Climate-Related Financial Disclosure: The New Convergence of Finance, Policy, and Science

The urgent need to look beyond short-term setbacks in US climate policy should spur greater collaboration between the financial world and climate economists and scientists to address longer-term financial risks related to climate change.

Recent reversals of US climate policy have elevated the role of investors and corporations to address the risks of climate change. Increasingly, climate science, economics, and policy are converging with the financial and environmental interests of shareholders. Investor interest in corporate climate risk disclosure, including risks from future climate regulations and physical risks from the impacts of a changing climate, are fueling a variety of initiatives and reporting programs. Companies and investors are adopting some of the tools and structures of the climate policy world, including corporate emissions goals, internal carbon pricing, and scenario analysis to guide corporate investment. These recent trends provide an opportunity for more collaboration between the financial world and climate economists and scientists to develop new tools and methodologies to assess the financial risks of climate change.

Rising Investor Interest in Climate Risk

Investor and shareholder interest in climate change and clean energy is not new—there is a history of activism that goes back decades. However, the last few years have seen a significant jump in activity and interest by investors in the climate risks of their portfolios. This has taken several forms. First, there are a number of socially responsible investment funds that screen companies for environmental, social, and governance (ESG) issues, including climate change, human rights, political lobbying, equal employment policies, and executive pay issues. A subset of these funds focus on climate change and clean energy exclusively, by screening out fossil fuel related stocks, emphasizing stocks from companies with low- or no-carbon products, or both. Investors can take advantage of a growing array of indexes and screening tools that address the risks of companies with high carbon assets. For example, investment research and analysis firm MSCI uses proprietary data to assess exposure to possible low-carbon transition risks (e.g., stranded assets) and opportunities (e.g., new clean energy products and markets). The firm’s screening tool evaluates more than 5,700 US-based mutual funds and exchange-traded fund families.

Overall, there has been significant growth in investment in funds that employ sustainable investment strategies, both in general and in climate or clean energy specifically. The US SIF: The Forum for Sustainable and Responsible Investment foundthat ESG criteria were applied to a total of $8.72 trillion of assets at the beginning of 2016, a jump of 33 percent since 2014. For climate change specifically, institutional investors such as pension funds and banks applied climate change criteria to $2.15 trillion in asset,s and money managers applied climate change factors to $1.42 trillion in assets in 2016. (There is some overlap between these two categories of investors.)

Despite the reluctance of the Trump administration to support the Paris Agreement, there continues to be significant interest in screening investments for companies that are better positioned for the transition to a lower-carbon world. A June 2017 analysis by S&P Global Market Intelligence found that some major investment management firms believe that the new administration’s position on climate change has actually increased investor interest in low-carbon and clean energy-related funds. Similarly, Morningstar reports that the use of ESG data the company provides to investment management clients quadrupled between January and June 2017.

Pressure by shareholders regarding climate risk has also increased. In 2017, shareholder resolutions at ExxonMobil, Occidental Petroleum, and electric power company PPL Corporation calling for an assessment of climate risk passed with unprecedented levels of support. For example, 62.3 percent of ExxonMobil shareholders backed a resolution that called on the company to produce an annual assessment of climate-related financial risks. The resolution specified that the assessment “should analyze the impacts on ExxonMobil’s oil and gas reserves and resources under a scenario in which reduction in demand results from carbon restrictions and related rules or commitments adopted by governments consistent with the globally agreed upon 2° Celsius target.” In 2016, a similar resolution received 38 percent shareholder support. Shareholders at PPL Corporation passed a resolution on climate risk with 57 percent support. The PPL resolution asked the company to assess how it could adjust its capital expenditure plans to align with a 2° scenario. It further requested information on the company’s plans “to integrate technological, regulatory, and business model innovations such as electric vehicle infrastructure, distributed energy sources (storage and generation), demand response, smart grid technologies, and customer energy efficiency as well as corresponding revenue models and rate designs.”

This high level of support, which is likely to continue in 2018, reflects a shift by some shareholders to a more financial rationale for supporting climate-related resolutions. For example, in a statement explaining its general position on climate change, Vanguard noted “[O]ur position on climate risk is anchored in long-term economic value—not ideology.” Similarly, BlackRock states it “could see climate-aware portfolios outperform amid tighter regulations, faster technological changes, or more frequent weather events.”

