Planning a successful TCFD project: Climate strategy

Part Two of a three-part series. Part One can be found here.

If the key stakeholders are genuinely committed to TCFD disclosures that support the objectives of the Financial Stability Board, they must necessarily commit to first integrating climate change into the firm’s internal management processes. This internal activity to enhance the firm’s capabilities should precede external reporting. “If you’re going to talk the talk, you’ve got to first walk the walk.”

Begin by working through policy choices. (More on that in Part Three.) This will inform planning for the activities described below. Then, develop a plan for integrating climate risks and opportunities into the firm’s existing frameworks for governance, strategic planning, risk management and internal control. 

Governance

Integrate climate change risks and opportunities into the firm’s governance framework with specific emphasis on board-level engagement and accountability. This may be a necessary first step to gaining buy-in of key internal stakeholders.

Elevating climate change to the level of board governance is justified by the distinctive elements of climate-related financial risks which, when considered together, present unique challenges and require a strategic approach to risk management. According to the Bank of England’s Prudential Regulatory Authority’s draft supervisory statement, climate-related financial risks are:

1. Far-reaching in breadth and magnitude. The financial risks from physical and transition risk factors are relevant to multiple lines of business, sectors and geographies. Their full impact on the financial system therefore may be larger than for other types of risks, and is potentially nonlinear, correlated and irreversible. Mark Carney, governor of the Bank of England and chairman of the FSB, previously has warned that climate change could have “catastrophic impact” for the financial system.
2. Uncertain and extended time horizons. The time horizons over which financial risks may be realized are uncertain, and their full impact may crystallize outside of many current business planning horizons in what Carney has called the “Tragedy of the Horizons” (PDF). Also, past experience may not be a good predictor of future risks.
3. Foreseeable in nature. While the exact outcome is uncertain, there is a high degree of certainty that financial risks from some combination of physical and transition risk factors will occur.
4. Dependent on short-term actions. The magnitude of future impact will, at least in part, be determined by the actions taken today. This includes actions by governments, firms and a range of other actors.

Financial risks with far-reaching breadth and magnitude by definition are not specific to individual firms but are instead systemic (or “macroprudential”). The FSB’s recognition of climate change as a systemic risk has important implications for firm governance.

For example, the exceptional nature of climate-related financial risks justifies 1) intervention by macroprudential regulators into the management of regulated banks and insurers, which will over time impact their customers in nonfinancial sectors; and 2) intervention into the management of nonfinancial firms by passive fund managers, such as BlackRock, Vanguard, State Street and Fidelity, because while these funds can diversify away firm-specific risk, they cannot diversify away systemic risk.

These large institutional investors have both the power and the motivation to drive public firms to improve climate strategy and disclosure.

Strategy

Integrate climate change into the firm’s existing processes for strategic planning and analysis. Start by getting the firm’s director of strategic planning, CFO and CSO in the same room. Work with existing processes and allow these to develop and mature over time.

As illustrated in below, enterprise strategic planning typically follows a stepwise process including:

• Strategic analysis (internal and external)
• Identification of critical issues facing the organization
• Development of a strategic vision that articulates the future
• Mission statement that sets the fundamental purpose of the organization
• Formulation of the enterprise strategy
• Preparation for operational planning based on the enterprise strategy

The PESTEL (Political, Economic, Social, Technology, Environment and Legal) approach is widely used in strategic analysis to identify long-term internal and external trends in the business and industry. Climate change presents every element of PESTEL risk. Increasing the firm’s resilience to the financial risks from climate change starts by recognizing climate change as both a firm-specific and a systemic external risk.

Then, proceed to mitigate climate-related risks by anticipating potential future scenarios and adapting strategy accordingly.

Scenario analysis is a tool widely used for developing an understanding of the uncertainty inherent in the external and future environments and testing the robustness of alternative strategies against a wide range of possible futures. Use scenario analysis to assess the impact of climate-related financial risks on the firm’s current business strategy and to inform the risk identification process. Use multiple scenarios spanning a range of outcomes on the transition to a lower-carbon economy and a range of climate change scenarios leading to increased physical risks. Where appropriate, include a short- and a longer-term assessment.

