Navigating the ESG and Climate Risk Landscape
In recent years, financial institutions worldwide have faced pressure from governments, regulators and even customers to step up their environmental, social and governance (ESG) and sustainability activities. In regulatory circles, climate risk has taken center stage, forcing banks and insurers to scrutinize and plan for climate-related financial risks like never before.
The “E” in ESG—environmental, with a focus on physical and transitional climate change risk—is causing the most headaches for financial executives. As bankers and investors formalize their ESG and climate risk processes, those requirements and expectations cascade down to their customers.
Against this backdrop, it should come as no surprise that government and regulatory authorities are starting to similarly eye how non-financial corporations are addressing climate risk. In fact, policymakers around the world are introducing various reporting regimes for businesses across industries. For example, last year, the U.S. Securities and Exchange Commission (SEC) debuted its long-anticipated climate risk disclosure rule. The proposal would require publicly traded companies to make extensive climate-related disclosures in their SEC filings.
Elsewhere in the world, the European Union’s Corporate Sustainability Reporting Directive (CSRD) will affect more than 50,000 companies beginning in 2024. The United Kingdom has introduced mandatory climate-related financial disclosures for more than 1,300 of its largest companies as part of its broader Sustainability Disclosure Requirements framework. Other examples include Singapore’s SGX Sustainability Reporting Guide and the IFRS Foundation’s Sustainability Disclosure Standards.
In the face of these new guidelines and mandates, companies across sectors will need to collect, analyze, process and disclose more sustainability and ESG data in a more standardized and auditable fashion. Key considerations include:
- Emissions. Reporting on carbon and greenhouse gas (GHG) emissions is no longer optional. Companies need to calculate direct and indirect emissions covering the entire value chain, both upstream (e.g., sale, usage and disposal of products) and downstream (e.g., supply chain). Companies must gather new information, establish new processes, and perform new calculations according to an established carbon and GHG accounting framework, such as the Greenhouse Gas Protocol developed by the World Resources Institute and the World Business Council for Sustainable Development.
- Double materiality. The traditional corporate social responsibility (CSR) approach needs to be significantly expanded to include double materiality assessment, covering not only the company’s impact on the environment but also the environment’s impact on the company. In short, companies must now report ESG and climate risks that impact their own operations and activities.
- Forward-looking perspective and strategy. New reporting areas now include forward-looking elements. How are the company’s future emissions likely to evolve? How will the deteriorating climate impact the company? What strategies will the company use to mitigate that impact?
- Net zero and Paris Agreement alignment. Some frameworks push forward-looking requirements even further, asking companies to disclose their strategy for decarbonization of their activities and plans for reaching a net-zero carbon footprint by 2050. According to Standard Chartered Bank, net-zero transition will be the most expensive project ever undertaken by 52% of top corporations and 61% of institutional investors will not invest in companies that lack a clear Paris-aligned transition strategy.
- Standardization. There is increasing need for investors to compare companies’ sustainability and ESG exposures to help decide which companies best suit their sustainability and ESG investment criteria, appetite and strategy. New reporting structures and formats are required to improve the comparability and transparency of these reports.
- Auditability. Many of the new reporting frameworks demand that all this new information be included in the annual management report, with sign-off from the board and external auditors. Firms must improve the auditability of their activities in this area, while also ensuring that the underlying methodology is governed accordingly, and that the supporting infrastructure is sound, transparent and reliable.
Emerging Frameworks and Guidance
There are already some industry best practices that can give us an idea of what to expect under these emerging frameworks. One example is the Task Force on Climate-Related Financial Disclosures (TCFD) framework.
TCFD was initially a voluntary climate reporting framework. Corporations are increasingly adopting it for climate reporting and policymakers have been using it to design sustainability, ESG and climate reporting frameworks. As a result, it is becoming the de-facto standard for climate reporting, and it is already mandatory in some jurisdictions.
Notably, the TCFD framework’s core elements for climate-related financial disclosures emphasize climate risk management and measurement. Changes to existing reporting frameworks will affect these key areas.
Climate (ESG) risk management. In order to properly identify and assess their exposures to physical risks like severe weather and transition risks like the impact of eliminating the sale of new gasoline-powered cars, non-financial corporations must ramp up existing enterprise and operational risk management processes.
Mapping this uncharted territory will require new data, new skills and new capabilities. It will also require close cooperation among risk, business and strategy teams to properly understand the sensitivities of the firm’s business model to those risks now and in the future.
The TCFD’s Guidance on Metrics, Targets, and Transition Plans provides extensive detail about metrics to use and how they should be calculated and reported. Companies should use this analysis to create transition and adaptation plans to address the corresponding risks.
Scenario analysis and net-zero planning. The TCFD pays particular attention to forward-looking metrics and calculations for assessing the risks and impact of alternative scenarios and strategies on a firm’s future performance. This will be a headache for non-financial corporations as their current business and financial planning processes have not been exposed to the same regulatory stress-testing and scenario analysis as financial institutions.
As a matter of fact, in its 2021 status report, the TCFD identified strategy resilience disclosure as one area where non-financial corporations most need to improve—only 20% of corporations analyzed disclosed information aligned with the TCFD. In the report, firms are asked to describe the resilience of the company’s strategy to climate risks, taking into consideration different climate scenarios. While this is an entirely new domain for many, TCFD has published Guidance on Scenario Analysis for Non-Financial Companies to help firms get started.
A number of alternative business models can help companies achieve net-zero goals, each with a different risk-return and cost profile. The challenge lies in finding the optimal strategy and product mix to facilitate a firm’s net-zero carbon footprint, combined with the lowest risks and highest returns under varying scenarios.
Scenario analysis is not just about climate risk. It is a well-established and powerful risk management and business planning tool that has been used by financial institutions for decades. The COVID-19 pandemic and geopolitical crises worldwide have made it much more relevant for non-financial corporations. Scenario analysis is an ideal tool for assessing the future implications of volatile and unstable environments on a company’s operations and revenue, and can help in searching for an optimal path forward.
Understanding the Risk
The new wave of ESG, climate risk and sustainability disclosures require companies to significantly boost their capabilities. They will need to produce required information and measures in an auditable format, while bolstering their ability to identify the climate change threats facing their businesses, and identifying and implementing optimal risk mitigation strategies.
As firms invest in new capabilities to address sustainability and climate risk, they will get better at predicting the impact of climate-related events. More importantly, they will also position themselves to make the right choices when navigating the uncertainty of the current and future risk landscape. After all, the first step in tackling any crisis is to better understand the critical situation at hand and the impact it will have on the business.
Reprinted with permission from Risk Management Magazine. Copyright Risk and Insurance Management Society, Inc. All rights reserved.
Written by Peter Plochan, 2023