AT COP21 in Paris, December 2015, Mark Carney – then Chair of the G20 Financial Stability Board (FSB) – announced the creation of a Task Force on Climate Related Financial Disclosures (TCFD). This was to be led by the private sector and chaired by Michael Bloomberg. Paul Fisher looks at the reasoning behind the TCFD and the many benefits of disclosing climate change exposure.
In June 2017 the TCFD reported a set of recommendations for voluntary disclosures – by all firms in the global economy – of the risks and opportunities presented by climate change. These should cover:
- risk management
- targets and metrics
Mitigating financial instability
The benchmark indices of many funds are full of fossil fuel producers and high greenhouse gas emitters. Many of these industries are unsustainable and eventually their value will fall to zero. Investments in such companies will become what are known as ‘stranded assets’.
Financial Markets do not always adjust asset prices smoothly – they have a habit of being surprised by ‘news’ and then jumping to new price levels. Indeed, price corrections often over-shoot initially until investors are convinced there is upside value from the new level.
If, say, the fossil fuel sector was to reprice suddenly, across the board, that could provoke a downward general movement in asset prices, fuelled by fire sales by distressed investors. This would cause a systemic event and financial instability, which explains the interest of the FSB.
One way to mitigate the likelihood and impact of such a tail event is for there to be more disclosure to investors of exposures to climate-related risks.
If investors have more information, then markets can price these risks better and earlier, meaning fewer, smaller and more accurate price corrections over time.
Mitigating liability risks
If a company knows it is exposed to risk from the transition to a lower-carbon economy – or to the risks from global warming itself – and does not investigate those risks and/or says nothing about them, then that is a failure of fiduciary duty.
Legal action will follow if the risk crystallises.
Making firms address their climate risks
But disclosure has micro as well as macro benefits. To disclose something, you first have to have some facts to disclose.
Given that most firms do not have estimates of their exposures to climate risks, the first response must be to carry out the very significant work in estimating and compiling them.
Many firms will have been – or will be – shocked when they realise the extent of those exposures. So the second step, before publication, has to be to take action to reduce unexpectedly high exposures.
The TCFD recommendations were not very detailed, so many firms have been on a journey towards their (voluntary) compliance. Most risk-modelling is backward-looking and based on data. But that is of limited help when one is faced by a risk that has never yet fully crystallised.
Hence the widespread adoption of scenario analysis to ascertain the range of possible outcomes. And to get the full picture, one needs to know the exposures of one’s suppliers and one’s customers.
So we can expect many iterations as more and more companies start disclosing.
Who will disclose, why and when
In its June 2019 status report, the TCFD notes that 785 of the largest companies worldwide have declared they will disclose. This includes over 374 financial firms responsible for assets exceeding $118trn.
The TCFD report was asked to produce a voluntary scheme, so it did, but regulators are likely to find ways to make disclosure mandatory. That’s because those with the biggest exposures – which are most difficult to reduce – are the most likely not to volunteer.
The EU – including the UK – have already started looking at ways that these risks can be reflected in reporting rules. Although, since they are material financial risks, arguably they are already covered.
It will take some time, but the disclosure of climate-related risks is going to become mainstream.
Dr Paul Fisher is a Fellow at the Cambridge Institute for Sustainability Leadership. He was previously a senior official and macroeconomist at the Bank of England for 26 years, including 5 years as a member of the Monetary Policy Committee and Executive Director for Markets and 2 years as Deputy Head of the PRA. He is a member of the European Commission’s High Level Experts Group on Sustainable Finance and was a member of the UK Green Finance Task Force. He holds a portfolio of other roles in finance and academia.