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Institutional investors increasingly recognize the potential for climate change to impact their investment portfolios, and ultimately their ability to fulfil their fiduciary duty to their clients. In an effort to enhance the resilience of their portfolios, investment managers are taking a range of approaches to ensure that the companies in which they invest understand the risks and opportunities that climate change presents.
For example:
The Task Force on Climate-related Financial Disclosures (TCFD) divides climate risks into two major categories:
While following the recommendations of the TCFD is still largely voluntary, companies looking to manage the increased scrutiny from investors must step up their climate risk disclosure efforts.
Naturally, this requires a range of qualitative and quantitative information, and internal buy-in and expertise. There’s no one-size-fits-all solution for climate risk disclosure, but what’s clear is that investors will soon come to expect every company to provide information about their exposure to climate change.
Investors should be skeptical of companies which do not convincingly disclose their climate-related financial risks.
Climate risks can be directly related to the physical impacts of climate change – for example, a hurricane or flood destroying a production plant, or climate variability affecting crop production. However, they can also be linked to the expected policy changes towards a low-carbon economy (e.g. carbon taxes or minimum energy efficiency standards).
Both risk types can be material for companies, depending on their industrial sector, their production locations, and their carbon footprint.
Climate change-driven extreme events and climate policy can compromise companies’ profitability, as well as affect their creditworthiness. Indeed, financial supervisory authorities in many countries have started to monitor and may soon regulate banks’ climate related risks, with focus on their credit portfolios.
Last but not least, institutional investors such as pension funds may be exposed to liability risks deriving from neglecting climate-related risks in their investment choices.
Climate Risk Disclosures present a challenge and opportunity for banking and capital markets.
Without a strong precedent for voluntarily or mandatorily releasing climate-related data (i.e. carbon, water and land-use intensities), financial sector participants require large-scale capital expenditures in software, reporting, and modeling to meet investors’ and consumers’ climate-stabilizing end goals.
Beyond the technical aspect challenge, banks and capital markets must co-navigate the information efficiency risk that arises with releasing information about GHG Scope 1-3 emissions originated by themselves or their clients as conduits of economic activity. As more information enters the decision-making space, central banks will begin to take notice of macro-level capital aggregations and flows, which effectively allow financial regulations to develop from industry-led standards convergence.
Over time, evolving climate risk disclosure frameworks will allow financials to attract, protect and preserve long-term capital for single issuers, rationalize to the market the co-benefits/profitability of climate-related flows, and future-proof their own businesses using adaptive management and financial innovation.
Pitted against a backdrop of consolidations in every major sector, a persistent low-rates environment, and a funds universe tilted towards passive management, firms that utilize climate risk disclosures to innovate will be successful in retaining customers and investors as loyal to their brands and their reputations.
