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

 The PESTEL (Political, Economic, Social, Technology, Environment, and Legal) approach is widely used in strategic analysis to identify long-term internal and external trends in the business and/or industry. Climate change presents every element of PESTEL risk—political, economic, social, technology, environment, and legal. Increasing the firm’s resilience to the financial risks from climate change starts by recognizing climate change as both a firm-specific and a ‘systemic’ external risk. Then proceed to mitigate climate-related risks by anticipating potential future scenarios and adapting strategy accordingly.

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.