Guest Blog: Planning a Successful Task Force on Climate-related Financial Disclosures Project
Guest Blog: Greg Rogers: Author, attorney, CPA and entrepreneur working at the intersection of law, accounting and the environment. Author of Financial Reporting of Environmental Liabilities & Risks after Sarbanes-Oxley (Wiley 2005). Founder of LinkedIn Group on Climate-Related Financial Disclosure. Originally published here.
As the recommendations of the
Financial Stability Board’s (FSB’s) Task Force on Climate-related Financial
Disclosures (TCFD) continue to gain support, managers of leading global
corporations are starting to plan for enhanced climate disclosure. Climate-related
financial disclosures, especially those explicitly considering alternative
climate scenarios, are entirely new. And like anything new, there is confusion
about ends and means—objectives and process. Best practices are not yet well
defined, and there are many potential pitfalls.
Avoid wasted time and resources
by following this brief guide on how to design and implement a successful TCFD
project.
I. Begin with the end in mind
A. Understand the FSB’s
objectives
In April 2015, after having
identified climate change as a systemic risk to global financial stability, G20
Finance Ministers and Central Bank Governors asked the FSB to review how the
financial sector could take account of and better manage climate-related risks.
This led to the formation of the TCFD, which was tasked with developing a
framework of financial disclosures that “would enable stakeholders to
understand better the concentrations of carbon-related assets in the financial
sector and the financial system’s exposures to climate-related risks.” Using these climate-related financial
disclosures, the FSB envisioned that:
Financial institutions and
other relevant stakeholders could then assess the credibility of firms’
transition plans and their ability to execute them, and analyze the potential
changes in value of their assets and liabilities that could result from a
transition to a lower carbon economy or to other climate-related events (e.g.
physical or legal risks). This would allow stakeholders not only to manage and
price these risks accordingly but also, if they wish, to take lending or
investment decisions based on their view of transition scenarios.
Stated differently, the FSB
believes that the systemic financial risk posed by climate change can be better
managed (i.e., avoided, mitigated, transferred or accepted) by encouraging
firms to (1) future-proof their organizational strategy against climate-related
financial risks, and then (2) provide financial disclosures sufficient to allow
financial markets to independently assess their progress and capabilities. Recommended
financial disclosures are included in the TCFD Final Report and discussed
below. For more background on the FSB and TCFD, review this PointDrive
presentation.
B. Clarify project objectives
At the outset, clarify the
objectives of the proposed TCFD project. For example, is the purpose to:
- Improve the firm’s environmental, social and governance (ESG) public image consistent with similar prior public relations efforts (e.g., improve the firm’s CDP ranking)?
- Get a head start on future mandatory disclosure requirements?
- Check the box as a TCFD adopter?
- Meet the letter and spirit of the TCFD recommendations?
- Improve the firm’s resilience to climate change?
The objectives will determine the
project’s stakeholders, leadership, risks, barriers, resources, budget and
schedule. Don’t begin detailed planning until objectives are well understood
and agreed.
C. Get buy-in from key
stakeholders
Get buy-in to project objectives
from key internal stakeholders early in the project planning process. An
otherwise well-designed TCFD project will not succeed without cross-functional
senior management buy-in. Begin by identifying the key internal
stakeholders—those who must support the project in order for it to succeed—and
gaining their support for the project. Depending on the project’s objectives,
key internal stakeholders may include the CEO, CFO, chief sustainability
officer (CSO), General Counsel, director of Strategic Planning & Analysis,
director of Investor Relations, and managers responsible for climate-related
risk (e.g., sustainability, corporate social responsibility and ESG experts).
After getting buy-in from all key
internal stakeholders, assign project leadership and ownership of the climate
disclosure function to one or more senior managers with sufficient authority to
ensure effective implementation and continuing operation consistent with the
firm’s objectives. For example, if the firm intends to integrate audited
scenario-based financial disclosures into its mainstream financial filings,
assign leadership to the CFO and not the CSO.
