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ESG: The metrics jigsaw

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Risk metrics jigsaw

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Moves to promote useful climate risk disclosure among companies are hampered by highly variable risk metrics and a lack of cohesive standards 

Key points

  • Central banks have begun to probe climate risk among lenders
  • Many investment firms expect mandatory climate risk disclosure 
  • Banks want collective action

A cog has turned. For the first time, in April 2019, a group of central banks launched their own quiet offensive against global warming. They jointly recommended the integration of climate-related risk into financial stability monitoring and urged for internationally consistent environment-related disclosure. 

But Frank Elderson, chair of the consortium, known as the Network for Greening the Financial System (NGFS), declared a limit to the powers of even these influential organisations. Reaching out to the wider community, he stated: “We cannot and will not do this alone.”

The statement no doubt alluded to the Rubik’s cube of individual blocks obstructing cohesive action over which the central banks have no control. They consist of investors, lenders, data providers, regulatory authorities and the general public. Central banks assessing climate risk in the financial system need to frame the problem themselves first. 

As they embark on their journey, they have identified the first barrier to that objective: no two models of physical risk to real estate, for example, are identical. At the same time, transition risk is subjective. In flood conditions, water flows can make surprising twists, and no two flood events are alike – even in the same location. “To identify the risks, you need to get the risk metrics right,” says Morgan Despres, deputy head of financial stability at Banque de France.

Standing between the central banks and an understanding of the groundwater, drains and sewers their cities depend on, as well as the potential impact of floods or hurricanes, are the private banks. Many of these have not evaluated climate risk. Until they deliver the data, the central banks remain in the dark.

“Take a global bank with a portfolio of residential mortgages. We expect them to experience more extreme weather events where the mortgage holders are but we don’t know where or how much risk exposure is in that particular portfolio – that’s very specific to each bank,” says Després.

Supported by Bank of England governor Mark Carney, who spearheaded the voluntary Task Force on Climate-Related Financial Disclosures (TCFD), the banks can inspire broader financial disclosure on climate – producing a knock-on effect on investors. However, they have hit the same wall as most asset managers: scenario analysis – assessing one’s own business against warming-change scenarios.

Numerous weaknesses have been identified in the scenario analysis proposed by the TCFD. Matthew Smith, head of sustainable investments at Norwegian asset manager Storebrand, draws attention to the oil and gas sector. 

Some hydrocarbons companies have concluded that they incur little or no climate risk by assuming that carbon capture and storage will eliminate 40% of their carbon emissions by 2035. “This technology is not commercially viable today. They define risk out of the equation, so it’s difficult to take such scenarios seriously,” he says.

derk welling

Equally, companies use a variety of input scenarios for their own analysis. These examine issues like global temperature increases in the context of fossil fuel combustion. Estimates on fossil fuel use vary owing to their dependence on evaluations of the pace of electrification. In addition, organisations such as the International Energy Agency, environmental consultancies or the UN differ in their views on warming. “We need a standard input reference scenario,” says Steve Waygood, chief responsible investment officer at Aviva Investors.

Even if the scenarios produced by individual corporations are reliable, they are not comparable due to differences in underlying data. “We don’t like multiple competing reporting standards – they’re a hindrance to improvement,” says Derk Welling, senior responsible investment & governance specialist at APG, asset manager for the €492bn ABP public pension scheme. “We’re all familiar with the financial reporting standards IFRS but there is no similar standard to assess physical risk for real estate, for instance,” he says.

Many agree that standardisation of metrics would help. Sustainability standards organisations, such as the Global Reporting Initiative, the CDP and the Sustainability Accounting Standards Board (SASB), place different emphasis on different issues in their metrics. 

For example, the SASB diverges from the two others by excluding scope 2 and scope 3 (purchased electricity and downstream carbon emissions) and only including a company’s direct energy usage. However, a study in September indicated considerable alignment (70%) between the TCFD’s metrics and the other three standards. 

Convergence is not imminent, however. “SASB is very focused on financial materiality. Others concentrate on more specific themes. We are still looking at what we should align to better facilitate company reporting,” says Jeff Hales, chair of SASB.

A simple way to cut through the deadlock caused by such disparities is to impose mandatory climate risk reporting, which would probably mean selecting a single standard. Hales suggests this is a complex challenge. “Standardising scenario analysis is the most challenging of all because it is the most complicated type of reporting – more forward-looking than reporting on current performance,” he says.

Nonetheless, expectations of mandatory reporting in some countries are widespread, as signalled, for example, in the UK government’s July 2019 Green Finance Strategy. This set out government expectations that all listed companies and large asset owners disclose in line with the TCFD recommendations by 2022. In October, Mark Carney reiterated a two-year timeframe for corporations to agree rules on reporting climate risks or expect them to become compulsory.

