The financial sector's seemingly sudden embrace of enhanced climate risk disclosures may have taken many by surprise, but the trend has actually been years in the making. Many of the sustainable investment bodies that have led calls for more sophisticated reporting on climate-related risks have been making their case for over a decade, while the Task Force on Climate-related Financial Disclosures (TCFD) that has played a central role in turbocharging corporate and investor interest in the concept was established by former chair of the Financial Stability Board (FSB) and Bank of England governor Mark Carney back in December 2015.
The group, which was announced on the sidelines of the Paris Climate Summit, came in response to demands from G20 finance ministers and central bank governors for a formal review of how the financial sector could take account of climate-related risks and opportunities. As such the TCFD was given the remit to "make recommendations for consistent company disclosures that will help financial market participants understand their climate-related risks".
The group had heavyweight clout and far-reaching influence from the start, with Michael Bloomberg, founder of financial data and news provider Bloomberg, appointed chairman of the Task Force and senior business figures from across the G20 representing both the preparers and users of financial disclosures. The taskforce got to work and draft disclosure recommendations were released in December 2016, with its final recommendations then confirmed in June 2017.
The recommendations were structured around four thematic areas: governance, strategy, risk management, and metrics and targets. The focus was on areas that were widely seen to have failed in the run up to the 2007/08 financial crisis, with the taskforce stressing that lessons from that period should be applied to the long term threat presented by climate change. "The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values," the TCFD's report on its recommendations stated. "This has resulted in increased demand for transparency from organisations on their governance structures, strategies, and risk management practices. Without the right information, investors and others may incorrectly price or value assets, leading to a misallocation of capital... One of the most significant, and perhaps most misunderstood, risks that organisations face today relates to climate change."
The costs associated with climate change, per a Value at Risk model cited by the Task Force, was estimated at up to $43tr by the end of the century. Transitioning to a low carbon economy was estimated, then in 2017, to require some $1tr a year of investment. Such sums point to the importance of not only getting a proper handle on climate-related risks, but also the way in which the cost of improving climate disclosures are small by comparison.
The Final Report: Recommendations of the Task Force on Climate-Related Financial Disclosures formed one half of two key reports published in 2017; the other is often referred to as the 'Annex', which outlines guidance on how to implement the recommendations. Subsequently, in May 2018, the TCFD with assistance from the Climate Disclosure Standards Board, set up the TCFD Knowledge Hub, an online platform to further assist organisations implement the recommendations.
Since then, the TCFD has published three annual Status Reports, which set out to describe the extent to which organisations are implementing the recommendations. It turns out engagement with TCFD reporting has been steadily building over time.
State of adoption
Looking at the latest TCFD Status Report, published in October 2020, reveals that some 1,500 organisations representing "every major type of financial market participant" have now expressed support for the recommendations, and that levels of disclosure have continued to rise at a rapid clip.
Over 1,300 companies with a market capitalisation of $12.6tr and financial institutions responsible for assets of $150tr are now reporting in line with the TCFD guidelines and over 110 regulators and governmental entities from around the world support the TCFD. Meanwhile, Canada, Chile, the EU, Hong Kong, Japan, New Zealand, the UK, Singapore, and South Africa "have announced new policies, partnerships, or other formal support for climate-related financial disclosure in line with the TCFD recommendations", according to the report. TCFD reporting is fast entering the mainstream.
However, the Status Report also suggests this is a journey that has only just started, and that implementation issues remain to be addressed. "Going forward, it will be important to bring more standardisation to reporting requirements across different countries and jurisdictions, in order to minimise the burden for reporting companies and maximise the value of disclosure for investors," it states.
Other key takeaways from the latest Status Report include:
- Nearly 60 per cent of the world's 100 largest public companies support the TCFD, report in line with the TCFD recommendations, or both.
- Disclosure of climate-related financial information has increased since 2017, but continuing progress is needed.
- Energy companies and materials and building companies lead on disclosure.
- Asset manager and asset owner reporting to their clients and beneficiaries, respectively, is likely insufficient.