The results of scenario analysis will feed the evaluation of options available to the firm. For example, options available to a mining company may include doing nothing (status quo), seeking continuous improvement opportunities or making a step change that could take the form of opening a new mine, expanding current operations, contracting current operations or closing a mine. Mining projects are characterized by investments that are either partially or completely irreversible, uncertainty over the future rewards from the investments and longtime lags between the decision to mine and the mining investment. These characteristics require consideration of the ability to change the course of a mine life to minimize downside risk and maximize any upside opportunity. This is the realm of real options, which values flexibility to adapt to new conditions (see, for example, Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions [PDF]).

A critical element of effective strategy development and execution is stakeholder engagement. Given that the support of the financial markets is needed for the firm to achieve its vision, effective financial disclosure and engagement with investors — in addition to employees, customers, suppliers, regulators and local communities — is a crucially important aspect of strategic planning. The TCFD recommendations provide a playbook for engagement on climate strategy between firm managers and investors.

Risk management

Integrate climate change into the firm’s existing risk management framework, in line with the firm’s board-approved risk appetite.

The financial impacts of climate-related issues on a firm are driven by the specific climate-related risks and opportunities to which the firm is exposed and its strategic and risk management decisions on managing those risks (that is, mitigate, transfer, accept or control) and seizing those opportunities.

Identifying the issues, assessing potential impacts and ensuring material issues are reflected in financial filings may be particularly challenging due to: limited internal knowledge of climate-related issues; the tendency to focus on near-term risks; and the difficulty in assessing the potential financial impacts of climate-related risks and opportunities.

To assist in this effort, Tables 1 and 2 in the TCFD Final Report (PDF) provide examples of climate-related risks and opportunities and potential financial impacts.

Internal control

Prepare to measure, monitor, manage and report on the firm’s climate-related objectives and performance against these objectives by integrating climate change into the firm’s existing internal control framework.

Appropriate information and reporting systems, both internal and external, will be needed to give the board, management and external stakeholders reasonable assurance that:

• the firm’s climate-related financial disclosures will be credible;
• the firm’s stated climate objectives will be achieved; and
• the firm will comply with applicable climate-related laws and regulations.

Each of these internal control objectives is briefly discussed below.

1. Financial reporting. Recognize that climate-related financial disclosures warrant the same scrutiny as published financial statements, whether they are included in the firm’s mainstream financial filings or elsewhere. Failure to apply appropriate internal control over climate-related financial reporting can result in claims of securities and accounting fraud. See, for example, Complaint in New York v. Exxon (PDF) (alleging fraud regarding Exxon’s reported use of a proxy carbon cost) and Order on Motion to Dismiss in Ramirez v. Exxon (PDF) (alleging material misstatements regarding use of proxy carbon costs in strategic planning and assessment of project economics).

Consider the potential interconnectivity of climate-related financial disclosures with existing financial statement and disclosure requirements under applicable rules of securities regulators, such as the U.S. Securities and Exchange Commission, and generally accepted accounting principles issued by accounting standards boards, such as the Financial Accounting Standards Board and the International Accounting Standards Board. Pay particular attention to matters concerning materiality, risks and uncertainties, contingent liabilities, asset impairment, asset retirement and environmental obligations and extractive industry reserve classification.

Determine whether the firm’s climate-related financial disclosures will (or should) be included within the scope of the independent financial audit. Consider also whether such disclosures may be sufficiently complex or subjective and potentially material to the financial statements to warrant the special skill or knowledge of a specialist to develop appropriate audit evidence.

2. Internal management. New information and reporting systems will be needed to assure that internal decision making aligns with the firm’s climate strategy and risk management process. Anticipate the need for new metrics and targets to assess climate-related risks and opportunities as well as the use of existing financial metrics in new ways. For example:

• A firm’s climate strategy and objectives may require it to measure and track past and forecasted future Scope 1, Scope 2 and, if appropriate, Scope 3 greenhouse gas emissions, carbon intensity, proxy carbon prices, energy mix, energy intensity and water usage.
• Firms may use scenario analysis to model the potential future impact of climate change on key financial metrics (for example, EBITDA margin and return on capital employed for mining firms).

To avoid confusion, develop clear policies (reinforced by employee training) to specify when and how these metrics are to be used in different decision contexts, such as long-term supply, demand and price forecasting, capital budgeting, project economics, petroleum reserve classification and impairment testing.

3. Legal compliance. New information and reporting systems also may be needed across multiple jurisdictions to assure compliance with environmental regulations, such as GHG reporting regimes, emission cap and trade systems and carbon taxes.