Climate risk disclosure needed

Climate change is quickly evolving into a financial concern from being a purely environmental one. Climate change threatens the financial system’s stability, financial services industry firms and investors’ portfolios while sparking new efforts to get a handle on the size and scope of the danger.

Concern about the impact of climate change is nothing new, but it’s increasingly permeating the financial services world. In the latest edition of the Bank of Canada’s (BoC) Financial System Review, the central bank flags climate change as a key threat to both the economy and the financial services system.

Most obviously, shifting environmental conditions include weather events, such as wildfires, floods and damaging storms. Those risks are beginning to materialize. The BoC reports that insured damage to property and infrastructure now averages $1.7 billion annually, up from approximately $200 million between 1983 and 1992.

But policy-makers also are increasingly concerned about the more significant, pervasive risks that may accompany the looming transition to a less carbon-intensive economy.

A large-scale shift away from oil and gas to alternative energy and greener technologies isn’t likely to happen with a straightforward reallocation of labour and capital from one sector to another. This sort of transition is sure to be uneven and disruptive.

“The move to a low-carbon economy involves complex structural adjustments, creating new opportunities as well as transition risk,” the BoC’s report warns.

For example, as the economics of energy production shift, reserves of fossil fuels could become “stranded” – leaving these reserves untapped and with little to no market value. The effects of this would, in turn, likely spill over into the financial services system – such as the banks that finance oil and gas companies and the asset-management firms that own stakes in these businesses.

At this point, these sorts of risks are mostly theoretical. Indeed, perhaps the biggest threat at the moment is the unknown. Without clarity about how the environment and the economy will evolve in the years ahead, there remains a great deal of uncertainty for companies and investors alike.

“Limited understanding and mispricing of climate-related risks could increase the costs of transitioning to a low-carbon economy,” the BoC’s report states.

This same significant uncertainty also afflicts asset prices that aren’t yet properly factoring in climate risks – yet another significant risk to the financial services system.

“If assets are mispriced, correct incentives will not be in place to manage and mitigate risks. Rapid repricing might cause fire sales and interact with other vulnerabilities – [such as] excessive leverage – destabilizing the financial system,” the BoC’s report warns.

To guard against that sort of outcome, policy-makers are calling on companies to make greater efforts to measure and disclose their climate-related risks.

In early August, the Canadian Securities Administrators (CSA) issued new guidance devoted to climate risk disclosure. Previously, the CSA set out its expectations for firms to disclose environmental risks in general, but the new guidance focuses on climate risks specifically, which the regulator now characterizes as a “mainstream business issue.”

Climate risk also is an area in which regulators are finding firms’ current financial disclosure to be lacking. The CSA reports that its reviews of climate- related disclosure among a sample of issuers listed on the Toronto Stock Exchange found that 22% provide boilerplate disclosure in this area and another 22% don’t produce any disclosure regarding their risks related to climate change.

Among the companies that do disclose the risks to operations, that disclosure often is deficient, states the CSA’s report. The CSA’s reviews found there wasn’t any comparability among issuers’ climate change risk disclosure and that some companies don’t include information needed to provide “sufficient context for the disclosure.”

Alongside these shortcomings in companies’ reporting, the CSA’s report indicates that there is growing demand from investors – particularly institutional investors – for more useful, meaningful climate change- related risk disclosure. The report points to increasing international efforts to develop some global standards in this area – such as the work of the Switzerland-based Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures (TFCD) – as factors driving the CSA to develop new guidance on disclosure regarding climate risk.

The TFCD, formed in 2015, released its initial set of disclosure recommendations in 2017. The task force is due to report to the FSB in September 2020 regarding the extent to which the TFCD’s proposals have been adopted throughout the financial world.

In the meantime, in June, the TFCD published its findings from a review of 1,100 companies around the world. That review found that disclosure of climate-related financial information has increased over the past couple of years, but remains inadequate for investors.

In particular, the TFCD review found that investors need more insight into the potential financial impact of companies’ climate change- related issues. Overall, the report concludes, “not enough companies are disclosing decision-useful climate- related financial information.”

This is precisely the shortcoming that the CSA’s guidance aims to address: “In order to make informed investment and voting decisions, investors, particularly institutional investors, are seeking improved disclosure on the material risks, opportunities, financial impacts and governance processes related to climate change.”

The CSA’s guidance aims to help companies craft disclosure of “material” climate change-related risks, noting that such information is considered material if it would be expected to affect a “reasonable investor’s decision” about investing in the company.