- Expert users find the impact of climate change on a company's business and strategy as the "most useful" for informing decision making.
Clearly, it is a mixed state of play. Other evidence for this comes from the UK, where HM Treasury in November 2020 published the Interim Report of the UK's Joint Government-Regulator TCFD Taskforce, which outlined a 'Pathway' for mandatory reporting in line with the TCFD recommendations. The Interim Report warned: "There has been considerable progress, but many organisations are not yet making sufficiently complete or high-quality climate-related disclosures. The FCA [Financial Conduct Authority] observed that, even where companies have established governance, strategy and risk management arrangements that help directors to assess the impacts of climate change on their businesses, they often do not fully describe the nature and scope of these arrangements in their disclosures. The FCA referenced research findings showing that, in 2019, on average across the TCFD's 11 recommended disclosures, only around a third of (premium-listed) companies were making the relevant reports."
It also pointed to further evidence of patchy reporting. "The minister for Pensions and Financial Inclusion wrote to 50 of the largest occupational pension schemes in October last year, requesting information on their climate strategy and disclosure," the report revealed. "Only 13 per cent of respondents were making disclosures in line with all of the TCFD's recommended disclosures, or expressed a clear intention to be doing so in the next year. There was a similar message in recent analysis of asset owners' and asset managers' disclosures by the UN Principles for Responsible Investment."
However, efforts are underway to improve the quality of TCFD reporting across the board. In January 2021, the How to improve climate-related reporting report was published following the first climate-related project from the European Lab of the European Financial Reporting Advisory Group (EFRAG), with a focus on the reporting burden put on insurers. The project was prepared by the Project Task Force on Climate-related Reporting (PTF-CRR) and is relevant to TCFD implementation, because, as one of the Group members Allianz noted in its own 2019 Sustainability Report, "there is no guidance on how different climate scenarios would impact on various types of insurance (eg, personal, Property-Casualty, Life/Health, reinsurance, etc.)".
The report also highlighted some specific weaknesses with current climate risk reporting. For example, it noted that "publications and guidance supporting TCFD implementation focus more on transition risk than physical risk; and transition risks are subject to a more detailed analysis and reporting than physical climate risks". It also stressed that "there are shortfalls with the extent to which companies provide quantitative impact of climate change risk on financial metrics".
The investor perspective
With the landscape suggesting TCFD reporting is still an area under development across all parts of the financial industry, there are myriad views on how organisations should approach its implementation.
Mark Lewis is Chief Sustainability Strategist at BNP Paribas Asset Management, and a Task Force member of the Data User group within the TCFD. He notes that the latest annual letter to CEOs from Larry Fink, chairman and CEO of BlackRock, "namechecks" both the TCFD guidelines and the work of the Sustainability and Accounting Standards Board (SASB). This, Lewis suggests, indicates the way the wind is blowing for the industry, although it does not mean everybody publishing TCFD reports is doing it to the same depth and quality. "There is variation," he admits, but quickly adds that the pressure on firms to improve disclosures is likely to intensify. The election of Joe Biden as US president will impact the world's biggest capital market, for example, and while Trump administration was sceptical about any form of climate policy there is now likely to be a "sea change" in attitudes towards climate risk disclosures from the new administration.
The appointment of Didem Nisanci, part of the TCFD secretariat and previously employed as Bloomberg's global head of public policy, as US Treasury Secretary Janet Yellen's chief of staff provides further evidence of how the new administration is likely to take a very different approach to climate risk. The move sends a clear signal that the US Treasury is going to take climate change much more seriously, Lewis says, which goes beyond the foreign policy change of rejoining the Paris Agreement.
And then there is the nomination of Gary Gensler to serve as chair of the US Securities and Exchange Commission. He is known for being progressive on climate issues, Lewis adds.
Meanwhile, the work of the TCFD goes on, with the group continuing to explore how to enhance reporting best practices. Lewis does not want to single out individual companies as exemplars, but he does note that "the best way to approach TCFD is to think about why Mark Carney would think about it being a good thing".