These types of shareholder resolutions are not binding on companies. Nevertheless, support from large investment management firms such as BlackRock, The Vanguard Group, and State Street Global Advisors (SSGA) (i.e., the three largest asset management firms globally) is hard for companies to ignore. In late 2017, both ExxonMobil and Occidental Petroleum announced that they would respond to these shareholder resolutions with reports that provided additional information in their climate-related risks. In the case of ExxonMobil, the company stated in a filing with the US Securities and Exchange Commission (SEC) that its board had agreed to provide information on “energy demand sensitivities, implications of 2° Celsius scenarios, and positioning for a lower-carbon future.”

Disclosure of Climate Risk

The demand by investors for better assessment of climate risk has been accompanied by a wide array of voluntary standards and reporting protocols through which companies provide emissions and other data about their operations. Some of these programs, such as the Global Reporting Initiative, Principles for Responsible Investment, and the Sustainable Accounting Standards Board, have standards that are broader than climate or environmental performance, and include aspects such as human rights and labor policies. Other programs such as the CDP (formerly the Carbon Disclosure Project) and Climate Disclosure Standards Board are focused on greenhouse gas emissions and climate change risks.

This interest in climate-related financial risk is a subset of general requirements for publically traded companies to disclose material financial risks in their filings with government agencies. In 2010, the SEC released guidance on disclosure related to climate change. In response to criticism that companies were not disclosing adequate information, the SEC asked for comments in April 2016 on how to improve disclosure requirements to provide better information on climate risks to investors. More specific disclosure guidelines on climate risk from the Securities and Exchange Commission are now unlikely under the Trump administration. However, there is a continuing obligation to disclose material risks to investors, and there is a long-term practice of reporting risks from emerging environmental standards in the United States. Meanwhile, the European Union and other countries continue to explore various approaches for disclosure of corporate climate risk.

Better Climate-Related Financial Data?

With growing demand from investors for better climate-related data, and with wide differences in climate risk disclosure across countries and companies, the G20’s Financial Stability Board set up the Task Force on Climate-Related Financial Disclosure (TCFD), which covers governance issues related to climate disclosures, corporate strategy around climate risks and opportunities, risk management surrounding assessment and management of climate risks, and metrics and targets used to manage climate risks (see figure below). The guidelines apply to both physical risks from climate change (e.g., sealevel rise and more intense weather events) as well as transition risks related to future regulatory requirements or changing technologies and markets.

Many companies already report their emissions to EPA under the mandatory GHG Reporting Program or disclose emissions, clean energy activities, and other climate- related information in corporate sustainability reports or under the voluntary reporting programs described above. However, the TCFD guidelines urge additional metrics and methodologies that may be new to many companies and investors. In particular, the TCFD recommends the use of scenario analysis to assess the financial implications of climate change. The TCFD guidelines advise that companies present a limited number of scenarios that reflect different potential future outcomes. At a minimum, the guidelines suggest using a scenario consistent with meeting a global 2° Celsius goal and to “consider using other scenarios most relevant to the organization’s circumstances, such as scenarios related to Nationally Determined Contributions (NDCs), business-as-usual (greater than 2° Celsius) scenarios, physical climate risk scenarios, or other challenging scenarios.”

The challenge of reaching a critical mass of companies that develop and disclose scenario analyses is considerable because very few companies have experience with this approach. A recent KPMG survey of 4,900 global companies found that only 28 percent acknowledged the risk of climate change in their annual reports. Among those who did acknowledge climate risk in their financial reports, only 2 percent modeled financial impacts of climate change using scenario analysis.

There are also significant challenges to adapting the methodologies themselves. Different industry sectors face different considerations—whereas an energy company may face direct impacts on demand for fossil fuels, a food processing company may be more concerned about weather impacts on its supply chain. Banks and other financial institutions may be concerned with a wider range of transition and physical risks to the assets within their portfolios.