“What’s important in our view is carbon pricing. Without this, it makes it more complicated to make the transition. This requires policy makers to price carbon and also in such a way that it reflects the real price of carbon at $80-90”Morgan Després

Some have already accepted this as desirable. “As long as reporting remains voluntary, there will be less consistency and standardisation. We are moving towards more of a mandatory framework,” says Sonya Gibb, managing director and head of sustainable finance at the Institute for International Finance, a trade association representing 500 commercial and investment banks, asset managers and insurance companies. 

Some companies such as APG, positively embrace a mandatory regime. “We have agreed with key financial players and government to start reporting on carbon dioxide reduction in a standardised way. We would like to see climate risk disclosure become mandatory,” says Welling.

Central banks, of course, have this within their grasp without waiting for government. In 2017, the Bank of England had already led the way with an unprecedented decision to incorporate climate risk into the banks’ financial stability mandates. The NGFS followed with strong leadership from De Nederlandsche Bank (the central bank of the Netherlands) and Banque de France. It now has 42 members globally but lacks the backing of the Federal Reserve in the US. 

The Bank of England plans to stress-test the commercial banking system for climate risks from 2021. Rules compelling these banks to disclose on climate risk could follow. However, the data jigsaw has yet to be assembled, as Després emphasises. 

“We may require banks to publish exposure to climate change risk. If we made it compulsory we would get better market discipline. However, if we make it compulsory we also need to be sure of our metrics,” he says. That road has yet to be travelled. The NGFS is still at an early stage, while not all commercial banks have voluntarily engaged on climate either.

In the meantime, some companies argue against mandatory reporting. For leading asset manager BlackRock, the ‘comply or explain why not’ rule of France’s Article 173 law on disclosures is preferable. “We do not believe these [TCFD/SASB] frameworks should be mandatory…. we recommend a flexible approach recognising the rapidly evolving market practices in the field of non-financial reporting,” states Amra Balic, head of investment stewardship for EMEA.

If the business community is in disagreement on climate reporting, inertia need not result. Climate advocates point to the emergence of leaders and the formation of peer groups to encourage action. According to Russell Picot, special adviser to the TCFD, those that make outlandish scenario analysis will eventually be filtered out as dialogue on scenarios continues. “If you get a minimum level of disclosure across a sector you can make a comparison. If shareholders see that a scenario is wholly out of kilter with its peers, they can ask themselves why,” he says. 

Considerable work still has to be done among senior management, to which the TCFD contributes, perhaps over a period that could last three to five years: “The scenarios can change discussions in the boardroom, get climate change on the executive agenda and be used to integrate insight into the resilience of strategy.” 

As laggards emerge, responsible investors have been conducting assessments. “If a company doesn’t consider climate change as a key material risk, that says something about how they perceive risk. If it’s not on their radar, that’s also a risk in itself,” says Welling of APG.

Like many fund managers incorporating environmental, social and governance (ESG) criteria, his team then takes action. “We take a view on leaders or laggards. If they are a laggard, we invest, provided there is an engagement plan in place. That they disclose through TCFD could be the consequence,” he explains. In many sectors, physical risk is not the only concern the company likes to see covered. In real estate, for example, risk analysis may involve an understanding of the tenants and other components in the value chain.

Voting on the quality and comprehensiveness of annual reports is one of the standard tactics of Aviva, which has voted down several annual reports by companies such as Boeing, American Airlines and multinational conglomerate Berkshire Hathaway. None of these companies currently supports the TCFD. Further still, Aviva campaigns on director remuneration. “We say that only when pay reflects ESG performance is ESG embedded into the company,” says Waygood.

The company also advocates creating league tables to ‘name and shame’ corporate performance. The World Benchmarking Alliance, set up in 2018, provides this insight on corporate progress on the UN Sustainable Development Goals – some of which relate to climate.

ESG investors see non-disclosure on climate as a risk. There are plenty of investors and corporations that see TCFD as a risk. The Rubik’s cube is still locked.

The central banks’ engagement is still tentative but respected. “It’s a very strong statement that the Dutch central bank is taking this as its first non-financial topic in its regulatory overview,” says Welling. If, as NGFS’s Elderson asserts, the banks will not act alone, the government and supervisory bodies, such as Prudential authorities, need to take action. Després suggests even more radical steps are necessary from them: 

“What’s important in our view is carbon pricing. Without this, it makes it more complicated to make the transition. This requires policy makers to step in and price carbon and also in such a way that it reflects the real price of carbon at $80-90,” he says.

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