance.
Panellists then discussed whether the IFRS Foundation should proceed with a “climate first” approach, prioritising the development of climate-related disclosures before considering how wider sustainability factors should be reported. This was widely regarded as a sensible and pragmatic way forward. With the COP26 on the horizon, there was a real window of opportunity if the Foundation moved expeditiously.
A key theme of the discussion was the need for a dynamic process that recognises that standards will need to evolve through time as our understanding of the risks improves. Moreover, there was no question that wider sustainability considerations affecting enterprise value would need to be considered down the road – the past year has demonstrated how quickly social attitudes can change. It would be wise to design reporting frameworks that can respond to these changes. In this regard, the IFRS Foundation might consider setting up a multi-stakeholder consultative committee to aid this dynamic process.
Finally, the panel discussed what success would look like for the IFRS Foundation’s work in this area. The right governance framework would be crucial – one that is regarded as legitimate and allows a large number of jurisdictions to sign up to the process; one that honours the needs of all stakeholders; and one that allows some countries to move ahead of others while also ensuring a consistent and common approach.
Watch the recording of the policy forum below: