Climate risk disclosure comes of age
Marie Kreipe | 14 December 2017
Companies’ disclosure of business risks from climate change could become mandatory in a few years as pressure from investors gathers pace.
Investors have long understood the need to manage risk. Since the emergence of triple-bottom-line accounting, the key indicators of an investment’s “sustainability” have been ESG – Environmental, Social, Governance.
At first, the investor emphasis was on the governance aspect: does the organisation have systems, processes, checkpoints and reviews?
Then, as energy efficiency became synonymous with operational efficiency, the environmental component began to increase its prominence. Increasingly now we are seeing investors look for solid social outcomes and businesses striving to maintain and demonstrate their social licence to operate.
However, ESG is arguably a system for evaluating internal risk management strategies.
The COP21 Paris Agreement in 2015 placed a binding agreement on all countries and consequently their businesses and governments. As extreme weather-related events have increasingly impacted the insurance sector and the bottom line of affected businesses, the focus has turned to resilience and managing the external forces that have a material impact on investments. This is climate-related risk management and disclosure.
Super funds have already led the way recognising long-term risk to portfolios. Indeed, they are naturally placed to do so and have been integrating this thinking to find low-risk investment approaches for years. Now these good intentions increasingly need to be backed up with strategies that are informed by robust analysis. Both analysis and strategy need to be transparently disclosed.
Companies’ disclosure of business risks from climate change could become mandatory in a few years as pressure from investors gathers pace. Investors have urged companies – particularly those operating in the oil, gas and coal sectors – to disclose the financial impact of long-term climate change and increase transparency as the world shifts away from fossil fuels.
John Roome, senior director of climate change at the World Bank, commented: “The disclosure of climate change risks and stress testing of investments by companies is gaining traction.”
According to a recently published study of the German consultancy company KPMG, there are only four countries in the world where the majority of top 100 companies report on climate-related financial risks. Those countries are Taiwan (88 per cent), France (76 per cent), South Africa (61 per cent) and Canada (52 per cent). In most cases the disclosure of risks through climate change is mandatory or encouraged.
Australia, with its exposure to primary industries, surely should be among those countries. If legislation will not pressure businesses to disclose financial risks from climate change, private sector stakeholders might. However, there is an urgency for new regulations, with the Commonwealth Bank sued in the Australian Federal Court for misleading shareholders over the risks climate change posed to their business interests.
Stranded assets and shareholder muscle
The CBA case was filed on 8 August 2017 by advocacy group Environmental Justice Australia on behalf of two longstanding CBA shareholders. The case [now discontinued following climate change risk being included in the 2017 annual report] argued that climate change created material financial risks to the bank, its business and customers, and that CBA failed in its duty to disclose these risks to investors.
The case was the first in the world to pursue a bank over failing to report risks from climate change. However, it’s building on a trend of similar actions against energy companies in the United States and United Kingdom.
Energy giant Exxon Mobile is currently under investigation by the attorney generals of New York and California over the company’s disclosure practices. At the same time, an ongoing shareholder class action alleges that ExxonMobil failed to disclose internal reports about the risks climate change posed to its oil and gas reserves. It argues that those assets have been valued artificially high.
Similar pathways are being pursued in the UK, where regulatory complaints have been made about the failure of major oil and gas companies SOCO International and Cairn Energy to disclose climate-related risks, as required by law.
This represents an important shift. Conventionally, climate change has been treated by reporting companies merely as a matter of corporate social responsibility. Now it’s affecting the financial bottom line of businesses.
The Australian Prudential Regulation Authority warned in March 2017 that individual directors may be financially accountable for failing to factor in losses from climate change.
As the industry-led Taskforce on Climate-Related Financial Disclosures (TCFD) recently reported, climate risks can be physical (for instance, when extreme weather events affect property or business operations) or transitional (the effect of new laws and policies designed to mitigate climate change, or market changes as economies transition to renewable and low-emission technology).
For example, restrictions on coal mining may result in these assets being “stranded,” meaning they become liabilities rather than assets on company balance sheets. Similarly, the rise of renewable energy may reduce the life span, and consequently the value, of conventional power generation assets. “Stranded assets” are assets that unexpectedly lose value as a result of climate change.
Companies who rely on the exploitation of fossil fuels face increasing transition risks. So do the banks that lend money to and invest in these projects. It is these types of risks that were central in the case against CBA.
The claim filed by the CBA shareholders alleged the bank contravened two central provisions of the Corporations Act 2001:
- companies must include a financial report within the annual report which gives a “true and fair” view of its financial position and performance, and
- companies must include a director’s report that allows shareholders to make an “informed assessment” of the company’s operations, financial position, business strategies and prospects.
The big four banks – CBA, Westpac, ANZ and NAB – are currently reviewing their exposure to fossil fuels and considering new lending practices for mortgages and agriculture in response to climate change [NAB on Thursday announced it had ruled out any new finance to thermal coal mining].
CBA re-announced its support of the COP21 Paris Agreement and re-committed to achieving the climate targets of that accord. However, CBA is far from transitioning away from coal. It will assess coal through past investment prisms that have, according to the numbers, been pretty demanding anyway.