"He really saw how it would unfold," he continues. "The idea is to give markets more information so they can ask the right questions, to get responses. The basic point is that capital markets are only as good as the information made available to them. If capital is to be efficiently allocated in the world we are heading into, then you need to give information on the risks."
He suggests more and more businesses are starting to grasp this big picture. "It takes two to three reports for companies to really get in the groove, but it is having a genuine impact now, not only in terms of how reporting is being done; it is not an end in itself, we are trying to sensitise investors and all actors on risks associated with climate change," Lewis explains. "It is not a one-off process. Don't publish a report and think 'that's it'. It is really about how you get people to rethink the nature of risk they are facing when it comes to climate change. Think of the Climate Action 100+ initiative; I don't think it would have come about without the TCFD final report, which pressed reasons why disclosures are required to help align business development with the Paris Agreement."
However, Robert Howard, senior compliance manager at welath management firm Charles Stanley, suggests that notwithstanding the Pathway outlined in HM Treasury's Interim Report, there remain certain key hurdles that need to be overcome to improve TCFD reports.
For example, he notes that while the FCA is to consult on climate-related disclosures by asset managers in 2021, amid expectations that the largest will need to comply by 2022, the industry is yet to see a regulatory definition of 'large' in this context.
And the pressure on asset managers to disclose climate metrics on their portfolios cannot be met if the companies held do not yet themselves have that data. "The corporate world needs to publish the data before the asset managers get it," Howard warns.
In theory, asset managers can be doing their own due diligence to get the necessary climate risk data out, but they then run the risk of delivering different data when set against other investors. The issue of accessing data, particularly forward-looking data, is front and centre for wealth managers reliant on data providers such as FE, FTSE Russel, MSCI et al. Theoretically, as investors, wealth managers could be putting end clients into any one of say, 10,000 financial instruments across all asset classes. For any open architecture, whole of market firm to do due diligence on thousands of instruments oneself is characterised as "very difficult", to say the least. It is one thing for a BP or Shell to issue data on their climate-related risk profile, but what about smaller companies on the Alternative Investment Market (AIM); how does this impact investing in growth markets; does it create a playing field that favours the largest firms?
Fundamentally, smaller companies may be developing the solutions to the climate crisis, but if they are not producing data on their climate-related prospects, it leaves a "black hole" for investors.
Regarding good examples of TCFD reports and the influence on asset management, Howard says it is probably too soon to say given the deadline for reporting is really 2022. On the issue of how to best account for climate risks, Howard notes that both the Investment Association and FCA point to the SASB framework as the one that TCFD report builders should look to.
Anecdotally, however, there is still a bit of a wait and see approach regarding requirements, which is further exacerbated by a lack of data or systems. But if aggregate client holdings imply a temperature rise of, say, 10C, it will leave firms looking not to clever, Howard warns. Regulators might view that as a proxy for governance issues, while share action groups might look at it for other reasons. And it would certainly spark conversations with clients.
The case for acting on TCFD reports is clear, but the question of how to respond remains the subject of intense debate. Some argue investors should seek to hold companies with 'good' scores, but there is a counterargument that it is more impactful to hold 'bad' companies and pressure them to get a better handle on their climate risks and effect climate action more quickly. Pooling institutional clout to calculate an Implied Temperature Rise (ITR) metric may be better; if the ITR is not 2C but 3C, this makes it harder for boards of companies to reject urgent meetings.
The Asset Manager View
Richard Burrett, chief sustainability officer at Earth Capital, says the main challenge is how to gain climate knowledge to satisfy TCFD requirements, understand what constitutes a good governance process for climate risks, and understand how that impacts corporate strategy.
"Most well organised companies can provide answers," Burrett says, but adds that metrics remain a challenging area.
Earth Capital reviews each investment to work out the 'climate awareness' of each company it has invested in. This includes qualitative questions such as whether companies understand their own CO2 footprint; whether they are measuring it; what forward-looking issues could impact the markets in which they operate; what profitability forecasting is being made; and how they are managing risks and opportunities.
