Climate-related disclosures – the best scenario? (part 1)

As we’ve addressed many times, the International Sustainability Standards Board has issued its first two exposure drafts, General Sustainability-related Disclosures (S1) and Climate-related Disclosures (S2), which were both open for comment until July 29, 2022.

A key aspect of the S2 document is the following proposed requirement:

  • An entity shall disclose information that enables users of general purpose financial reporting to understand the resilience of the entity’s strategy (including its business model) to climate-related changes, developments or uncertainties—taking into consideration an entity’s identified significant climate-related risks and opportunities and related uncertainties. The entity shall use climate-related scenario analysis to assess its climate resilience unless it is unable to do so. If an entity is unable to use climate-related scenario analysis, it shall use an alternative method or technique to assess its climate resilience. When providing quantitative information, an entity can disclose single amounts or a range.

The document defines climate-related scenario analysis asa process for identifying and assessing a potential range of outcomes of future events under conditions of uncertainty. In the case of climate change, climate-related scenario analysis allows an entity to explore and develop an understanding of how the physical risks and transition risks of climate change may affect its businesses, strategies and financial performance over time.” It’s been defined elsewhere as “a forward-looking projection of risk outcomes that provides a structured approach for considering potential future risks associated with climate change.” The Basel Committee on Banking Supervision put it this way in a banking context:

  • “Climate scenario analysis is a forward-looking projection of risk outcomes that is typically conducted in four steps: (1) Identify physical and transition risk scenarios; (2) Link the impacts of scenarios to financial risks; (3) Assess counterparty and/or sector sensitivities to those risks; and (4) Extrapolate the impacts of those sensitivities to calculate an aggregate measure of exposure and potential losses.”

The S2 basis for conclusions notes: Although scenario analysis is a widely accepted approach, its application to climate-related matters in business, particularly at an entity level, and its application across sectors is still evolving. Some sectors, such as extractives and minerals processing, have used climate-related scenario analysis for many years; others, such as consumer goods or technology and communications, are just beginning to explore applying climate-related scenario analysis to their businesses… Preparers raised other challenges and concerns associated with climate-related scenario analysis, including: the speculative nature of the information that scenario analysis generates, the potential legal liability associated with disclosure (or miscommunication) of such information, limited data availability and the potential disclosure of confidential information about an entity’s strategy.” These and other factors led to the approach summarized above.

As you’d expect, the comment letters engaged with all this in a variety of ways. One interesting perspective came from the independent non-profit entity RMI, focused mainly on financial institutions, and challenging the basic premise of scenario analysis”

  • Whereas scenario analysis informs how a corporate “might” deal with climate change against a set of different hypothetical scenarios – i.e an assessment of its resilience – It does not speak to how it is “dealing with or contributing to climate change”. For this we need a new set of metrics – Climate scenario alignment metrics.
  • The former could reveal a good level of resilience of a corporate based on their diversification activities i.e they may have good hedging systems in place that allow for them to continue being a robust business in light of climate change. But this doesn’t speak to their actions to align with global climate goals and hence mitigate the risks of climate change in the real economy and hence the worst of its effects on the financial system over longer time horizons.
  • The latter would look at how a corporates activities (real economic activities) align with climate goals. In this case the climate goals are read from scenarios and translated into sectoral pathways that provide one potential route for the given sector to achieve climate goals. This speaks directly to how the corporate is contributing to a given climate goal as opposed to its resilience to deal with a climate impact (shock).
  • To address climate change and in particular to mitigate the risks of climate change on the financial system an ex ante approach to risk management is required – i.e. one that is forward looking and pro-active. So the question should be “what actions/contributions is a corporate taking to address climate change and the inverse mitigate it”. Rather than the reactive – now that it has happened “how good is the company at dealing with it”.

RMI has a particular interest in this, through its interest in PACTA (the Paris Agreement Capital Transition Assessment), “one of the leading climate scenario analysis approaches and tools in the world, applied by banks, investors, supervisors, and governments in all major financial markets.” The question may arise (relative to the CFA Institute input we cited here) whether their comments are sufficiently investor-driven. But anyway, their letter provides some stimulating input. We’ll come back to this next time…

The opinions expressed are solely those of the author.

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