Sustainable business practices have risen to the forefront of global concerns. But while a consensus has formed around the need for action, it is a relatively new frontier — and a disorderly one when it comes to measuring a company’s climate finance risks and opportunities.
As climate finance expands into the mainstream, it’s vital that investors and other stakeholders understand how a company measures and monitors these targets. The job is daunting, but it will have an huge impact on the future of doing business.
For good measure
Access to a company’s metrics enables investors to better assess its potential risk, ability to meet financial obligations and general exposure to climate-related issues, as well as its progress in managing or adapting to those issues. If carefully calibrated and uniform, such metrics also provide a basis on which one can compare different companies within a given sector.
Measuring climate risk is complicated. Take carbon dioxide emissions, which businesses typically break down into three classifications: Scope 1 emissions are generated by a company; Scope 2 emissions extends to include the energy that the company buys; and Scope 3 emissions include those generated by the company’s suppliers and consumers using its products, and often form the bulk of emissions (98.2% of emissions at Toyota, for example).
How can these assessments be made more accurate, given the outsized influence of external parties?
The Task Force on Climate-related Financial Disclosures (TCFD) has emerged as the most promising standard of measurement. The TCFD has quickly grown to comprise more than 1500 supporter organisations, with a combined market capitalisation of more than $12.6tn.
The TCFD helps businesses implement climate measures across four areas:
- The company’s governance around climate-related risks and opportunities;
- The impact of climate-related risks and opportunities on the company’s strategy;
- The processes used by the company to identify, assess and manage climate-related risk metrics; and
- The metrics and targets used to assess and manage climate-related risks and opportunities.
The TCFD has also incorporated the notion of ‘materiality’ as a means of classifying and communicating metrics. In practice, materiality dictates that sustainability criteria are not equally relevant across all companies, and that each individual firm should weight certain criteria more heavily.
Compliance with the TCFD is voluntary, and still lacks clear standardised disclosure requirements regarding the sustainability factors that are material (that is, financially relevant) to companies.
The current system of voluntary sustainability reporting puts a heavy burden on companies and investors. There are many different standards worldwide. Given the lack of full guidance, companies are having to hire environmental, social and governance consultants to help draft the reports, define metrics and compile the data. However, these consultants frequently use different methodologies and approaches — resulting a lack of comparability across companies and consequently, headaches for investors.
The current system of voluntary sustainability reporting puts a heavy burden on companies and investors
The development of mandatory common sustainability reporting standards is crucial so that sustainability information achieves the same status as financial information, and is subject to the same rigorous criteria.
Imminent events could drive this. In light of the challenges posed by climate change, governments, central banks and regulators have identified the need to have reliable climate-related financial information, so that financial markets can properly price climate-related risks and opportunities. The EU is expected to announce new mandatory requirements for climate reporting for large businesses next year.
From 2023, all public UK companies with a premium listing will be required meet the TCFD requirements. The US Securities and Exchange Commission, meanwhile, is preparing new rules that will enforce mandatory reporting.
Shifting finance fortunes
Climate risk also exists in the assets held by financial institutions, which could suffer losses from exposure to companies whose business models are heavily exposed to climate-related risks, so banks and regulators are becoming increasingly concerned about the financial risks stemming from climate change.
The rationale for incorporating climate issues into banks’ supervision is that these risks should be adequately priced and incorporated by financial institutions. If ignored, they can result in greater credit risk; the impairment of collateral due to severe weather events; or mark-to-market losses from exposure to companies with stranded assets. More effective climate-related disclosures enable a better understanding of the concentrations of carbon-related assets in the financial sector, and the financial system’s exposures to climate-related risks.
Climate reporting by banks will evolve. Today, very few banks have clear policies, disclosed metrics or targets. Disclosure varies greatly across institutions and business models. But again, things are changing. The European Central Bank has come out with new supervisory expectations relating to the adoption of risk management and disclosure measures for the banking system. For instance, tracking Scope 1 and 2 emissions at financial institutions is not particularly relevant, as banks do not consume or emit large amounts of carbon dioxide from their offices or branches.
But what do bank clients do with the money they’ve borrowed? The new rules clearly highlight that, in their credit risk management, banks are expected to consider and monitor climate-related and environmental risks at all relevant stages of the credit-granting process.
The path forward
Historically, companies only disclosed financial information. However, there is a growing demand for sustainability reporting, and it is even becoming mandatory in certain areas. Now, a convergence is occurring. Designing a more uniform system of metrics will be difficult and will depend on a company or sector’s priorities.
Changing these reporting standards will have major implications. Investors and financiers want to see clearer and adequate disclosures. And companies that are not capable of convincing investors face a significant loss of capital further down the road.
Nuno Fernandes is a full professor of finance at IESE Business School.