Burrett notes that in the case of Earth Capital, this is being done as a private equity investor with some 15 to 20 investments. But how does a fund with potentially hundreds of investments take a similarly comprehensive and granular approach?
"You are totally dependent on the disclosures of the entities, and they may often disclose on a different basis," Burrett admits. "Investors need to make sense of this, to challenge a bit."
The issues arising from a shortfall of high quality and comparable data is one that data providers and users are well aware of, Burrett accepts. This is why index providers have been putting out 'green' indices, to help tilt passive investment strategies, to potentially make them more climate sensitive.
"Does it mean the companies that produce the best data will achieve the best investment flows?" Burrett asks. "Yes - that proves the point you should be doing it. It proves that better managed companies tend to outperform over time." There is ample evidence this is indeed the case with this week's Carbon Clean 200 report the latest in a string of studies to show how corporates with strong environmental credentials have comfortably outperformed the wider market over the past five years.
However, the challenge for smaller businesses - like those Earth Capital eyes up as a small growth private equity investor - is they tend to be quite leanly managed and do not have lots of reporting resources to draw on. Earth Capital ends up doing some of this work for them, but it must be very forward-looking; these are growth companies so, for example, the CO2 footprint could grow over time.
This is where effective TCFD reporting should help. Reports are meant to indicate that companies understand how climate change impacts them as a business, both in terms of physical risks to operations, supply chains and regulatory risks, but also the transition risks they face as new clean technologies emerge and polluting incumbent technologies are marginalised.
It all comes down to whether or not "your plans as a business [are] compatible with a transition to Net Zero", Burrett reflects. "We are looking to them to tell us if they really understand the risks and whether they are managing that for their future," he explains. "If they can convince you that they are doing that, that makes for a good TCFD report."
Iselin Aslakstrom, responsible investment officer at Fulcrum Asset Management, was heavily involved in the development of the Climate Change Fund launched by the manager in August 2020. Run by portfolio manager Fawaz Chaudhry and team, including Aslakstrom, the global diversified equity strategy is committed to align with the Paris Agreement target of keeping warming below 2C.
As such, the fund looks to ITR metrics for the listed companies in its universe across the market cap spectrum. This facilitates constructing an actively managed portfolio with the goal of maintaining a temperature target, with an eye to what Carney and others are looking to in future TCFD scenario analysis and reporting.
"The argument made in the past six months or so is that the carbon footprint alone - although incredibly important - is backward looking," Aslakstrom reflects. "It does not take into account the forward-looking nature of climate change, and does not take into account companies' climate pledges."
From Aslakstrom's perspective, the ITR metric is the best one to use, as it suggests companies with lower temperatures should be better positioned for climate transition. However, with some 5,000 companies in the relevant data set, from the data provider's point of view they need appropriately reported data and for it to be of high quality. But at the same time, from the companies' point of view, they need to be not overwhelmed by reporting requirements. Like others, Aslakstrom feels that there is a harder challenge facing smaller companies regarding data sourcing and compilation.
However, calls for companies of all stripes to embrace TCFD reporting are only going to grow. Gerrit Ledderhof, responsible investment manager at Aegon Asset Management, notes that as an investor it is both applying TCFD recommendations itself and encouraging investee companies to do the same. Companies are engaged directly as well as via institutional investor groups.
As such, Aegon AM actively asks companies to report against TCFD recommendations, to run stress tests against climate scenarios, and to disclose relevant climate information. The reports are used for investment decisions and research, particularly in respect of climate as a material issue.
But it is still relatively early days, and Ledderhof agrees there has so far been a range of quality and quantity when it comes to TCFD reports, with the company seeing everything from a single page of cross references to fully contained separate reports. "But we do see them improving year-on-year," he says. "Part of that is it is becoming more prevalent as a framework. There is more guidance, more best practice examples."