Westpac delivered an abridged coal investment framework that the mining industry received as “virtue signalling”. The new rules in that framework include a set of refined qualitative constraints on lending to developments in existing coal territories. To win Westpac funding in the future coal miners will need to prove that they are producing 6300k/Cal/kg coal. Westpac believes that this constraint will leave it exposed to only the top 15 per cent of Australian coal production by quality. Westpac’s coal policy is a statement of intent that brings an end to an extended discussion within the bank over the risks of investing in coal in an increasingly carbon-constrained world.
Quite interestingly, neither CBA nor Westpac have been particularly vigorous lenders to the coal sector in the first place. Actually, the Bank of China is the single biggest lender to Australia coal miners. At more than $3.3 billion, its exposure matches the total lending to the sector by Australia’s big four banks.
According to the rankings prepared by the anti-fossil fuel lobby Market Forces, Westpac only runs a distant fourth of the banking pillars in its exposure to coal mines and coal-fired power stations and is, by a big margin, a comfortable third in its the level of exposure to coal ports.
CBA sits with Westpac-like exposures to mines and power stations but is the biggest of the big four when it comes to lending to coal ports, where its exposure is put at $2.81 billion.
It is worth mentioning that divestment commitments have also been made by local councils, such as City of Sydney, the Australian Capital Territory, universities (La Trobe University, Swinburne University, Queensland University of Technology), super funds and charitable trusts. However, as long as international investors are not convinced to adopt climate risk disclosure, a real divestment from coal is unlikely.
Status of climate-related financial disclosures
The release of a report by the Financial Stability Board’s (FSB) taskforce on climate-related financial disclosures is expected to add pressure on publicly listed companies to formalise their climate risk disclosure practices (particularly through scenario analysis) or risk investors pulling finance and rating agencies making assumptions about their risk profile. The FSB welcomed the publication of the recommendations for effective disclosure of climate-related financial risks published by TCFD in June 2017.
The TCFD, chaired by Michael Bloomberg, was established by the FSB in December 2015. It developed recommendations on climate-related financial disclosures that are applicable to organisations across sectors and jurisdictions. The recommendations are structured around four thematic areas:
- Governance – the organisation’s governance around climate-related risks and opportunities
- Strategy – the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning
- Risk Management – the processes used by the organisation to identify, assess and manage climate-related risks
- Metrics and Targets – the metrics and targets used to assess and manage relevant climate-related risks and opportunities
In April 2017, global business leaders (representing companies with US$4.9 trillion (AU$6.4t) in assets under management) convened by the World Economic Forum joined together to urge the G20 governments to formally accept and act on the TCFD’s recommendations. The report of the TCFD under FSB was submitted for discussion to the Hamburg G20 summit in July 2017.
Unfortunately, the Hamburg Action Plan evolving out of the Hamburg summit only mentions that the TCFD’s recommendations are voluntary disclosures of climate-related financial risks by corporations, reflecting the principles of materiality. Neither the Hamburg Action Plan nor the Leaders’ Declaration mentions any specific response to the TCFD’s recommendations. One of the TCFD members said that the leaders of the G20 dropped the ball by failing to endorse the climate change guidelines proposed by the FSB’s TCFD.
Despite the lost chance on the G20 summit to carry TCFD’s recommendations further, climate risk disclosure is being increasingly accepted by the industry. The Australian energy company AGL is a leader in terms of climate risk disclosure. They’re one of only two companies that have done scenario analysis publicly. The other is BHP Billiton. Origin has made commitments but hasn’t delivered in terms of disclosure.
Investment future outlook
Regulators will tighten carbon emissions limits until 2050, which is well within the lifetime of most large-scale infrastructure projects. An independent financial think tank, the Carbon Tracker Initiative, has referred to this as a “carbon bubble”.
The more information that is out there, the more it can be incorporated into decision-making. This way a better capital allocation will be achieved with less risk of a systemic shock.
In Australia, carbon-intensive oil, gas, coal and iron ore extraction industries drive trade, economic prosperity and geopolitical influence. Many of the largest listed banks, insurers and super funds are heavily invested in these primary industries and are set to drive further change. Institutional investors such as Blackrock, Fidelity and Legal & General Investment Management are voting to support shareholder resolutions on climate risk disclosure.
The Asset Owner Disclosure Project (AODP) released its fifth global index in April 2017, ranking the world’s largest 500 asset owners. For the first time, the 50 largest asset managers have also been ranked by their performance managing financial risks associated with climate change. The AODP report found that “the scales have tipped”, as 60 per cent of asset owners are now taking some action. Australia and New Zealand were among the 10 best-performing countries, which were all in Oceania and Europe. Australia’s Local Government Super ranked first among asset owners in the world and First State Super ranked third, both with a triple A rating.
Maybe in the next KPMG study Australia will be among the countries with the majority of its companies reporting about their climate related financial risks. Banks, investors and other stakeholders have to be empowered to make the right investment decisions: from a sustainable but even more so from a purely financial point of view.
The result – capital would automatically be redirected to future focused purposes with solid long term economic returns for the local economy. A sustainable, zero carbon emissions future will then be a stone’s throw away.
Marie Kreipe is an international economist and energy expert who has worked in strategic planning and sustainability in the energy industry for the past eight years. She is working in sustainability programs at the City of Sydney.