Climate risk: Lessons learnt from the last financial year

Organisations are showing greater maturity in how they handle the governance of climate-related risks – and that’s a good indicator that other key pillars will follow. But most still need to improve their understanding and take greater accountability.

Good: The companies doing this best have a clear assignment of roles and responsibilities across the Board and management, as well as defined reporting lines. One organisation assigned ownership of climate issues at a functional and geographic level. That’s particularly effective as climate risks and opportunities will vary by location.

The pace of change in the climate space has been significant, and the best firms are providing ongoing training to boards and management to ensure they stay abreast of climate risks and climate reporting.

Developing: More commonly, organisations are still working to establish roles and responsibilities as they come to grips with the content and cross-functional working. For example, one business has set up a committee to take responsibility for TCFD, but there’s no formal process as yet for the Board to review the risks and opportunities. That can result in uncertainty in the lines of reporting.

Linking climate-related disclosures to other risk management and governance processes and providing granular information on the effects of climate change on different geographies and business sectors are both highlighted as key improvement areas for future disclosures.

Scenario analysis is key to developing a strong climate strategy, to stretch planning horizons and help management teams get their head around the wide-ranging impacts of the transition to a low carbon economy, as well as the potential physical impacts of climate change. But most businesses are just looking at a small selection of risks under limited scenarios and discussions lack the appropriate balance between climate-related risks and opportunities. Scenario analysis around climate risks and opportunities is often divorced from company strategy.

Good: By categorising climate risk time horizons to align with its strategic planning processes, one organisation has been able to integrate risk mitigation into strategic planning timelines. Another company is disclosing its climate value at risk (VaR) – a measure for estimating loss due to climate change – as a percentage of current market value, and providing a breakdown by product, sectors and geographies, as well as type of climate risk. That provides a strong set of metrics against which to track its transition to low carbon.

Developing: With limited scenario analysis, it’s difficult to produce a well-informed climate strategy response. Take the example of a global packaging supplier. It has calculated the level of emission reductions needed to get into line with the Paris Agreement and compared this to business as usual. But it hasn’t undertaken any wider temperature-related scenario analysis to test different trajectories. Its picture is incomplete.

Most organisations aren’t able to quantify risks over different timeframes, and that makes it hard to prioritise risks or integrate them into the enterprise risk management (ERM) framework. Through quantification, companies are better able to disclose how they decide which climate-related information is reported, a key improvement area for future disclosures identified by the FRC.

Good: Of course, there are some best practice examples of climate being integrated into ERM processes. One organisation that’s done just that is now able to use its existing frameworks to monitor and prioritise risks, providing consistency of approach.

Developing: Most organisations, however, are completing risk management without using the full list of climate-related risks and opportunities (CRROs) within the TCFD. For example, one company used horizon scanning workshops to identify risks and opportunities. But did not consider all the CRROs identified within the TCFD guidance. It has now changed its process and introduced a workshop informed by TCFD CRROs.

Metrics and targets remain limited – typically restrained to carbon dioxide equivalent emissions. They seldom span broader climate risks – for example, the value of assets at risk from flooding – and opportunities, such as revenue from low-carbon products. Recent TCFD guidance set out a range of cross-industry metrics, including a number of non-emissions related metrics, which firms should disclose on. The FRC has specifically called out explanations of how climate scenarios and net zero commitments may affect the valuation of assets and liabilities as an area requiring quality improvements.

Many organisations are only reporting on Scope 1 (direct emissions from owned or controlled sources) and Scope 2 (indirect emissions from purchased energy) emissions. They typically fail to report Scope 3 emissions (indirect emissions, other than the ones under Scope 2, that occur in the value chain of a company) – even when these could be considered material.

Good: The most credible metrics and targets are calculated using standardised frameworks. Take the example of a global food group, which includes Scope 1, 2 and 3 emissions calculated using the GHG (Greenhouse gas) protocol. Its reduction targets have been approved by the SBTi (Science Based Targets initiative).

Developing: For many, though, Scope 3 emissions are omitted from the disclosure. That can prove an issue if these could be considered material. A heavy GHG emitter calculated only Scope 1 and 2 emissions. But Scope 3 emissions were the most material category to the business, meaning its disclosure doesn’t reflect the exposure to potential carbon pricing or regulation.

Although we’re seeing some examples of strong governance particularly in relation to assignment of roles and responsibilities, TCFD reporting is in its infancy. It’s going to take further reporting cycles before we start to see best practice emerge more widely and more consistently. For example, while one company demonstrated best practice for the financial quantification of its scenario analysis, it failed to link the results to any strategic responses.

To wrap up, here’s a summary of the most common gaps in climate risk reporting we’ve seen:

• Reports lacked a discussion of the implications of climate risks on current strategies, and how risks can be mitigated. And they lacked detail on the exposure of the company to climate risks and opportunities across different geographic and functional levels under each time horizon.
• Few organisations have used scenario analysis to inform strategic direction – or they’ve used different scenarios for front-half reporting and their financial statements.
• Scenario analysis of climate risks rarely quantifies the financial impact. And even where it does, the financial impact may not have been disclosed to the market. Organisation should explain how different scenarios and the company’s net zero commitments may affect the valuation of their assets and liabilities.
• Other than carbon emissions, climate-related metrics are generally not included. For example, flood risk could be tracked by monitoring the percentage of portfolio properties in flood risk areas.
• Details of how companies decide which climate-related information should be disclosed is lacking from reports.

Please look out for our next article in this series, where we’ll be looking at what you need to know as you prepare for mandatory reporting for FY22.