One area of improvement is focus. Initially there was a feeling that "companies needed to throw the kitchen sink in there", Ledderhof recalls. But the good ones are those that focus on what is relevant to their business, he continues. "It is such a broad framework, meant to apply to every industry," he says. "Sometimes it can involve things not totally relevant to a particular industry or business. It is not a protocol, like SASB, where there is specific guidance - it is recommendations. There is a lot of freedom. Every country, every company looks at it differently. But it is getting better."
Execution of TCFD reports may be impacted by geography. For example, companies in the US or with US operations may have legal concerns about putting out certain information versus those in the EU. But, in the end, all reports should be about acknowledging that climate change is coming and asking companies how they intend to respond, so there is a big push from investors for companies to deliver those plans, Ledderhof adds.
Rick Stathers, senior global responsible investment analyst and climate specialist at Aviva Investors, illustrates how TCFD reporting is starting to shape organisations' response to the climate crisis. As iterations of Aviva group's climate-related disclosure have subsequently been published, they have generated "ripples through the organisation", as he describes it.
Looking at scenarios, looking at underwriting activities, and the investment portfolio, has resulted in further consideration of changes to mitigate the climate-related impact, he suggests, just as Michael Bloomberg's taskforce originally envisaged.
The Research View
Pooja Khosla, vice president for client development at Entelligent, a Boulder, Colorado-based provider of climate-related risk analysis and solutions, notes that TCFD reporting and the EU's Sustainable Finance Taxonomy are about letting companies know "it is time, if we don't [act], we will fail".
However, she also feels that much of the thrust behind TCFD reporting is coming, historically, from social sciences, while a science-based approach may be different, and arguably needs to be brought more into the discussion. There is an abundance of information available, but this is not necessarily met by the ability of people to absorb it, she notes. It is not just about incorporating an emissions target, it is about accepting the process, educating on what is in the market and understanding what is really material and what is not - then action will come, she says.
There is also still a need to look at execution. For example, she says that currently the world is nowhere near being on track to meet the Paris Agreement goals. Thus, measurement and scale of measurement, and what data providers are given to measure are important to address going forward. "TCFD reports are broad, they give the final destination," she reflects. "But the 'GPS', how to get there, what fuel to use in the car to drive there - these will take longer to understand as a science."
Khosla has also spotted different levels of quality in TCFD reports to date. One issue is that even where reports indicate 'good' companies, the findings put forward are based on using particular metrics in the evaluations. These metrics may differ between companies.
And, while investors may debate esoteric points on whether to divest or engage "as a scientist, when I see a small percentage of companies producing most emissions, then we need to focus on the basics - so, cut their output rather than [change to] solar companies".
Nina Seega, research director for sustainable finance at the Cambridge Institute for Sustainability Leadership (CISL), says certain TCFD reports put out to date seem to come with assumptions built in. An example she cites is that of a large bank, which had done a good job in qualitative terms through its sustainability report, but when it came to TCFD disclosures it stated that the material climate-related risk on its balance sheet stood at "none". It is a stark assessment that leads to the question whether, having done the analysis, it might have found some risks, but assumed that was alright because it was insured against them.
That type of assumption is being addressed by the Bank of England and further risk analyses from both banks and insurers, Seega says. "A lot of banks assume their portfolios are insured," she explains. "But the insurers look at this in terms of 12-month cycles. They can decide whether to hike the premiums or remove themselves from the market. So, if the banks say there are no climate-related risks on the balance sheet, then, yes, they have looked at it and they do have insurance, but that does not mean there are no underlying risks there."
Given the scale of the climate crisis and the pace and reach of the net zero transition there are risks and opportunities for every business, and their shareholders want to know about them. That, ultimately, is why TCFD reporting is so important and why it is set to be a mainstream financial concern for years to come.
Want to find out more about Net Zero Finance, TCFD reporting, and the investment trends impacting businesses and investors of all types? Then join us at the Net Zero Finance pathway event, as part of the Net Zero Festival 2021, which will take place online on March 16th. You can request an invitation to the event here.
