The Importance of Climate Risk Disclosure for Business

With the effects of climate change increasingly pronounced, disclosure of climate risks is critical for businesses. Failure to make a disclosure can facilitate poor investment decisions, asset losses and the continuation of trade practices that lead to climate change. According to the November 2015 study Global Non-Linear Effect of Temperature on Economic Production, “unmitigated [global] warming is expected to…[reduce] average global incomes roughly 23% by 2100 and [widen] global income inequality, relative to scenarios without climate change.” Climate risk disclosure makes good business sense—it drives businesses to adopt sustainability measures that will help address climate change. When climate change is managed, profitability is more likely.

Financial Implications of a Company’s Climate Change Risks

An increased awareness of the effects of climate change has created the need for useful climate change information. Businesses‘ investors, customers and other stakeholders are demanding greater transparency through the disclosure of their climate change risks. This demand has become so strong that businesses that fail to disclose their climate change risks could jeopardize their reputations. In 2015, Exxon Mobil was investigated for deceiving both investors and the public about its climate change risks.

There are many standards in place that can help businesses become more transparent about the disclosure of their climate change risks. Many of these standards focus on climate change-related data and other sustainability metrics, such as water use and greenhouse gas (GHG) emissions, and do not provide information about the financial implications of a company’s climate risks. These limitations can discourage businesses from prioritizing climate change risk disclosure and incorporating sustainability measures into their investment decisions and operations.  A business may not have an incentive to disclose its climate change risks if they are not aware of the connection between climate change and profitability.

In April 2015, the G20 Finance Ministers and Central Bank Governors requested the Financial Stability Board (FSB) to “convene public- and private-sector participants to review how the financial sector can take account of climate-related issues.” The FSB, in response, created the Task Force on Climate-Related Financial Disclosures (TCFD) in December 2015. The TCFD came up with several recommendations that will help businesses effectively disclose their climate change-related financial risks.

Types of Climate Change Risks

The TCFD divided climate change risks into two main categories: transition risks and physical risks. In a financial context, these are the climate change risks a business will encounter and address, and must include in its disclosure.

  1. Transition Risks – Transition risks refer to the financial and reputational risks businesses are likely to face as they shift to a lower-carbon economy. Shifting to a lower-carbon economy is important for climate change mitigation. This transitioning expects businesses to make changes that may expose them to certain financial and reputational risks.
    • Policy and Legal Risk – In order to help address climate change, businesses can implement policies that either limit industry practices that lead to climate change or promote adaptation to climate change. These policies include encouraging greater water and energy efficiency, as well as more sustainable waste management. Implementing a new policy may have a financial impact, depending on the nature of the new policy.

      Ineffective climate change mitigation policies can expose a business to legal risks. Examples of ineffective climate change mitigation policies include inadequate or misleading climate risk disclosure, which can lead to possible lawsuits from investors and other stakeholders.
    • Technology Risk – Investing in technologies that help address climate change can have significant financial impacts on a business. When a company decides to run its facilities on renewable energy, this decision will affect the bottom line. Will the business absorb new operational costs? If yes, how much will they be? Will the quality of its products and services be affected? These are some of the financial risks that businesses may face when investing in climate change-mitigating technology.
    • Market Risk – Transitioning to a lower-carbon economy may involve altering or phasing out products and services that are popular among consumers. In order to minimize or avert the potential loss of profit, a business may create a substitute product or service that is more conducive to facilitating a lower-carbon economy. This decision also has a financial risk with the possibility that consumers might not purchase the substitute product or service.
    • Reputation Risk – The shift to a lower-carbon economy can either build or damage a business’ reputation among stakeholders. As stakeholders become increasingly aware of the negative impacts of climate change, an effective transition to a lower-carbon economy can help businesses earn their respect. Lawsuits due to ineffective climate change mitigation policies, on the other hand, can damage their reputation among stakeholders.
  2. Physical Risks – Physical risks refer to both direct and indirect asset losses businesses may incur as a result of climate change.
    • Acute Risks – Acute physical risks refer to asset losses brought by climate change-related disasters such as hurricanes and floods. Acute physical risks may include damaged sites, equipment and merchandise.
    • Chronic Risks – Chronic physical risks refer to asset losses brought by long-term effects of climate change such as longer summers and rising sea levels. Chronic physical risks may include resource depletion and extreme temperature changes that compromise employee health and safety.