D. Identify and resolve potential
barriers
Identify and resolve key barriers
to achieving project objectives. Key stakeholders may be skeptical about the
feasibility and benefits of increased climate disclosure. Following are
potential barriers to buy-in from key internal stakeholders and suggestions to
resolve them:
- Barrier: Concern that TCFD disclosures will mislead investors and distort markets. Response: Reconcile this with the growing support for TCFD: since the recommendations were issued in June 2017, the number of firms in support of TCFD has grown to over 500, with market capitalizations of over $7.9 trillion, including financial firms responsible for assets of $100 trillion.
- Barrier: Perception that climate-related financial risks are not material. Response: Deciding the materiality of climate change before conducting strategic analysis is putting the cart before the horse.
- Barrier: Skepticism about the feasibility/utility of long-term (30 plus years) forecasting. Response: If the firm currently performs long-term economic forecasting of supply, demand and prices for its products, what is the rationale for excluding consideration of climate change?
- Barrier: Concern that limitations in data availability and quality will prevent reliable strategic analysis and planning. Response: Strategic analysis always has certain data limitations. Such limitations should be clearly explained when communicating the degree of uncertainty to internal or external audiences, consistent with existing guidance in securities regulations and accounting standards.
- Barrier: Scenario-based disclosures will expose the firm to potential litigation when future outcomes underperform forecasts. Response: Scenario analysis is not used to predict what will happen but to help plan for what could plausibly occur, and scenario-based disclosures are not forecasts. Mandatory disclosure regimes provide protections for ‘forward-looking’ statements made in good faith with a reasonable basis (see, e.g., 17 CFR 240.3b-6 - Liability for certain statements by issuers). Firms can mitigate litigation risk to an acceptable level by clearly and accurately communicating the types and levels of uncertainty inherent in climate-related strategic planning and analysis.
- Barrier: Uncertainty about first-mover advantages vs. safety of running with the pack. Response: Climate strategy must precede and inform climate disclosure. Is running with the pack an acceptable approach to strategic planning?
- Barrier: Concern about disclosure of confidential business information (CBI). Response: Don’t disclose CBI. TCFD disclosures are voluntary, and mandatory disclosure regimes provide protections for CBI (see, e.g., 19 CFR 201.6 - Confidential business information).
Preparing a ‘stakeholder role
matrix’ that lists the names/functions, objectives and barriers of key internal
stakeholders is a good way to facilitate discussion and gain buy-in.
E. Develop an implementation path
Develop a realistic phased
implementation path over time to set appropriate expectations and avoid costly
missteps. Depending on the project’s objectives, a phased approach may be
necessary or appropriate. Strategic planning and analysis managers are
accustomed to forecasting long-term supply, demand, and prices and using
scenario analysis to optimize strategy against uncertainty. However, few firms
have fully incorporated climate-related risks into their strategic planning
processes, and none are accustomed to disclosing the data inputs, assumptions,
methodologies, and distributional results of their analysis.
The time required to integrate
climate change into the firm’s internal management processes may alone span
more than a single reporting cycle. Full implementation of the TCFD’s
recommendations, including scenario analysis, with the quality required for
mainstream financial filings may take several more reporting cycles.
II. Climate strategy
If the key stakeholders are
genuinely committed to disclosures that support the FSB’s objectives, they must
necessarily commit to first integrating climate change into the firm’s internal
management processes. This internal activity to enhance the firm’s capabilities
should precede external reporting. “If you're going to talk the talk, you've
got to first walk the walk.”
Begin by working through the
policy choices in Section III below. This will inform planning for the activities
described in this section. Then develop a plan for integrating climate risks
and opportunities into the firm’s existing frameworks for governance, strategic
planning, risk management, and internal control, as discussed below.
A. Governance
Integrate climate change (risks
and opportunities) into the firm’s governance framework with specific emphasis
on board-level engagement and accountability. This may be a necessary first
step to gaining buy-in of key internal stakeholders.
Elevating climate change to the
level of board governance is justified by the distinctive elements of
climate-related financial risks which, when considered together, present unique
challenges and require a strategic approach to risk management. According to
the Bank of England’s Prudential Regulatory Authority’s draft supervisory
statement (SS), climate-related financial risks are:
Far-reaching in breadth and
magnitude: The financial risks from physical and transition risk factors are
relevant to multiple lines of business, sectors and geographies. Their full
impact on the financial system may therefore be larger than for other types of
risks, and is potentially non-linear, correlated and irreversible. Mark Carney,
Governor of the Bank of England and Chairman of the FSB, has previously warned
that climate change could have “catastrophic impact” for the financial system.
Uncertain and extended time
horizons: The time horizons over which financial risks may be realized are
uncertain, and their full impact may crystallize outside of many current
business planning horizons in what Carney has called the “Tragedy of the
Horizons”. Also, past experience may not be a good predictor of future risks.
Foreseeable nature: While the
exact outcome is uncertain, there is a high degree of certainty that financial
risks from some combination of physical and transition risk factors will occur.
Dependency on short-term actions:
The magnitude of future impact will, at least in part, be determined by the
actions taken today. This includes actions by governments, firms, and a range
of other actors.
Financial risks with far-reaching
breadth and magnitude by definition are not specific to individual firms but
are instead systemic (or “macroprudential”). The FSB’s recognition of climate
change as a systemic risk has important implications for firm governance. For
example, the exceptional nature of climate-related financial risks
justifies—(1) intervention by macroprudential regulators into the management of
regulated banks and insurers, which will over time impact their customers in
non-financial sectors; and (2) intervention into the management of
non-financial firms by passive fund managers, such as BlackRock, Vanguard,
State Street and Fidelity, because while these funds can diversify away
firm-specific risk, they cannot diversify away systemic risk. These large
institutional investors have both the power and the motivation to drive public
firms to improve climate strategy and disclosure.
B. Strategy
Integrate climate change into the
firm’s existing processes for strategic planning and analysis. Start by getting
the firm’s director of Strategic Planning, CFO and CSO in the same room. Work
with existing processes and allow these to develop and mature over time.
As illustrated in Figure 1,
enterprise strategic planning typically follows a stepwise process including:
- Strategic analysis (internal and external)
- Identification of critical issues facing the organization
- Development of a strategic vision that articulates the future
- Mission statement that sets the fundamental purpose of the organization
- Formulation of the enterprise strategy
- Preparation for operational planning based on the enterprise strategy
Figure 1. The strategy development process |
Scenario analysis is a tool
widely used for developing an understanding of the uncertainty inherent in the
external and future environments and testing the robustness of alternative
strategies against a wide range of possible futures. Use scenario analysis to
assess the impact of climate-related financial risks on the firm’s current
business strategy and to inform the risk identification process. Use multiple
scenarios spanning a range of outcomes on the transition to a lower-carbon
economy and a range of climate change scenarios leading to increased physical
risks. Where appropriate, include a short and a longer-term assessment.
The results of scenario analysis
will feed the evaluation of options available to the firm. For example, options
available to a mining company may include doing nothing (status quo), seeking
continuous improvement opportunities, or making a step change that could take
the form of opening a new mine, expanding current operations, contracting
current operations, or closing a mine. Mining projects are characterized by
investments that are either partially or completely irreversible, uncertainty
over the future rewards from the investments, and long time lags between the
decision to mine and the mining investment. These characteristics require
consideration of the ability to change the course of a mine life to minimize
downside risk and maximize any upside opportunity. This is the realm of real
options, which values flexibility to adapt to new conditions (see, e.g., Real
Options Analysis: Tools and Techniques for Valuing Strategic Investments and
Decisions).
A critical element of effective
strategy development and execution is stakeholder engagement. Given that the
support of the financial markets is needed for the firm to achieve its vision,
effective financial disclosure and engagement with investors—in addition to
employees, customers, suppliers, regulators and local communities—is a crucially
important aspect of strategic planning. The TCFD recommendations provide a
playbook for engagement on climate strategy between firm managers and
investors.
C. Risk management
Integrate climate change into the
firm’s existing risk management framework, in line with the firm’s
board-approved risk appetite.
The financial impacts of
climate-related issues on a firm are driven by the specific climate-related
risks and opportunities to which the firm is exposed and its strategic and risk
management decisions on managing those risks (i.e., mitigate, transfer, accept,
or control) and seizing those opportunities. Identifying the issues, assessing
potential impacts, and ensuring material issues are reflected in financial
filings may be particularly challenging due to: (1) limited internal knowledge
of climate-related issues; (2) the tendency to focus on near-term risks; and
(3) the difficulty in assessing the potential financial impacts of
climate-related risks and opportunities. To assist in this effort, Tables 1 and
2 in the TCFD Final Report provide examples of climate-related risks and
opportunities and potential financial impacts.
D. Internal control
Prepare to measure, monitor,
manage, and report on the firm’s climate-related objectives and performance
against these objectives by integrating climate change into the firm’s existing
internal control framework.
Appropriate information and
reporting systems, both internal and external, will be needed to give the
board, management and external stakeholders reasonable assurance that:
- the firm’s climate-related financial disclosures will be credible;
- the firm’s stated climate objectives will be achieved; and
- the firm will comply with applicable climate-related laws and regulations.
- Each of these internal control objectives is briefly discussed below.
1. Financial reporting. Recognize
that climate-related financial disclosures warrant the same scrutiny as published
financial statements, whether they are included in the firm’s mainstream
financial filings or elsewhere. Failure to apply appropriate internal control
over climate-related financial reporting can result in claims of securities and
accounting fraud. See e.g., Complaint in New York v. Exxon (alleging fraud
regarding Exxon’s reported use of a proxy carbon cost) and Order on Motion to
Dismiss in Ramirez v. Exxon (alleging material misstatements regarding use of
proxy carbon costs in strategic planning and assessment of project economics).
Consider the potential
interconnectivity of climate-related financial disclosures with existing
financial statement and disclosure requirements under applicable rules of
securities regulators, such as the U.S. Securities and Exchange Commission
(SEC), and generally accepted accounting principles (GAAP) issued by accounting
standards boards, such as the Financial Accounting Standards Board (FASB) and
the International Accounting Standards Board (IASB). Pay particular attention
to matters concerning materiality, risks and uncertainties, contingent
liabilities, asset impairment, asset retirement and environmental obligations,
and extractive industry reserve classification.
Determine whether the firm’s
climate-related financial disclosures will (or should) be included within the
scope of the independent financial audit. Consider also whether such
disclosures may be sufficiently complex or subjective and potentially material
to the financial statements to warrant the special skill or knowledge of a
specialist to develop appropriate audit evidence.
2. Internal management. New
information and reporting systems will be needed to assure that internal
decision making aligns with the firm’s climate strategy and risk management
process. Anticipate the need for new metrics and targets to assess
climate-related risks and opportunities as well as the use of existing
financial metrics in new ways. For example:
A firm’s climate strategy and
objectives may require it to measure and track past and forecasted future Scope
1, Scope 2, and, if appropriate, Scope 3 greenhouse gas (GHG) emissions, carbon
intensity, proxy carbon prices, energy mix, energy intensity and (or) water
usage.
Firms may use scenario analysis
to model the potential future impact of climate change on key financial metrics
(e.g., EBITDA margin and return on capital employed for mining firms).
To avoid confusion, develop clear
policies (reinforced by employee training) to specify when and how these
metrics are to be used in different decision contexts, such as long-term
supply, demand and price forecasting, capital budgeting, project economics,
petroleum reserve classification and impairment testing.
3. Legal compliance. New
information and reporting systems also may be needed to assure compliance with
environmental regulations, such as GHG reporting regimes, emission cap and
trade systems, and carbon taxes, across multiple jurisdictions.
III. Climate disclosure
Key policy choices for climate
disclosure include the substance, form and location of disclosures. How the
firm decides to address these policy choices will influence planning for the
activities in Section II above.
A. Substance
Firms must decide what to
disclose (and what not to disclose). The TCFD Final Report and Implementation
Guidance provide detailed disclosure recommendations for all sectors, plus
supplemental disclosures for financial institutions (banks, insurers, asset
owners and asset managers) and certain non-financial sectors (energy,
transportation, materials and building, and agriculture, food and forest
products). Also, Appendix 4 in the TCFD Technical Supplement on scenario
analysis provides examples of corporate disclosures on scenario analysis.
