TCFD and the Reality of Transition Risk for Investors: Part II

Climate risk disclosure is rapidly moving past voluntary corporate social responsibility (CSR) reporting to mandatory regulation around the world. It’s important for industry players to realize that, though the landscape is currently a regulatory patchwork, the recommendations from the Task Force on Climate Related Financial Disclosures (TCFD) appear to be governing bodies’ north star. Governments and regulators are telling businesses to phase out carbon or lose contracts. However, these developments come with an increase in transition risks for market participants in the form of compliance risks, market and business risks, and liability risks.

Therefore, investors need to understand the disclosure landscape against the backdrop of the TCFD. This article builds on Part I in this series and aims to give investors an explanation of how they should begin to consider the TCFD’s recommendations and why.

What Is the TCFD?

The TCFD is the brainchild of the Financial Stability Board (FSB), whose general mandate is to promote international financial stability through various risk management strategies. Having been formed by the G-20 countries and a collection of international financial institutions, the FSB attempts to represent the widest financial risk management interests across nations. The FSB-TCFD’s fundamental goal is to provide a consistent framework upon which entities—companies, cities, and even non-profits—can measure and report climate risk threats and opportunities to their stakeholders.

Therefore, it is unsurprising that the work of the TCFD was initiated the year following the publication of the highly collaborative Intergovernmental Panel on Climate Change’s (IPCC’s) Fifth Assessment Report in 2014. In this report, it was established that climate change poses an imminent threat to life systems—including economic and financial systems. The TCFD answers the need for collaboration on the disclosure front; therefore, it is little surprise that it is becoming one of the most accepted recommendations by many governments and corporations.

Why All the Fuss About Disclosure?

As an established principle, one of the first steps to solving any problem is to measure it. It is fitting that many of the laws, policies, guidelines, and recommendations for entities regarding climate change have been focused on the measurement and reporting or disclosure of the dimensions of climate risks and opportunities that confront them.

However, disclosure must not be confused as a solution to climate change. In a recent report published by Entelligent in partnership with Société Générale, CEO Thomas Stoner observes that it is time to move on from disclosure for the mere sake of it. He states, “in order to produce truly beneficial solutions, the bulk of the concerted effort must start to shift from recording and communicating climate change contributions to interpreting these into forward looking mitigation tools.”

The two main principles underpinning the need for disclosure are tracking and transparency. These two principles house the hope that in tracking climate risks, entities will understand their true positioning in terms of their contribution to the anthropological global warming problem and the threats they face. Through transparency, companies and investors shall be forced to improve their activities and thus be able to present themselves in a more positive light to their stakeholders relative to their competitors.

Yet these two principles have been severely undermined by a lack of complete or accurate data due to the disclosure regulation vacuum. This has allowed large blind spots to develop due to data unavailability, inconsistent means to gather and process it, and greenwashing. However, as indicated by the many tectonic shifts in the climate disclosure regulatory space, that is about to change. According to the task force’s latest status report, about 60% of the world’s 100 largest public companies support TCFD disclosures on climate risk evaluations. Support and understanding of reporting metrics are growing every day and we may soon bridge the reporting vacuum gap.

There are numerous upsides for investors as well as the managers of firms who would be required to file these disclosures. Chief among them is the highly probable eventual standardization of methodologies, processes, and metrics which will help eliminate the uncertainty and mistrust around disclosures. However, until then it is expected that disclosures will be made with principles according to, or that bear some resemblance to, the recommendations, frameworks, and guidance of many of the non-regulatory initiatives and organizations such as TCFD.

Why Is It important For Investors To Understand the Role of the TCFD?

The TCFD recommendations help manage transition risks by providing the following:

Compliance

Since their publication in 2017, the TCFD’s recommendations have been broadly adopted. In 2019, the UK announced its plans to make TCFD mandatory by 2025 and in November of 2020 released a roadmap towards mandatory climate-related disclosures based primarily on the recommendations of TCFD. Efforts have recently been made to bring the timeline forward to 2022. In December 2020, Hong Kong proposed making climate disclosures according to the TCFD mandatory by 2025. There are many such examples that indicate that the TCFD framework is increasingly becoming the de facto framework for climate-related disclosures in many jurisdictions. Therefore, it is in the interest of investors to understand its scope and applications to resolve any compliance complications in the near term and eliminate regulatory transition risks as far as disclosure is concerned.