Four Recommendations on Climate-Related Financial Disclosures

The TCFD came up with four recommendations on climate-related financial disclosures. The TCFD holds that when a business’ climate change-related financial information is included in its financial filings, investors and other stakeholders gain an informed understanding of the business’ climate change-related risks. This outcome leads to a more transparent disclosure, better investment decisions and protected assets. 

The TCFD’s four disclosure recommendations are built upon the following core elements:

  1. ​Governance – Calls for the "[disclosure of an] organization's governance around climate-related risks and opportunities." The TCFD similarly provided supporting recommended disclosures:
    • A business should “describe the board’s oversight of climate-related risks and opportunities.”
    • A business should “describe [its] management’s role in assessing and managing climate-related risks and opportunities.”
  2. Strategy – Calls for the “[disclosure of] the actual and potential impacts of climate-related risks and opportunities on [an] organization’s businesses, strategy, and financial planning.” The TCFD also itemized supporting recommended disclosures:
    • A business should “describe the climate-related risks and opportunities [it] has identified over the short, medium and long term.”
    • A business should “describe the impact of climate-related risks and opportunities on the [its] businesses, strategy and financial planning.”
    • A business should “describe the potential impact of different scenarios, including a 2°C scenario, on [its] businesses, strategy, and financial planning.”
  3. Risk Management – Calls for the “[disclosure of] how [an] organization identifies, assesses and manages climate-related risks.” The TCFD follows with supporting recommended disclosures:
    • A business should “describe [its] processes for identifying and assessing climate-related risks.”
    • A business should “describe [its] processes for managing climate-related risks.”
    • A business should “describe how processes for identifying, assessing, and managing climate-related risks are integrated into the organization’s overall risk management.”
  4. Metrics and Targets – Calls for the “[disclosure of] the metrics and targets used to assess and manage relevant climate-related risks and opportunities.” Supporting recommended disclosures include:
    • A business should “disclose the metrics [it is using] to assess climate-related risks and opportunities in line with its strategy and risk management process.”
    • A business should “disclose Scope 1, Scope 2, and, if appropriate, Scope 3 greenhouse gas (GHG) emissions, and the related risks.”
    • A business should “describe the targets [it uses] to manage climate-related risks and opportunities and performance against targets.”

Scenario Analysis

Included in the TCFD’s recommendations for a climate-related financial disclosure is the use of scenario analysis. Markets can be volatile, and climate change risks that are non-existent today may develop in the short- or long-term future. Businesses must be forward-thinking to evaluate and predict future sustainability performance.

Scenario analysis allows businesses to picture how the future of their businesses might look if particular trends emerge or continue by anticipating and preparing for potential climate issues. Ultimately, their disclosures will be more transparent and their strategic plans will be more flexible, effective and inclusive.

The TCFD outlines a process for applying scenario analysis to climate-related risks and opportunities:

  1. Ensure Governance – Scenario analysis must be part of a business’ strategic planning and enterprise risk management frameworks. The board, management and other stakeholders must be involved and their roles clearly specified in the disclosure.
  2. Address materiality of climate-related risks – What are the climate change risks a business is currently facing? What are the potential climate change risks it will face in the future? Will these affect the company’s stakeholders? 
  3. Identify and define range of scenarios – What are the present scenarios? What are the future scenarios? Both must be explained in complete detail.
  4. Evaluate business impacts – What are the effects of actual and potential climate change risks on a business’ input costs, operating costs, revenues, supply chain, business interruption and timing? Each must be completely and accurately detailed.
  5. Identify potential responses – What are the possible solutions to the business’ potential and actual climate change risks? Will it be necessary to adjust the business’ strategic and financial plans? Solutions and adjustments must be included.
  6. Document and disclose – All aspects of the process (e.g., important inputs and management responses) must be included in the disclosure and relayed to all concerned parties.

Climate Risk Disclosure: Helping Businesses Become More Sustainable and Involved in Climate Change Mitigation

The TCFD’s four recommendations on climate-related financial disclosures, as well as the usage of scenario analysis, effectively help businesses become more sustainable and involved in climate change mitigation. These disclosure recommendations show a link between climate risks and a company’s bottom line; thus, businesses are more inclined to follow them. By following these disclosure recommendations, businesses are able to identify, evaluate and address actual and potential climate change-related risks, leading to better investment decisions, protected assets, greater business continuity, improved reputation among stakeholders and increased profits.

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