Key policy choices regarding the
substance of disclosures include:
- What information is material to investors
- What financial and non-financial metrics and targets to report
- How much to disclose on scenario analysis
- What CBI and other potentially prejudicial information will not be disclosed
- Consistency of disclosures across media
Of these, scenario analysis
disclosure is the most sensitive because it touches on speculative information
that firms consider to be confidential for competitive, legal or other reasons.
This sensitivity may explain BP CEO Bob Dudley’s assertion that, “They [e.g.,
the FSB, TCFD, Bank of England and others] push for potentially confusing
disclosures, raise the specter of a systemic risk to the financial system from
stranded assets, and campaign for divestment” and to caution that such
disclosures can open companies up to potential litigation: “I know what will
happen: we’ll get sued because we’re off the path after a year.”
If Dudley and other like-minded
CEOs are nonetheless compelled to adopt the TCFD’s recommendations, effective
communication of the types and levels of “uncertainty” will be critical to
mitigating such concerns.
B. Form
Firms must decide how to
communicate the significant levels of uncertainty inherent in climate-related
risks and opportunities—qualitatively and quantitatively.
Climate strategy and disclosure
are about the same thing—making better decisions under conditions of
uncertainty. Climate strategy reflects management’s best efforts to address
uncertainty. Climate disclosure is intended to help investors price
uncertainty. Yet, communicating the current state of a firm’s understanding
about the characteristics and implications of climate-related uncertainty and
variability to a statistically-challenged group of investors, analysts,
financial journalists is a formidable challenge. This challenge is comparable
to that faced by scientists in communicating mankind’s current understanding of
climate change to non-technical policymakers and members of the media and
general public. Firms contemplating scenario-based climate-related financial
disclosures can learn much from their efforts (see e.g., Best Practice
Approaches for Characterizing, Communicating, and Incorporating Scientific
Uncertainty in Climate Decision Making).
Describing uncertainty in
qualitative language, using words such as “likely” or “unlikely”—terms often
used in securities and GAAP disclosures—is potentially confusing, as such words
can mean very different things to different people or different things to the
same person in different contexts. When uncertainty is described
quantitatively, a variety of analytical tools and models are available to
investors to perform analysis and support decision making, which is the TCFD’s
goal. The challenge is to communicate uncertainty in a way that is
decision-useful and not confusing.
Clear communication about
uncertainty in climate-related financial disclosures is essential. Yet, few
organizations, other than insurance companies, have experience in communicating
the uncertainty of future events or the future effects of prior events to
investors in quantitative terms. In addition to scenario based quantitative
analysis, ‘mental model’ methods may be useful when—as in the case of financial
disclosure—it is possible to study the relative effectiveness of different
communication methods and messages.
C. Location
Firms must decide where to
disclose. TCFD recommends publication of climate-related financial information
in mainstream financial filings on the grounds that this will foster broader
utilization of such information, promoting an informed understanding of
climate-related issues by investors and others, and support shareholder
engagement. Alternatively, firms may choose to include TCFD disclosure on their
websites or in non-financial reports.
IV. Avoid foreseeable pitfalls
Don’t let the tail wag the dog.
Climate-based analysis, planning and strategy development should precede and
inform climate disclosure not vice-versa.
Don’t confuse public relations
with financial disclosure. Materially misleading climate-related financial
disclosures can result in liability for securities and accounting fraud.
Don’t use a single or just a few
scenarios. Scenario analysis is intended to encompass a large number of plausible
future climate states and pathways in order to provide a mathematically robust
representation of possible—but highly uncertain future events.
Don’t let the perfect become the
enemy of the good. Start now to
integrate climate change into existing systems and processes instead of waiting
for the perfect solution.
V. Conclusion
Failing to plan is planning to
fail. Follow this guide to successfully implement the recommendations of the
TCFD.
Start now. The stakes are too
high to rush the process.
More info on FSB/TCFD can be found here.
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