Guidance

Even though the TCFD’s recommendations are not particularly instructional, they provide certain parameters that have proven to be extremely helpful in thinking about and reporting on climate risks. For investors, using the TCFD’s recommendations means less groping in the dark about what climate risks matter most for their portfolios.

First, the TCFD provides definitional clarity on climate risks and establishes the two main streams of risks—transition risks and physical risks (see Figure 1 in Part I of this article series). In addition to creating a common lexicon, understanding the types of risks enables investors to take a proper survey of potential threats. This helps to prepare for and manage possible liability risks.

Second, the TCFD amalgamates scientific approaches to the enterprise risk issues of climate risk through its prescription of scenario analysis. It also suggests the setting of carbon-related targets, aligning with the work of Science Based Targets (SBTs). Additionally, the TCFD, by recommending that disclosers report their GHG emissions under scopes 1, 2, or 3 aligns with the established carbon foot-printing methodologies established by the Greenhouse Gas Protocol (GGP). Using the methodologies of the GGP has many implications. One of which is that the carbon footprints recorded are implied to be in units of carbon dioxide equivalence (CO2e). This is critical to ensuring that investors understand which of the many warming gases are at play in their portfolios and help avoid the pitfall of trading one warming gas for another in a bit to rebalance holdings to reduce only carbon.

This may seem inconsequential, but in the grand scheme of things, the types of gases emitted by a component of a portfolio should be considered as this could potentially affect the true carbon reduction trajectory (transition gamma, to be expounded upon in Part III of this series) of a portfolio, and much more alarmingly, the actual contribution to global warming. A good example of this is the stealthily notorious Kyoto Protocol gas sulfur hexafluoride (SF₆), typically used in switchgears in the electricity sector. SF₆ is known to have a global warming potential (GWP) 23,900 times that of a unit of carbon and lasts an estimated 800-3200 years to carbon’s 100. Reducing the climate impacts of a portfolio and hence its climate risks is not simply a game of hopscotching from fossil fuels to the good-looking electricity sector to which the renewable energies industry is related.

Structure

For banks, asset owners, asset managers, and insurance companies, TCFD’s framework comes as a template of four pillars and six steps. This provides an organized structure to tackle the task of climate risks disclosure. The structure provided by the framework also ensures that deep analysis is made of every aspect of a business, allowing proper enterprise risk management strategies to be formed to address climate risks.

• The four pillars, titled Recommendations and Supporting Recommended Disclosures, address the core functionalities at the various levels in an organization. They provide a progressive consideration of climate risks and opportunities in appropriate detail as per level and indicate the appropriate disclosures.
• The six steps are high-level actions marking the processes involved in preparing an investment process and disclosure procedure using scenario analysis. The TCFD refers to them as Process for Applying Scenario Analysis to Climate-Related Risks and Opportunities.

The pillars and steps move hand in hand and should be considered complementary.

Figure 2: TCFD Pillars and Stages

Source: TCFD

Conclusion

The work of the TCFD is necessary, not only because it calls for climate risk disclosure by entities, but also because it is one of the surest avenues to develop a globally accepted framework. The growth of regulation around the world will be inconsequential if it is piecemeal, with every jurisdiction crafting drastically distinct requirements.

Admittedly, there must be context applicability and relevance but there must be a “steel thread” like the TCFD recommendations that brings it all together. Individual investors, asset managers, asset owners, and insurers would do well to acquaint themselves with TCFD guidance in anticipation of its adoption by their jurisdiction’s regulators.

In the third part of this article series, we shall explore the concept of transition gamma and its relationship with scenario analysis, why it is important for investors, and the ways in which it can be incorporated in their climate risk management strategies.

Article Reposted with Permission from FactSet.