To assess physical risk, scenarios must be able to match potential climate impacts to the physical footprints of their facilities and supply chains. Tools and methodologies for assessing the physical risks faced by companies are starting to emerge. For example, Deutsche Asset Management’s Global Risk Institute recently published a paper on an approach to assess the physical financial risks to corporate facilities using an analytic tool developed by the consulting firm Four Twenty Seven. The tool matches several climate impacts (e.g., wildfires, sea level rise, and stress on water resources) to more than one million facilities around the world and scores the operational, supply chain, and market risks of companies.

Ultimately, screening tools for financial and physical risks are still at an early stage of development and will be improved with better data and methodologies. Going forward, climate-related economic and policy analysis can make a large contribution to the financial world’s assessment of climate risk. Scenario analysis has long been a staple of climate economics, and modeling methodologies and analytical approaches can be shared that can assist with corporate disclosures. For example, with regard to transition risks, economic modeling can project the impacts of potential future carbon pricing policies and can assess impacts on industry sectors. Climate analysts can also provide important expertise on technology and energy prices, macroeconomic data, demographic trends, and other modeling parameters. In the case of physical risks from climate change, integrated assessment models—particularly models under developmentthat can assess climate impacts and costs at regional and local levels—could provide projections of a range of climate impacts that may be relevant to assessment of corporate risks across multiple industries.

At the same time, scaling and adapting modeling results to meet the needs of investors and companies is likely to require the development of new methodologies and approaches. The perspectives of investors and companies could add an important dimension to climate economics and policy and could provide the basis for new research and enhancements in climate modeling and analysis. Ultimately, close collaboration between climate economists, scientists, investors, and corporate analysts could further the state-of-the-art of scenario analysis used for corporate climate risk disclosure. This type of collaboration has already begun. For example, a recent conference by the TCFD and the Bank of England brought together academics and practitioners, among others, to consider some of these issues. But more efforts will be needed—particularly in the United States.

Finally, efforts to improve climate-related risk disclosure are often linked with initiatives to encourage companies to adopt internal carbon prices and corporate greenhouse gas goals. In the case of internal carbon prices, there can be considerable variation in the prices used because they embody a wide range of assumptions about future regulations, technological change, energy markets, and economic growth. Nevertheless, there have been two recent initiatives by expert panels to develop standardized “carbon price corridors” to be used by investors and policymakers to address policy and corporate planning for a 2° scenario. The CDP and the We Mean Business coalition released a report that is targeted toward investors and businesses, and focused on the electric power sector. Their price corridor is $24–39 per metric ton of carbon dioxide equivalent (mtCO2e) in 2020, $30–60 per mtCO2e in 2025, and $30–100 per mtCO2e in 2030. The High-Level Commission on Carbon Prices, chaired by economists Joseph Stieglitz and Nicholas Stern, released a report more targeted toward policymakers. Their price corridor is $40–80 per metric ton of carbon dioxide (mtCO2) in 2020 and $50–100 per mtCO2 in 2030. Both reports stress the need for additional complementary policies to be put in place alongside carbon prices.

Regarding carbon targets, a 2017 survey of 1,000 global “high-impact companies” (i.e., companies with large market capitalization and environmental impact) by CDP found that 89 percent of the companies responding had emissions targets, with 68 percent setting targets to 2020, and 20 percent setting targets to 2030 and beyond. Meanwhile, more than 300 companies have put forward targets under the Science Based Targets Initiative where companies commit to a corporate greenhouse gas target that is pegged to the Paris Agreement goal to limit temperature increase to below 2° Celsius.

Conclusions

Ultimately, investment in climate mitigation will be driven by the anticipation of future government policies that place a price on carbon and a value on avoiding emissions. While this longer-term investment horizon is important globally, it is particularly critical in the United States, where the stop-and-go nature of climate policies that change with each new administration has created uncertainty. A longer-term investment perspective would anticipate significant regulatory, technological, market, and physical risks related to climate change that are likely despite near-term political changes. Emphasis on climate-related disclosure, including scenario analysis, internal carbon pricing, and corporate emissions goals can provide better information for investors on how companies are addressing these risks. At the same time, these methodologies and metrics have long been the common currency in climate economics and policy. Increased collaboration between the financial and climate policy worlds can help develop approaches that will lead to lower cost and more environmentally beneficial pathways on climate mitigation and resilience.