Mandatory climate risk disclosures and the TCFD recommendations: What UK financial firms should know
19 March 2021
Two years after the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations were made, the UK became the first major economy in the world to pass laws to bring all of its greenhouse gas emissions to net-zero by 2050 – sparking a host of new climate initiatives spanning across all sectors.
Following this legally binding and highly ambitious target, the government launched its Ten Point Plan to help Britain end its contribution to global warming. The plan focuses on ten key priority areas which include advancing offshore wind, delivering new nuclear power, protecting the natural environment, and bolstering the UK’s presence as a leader in green finance and innovation.
As we know, climate change is not something tentatively predicted to cause difficulties in the future, it is happening right now. And the finance industry is one among many keenly feeling the impact as it works to adapt and transit its business models to a low-carbon economy.
Supporting the ‘greening’ of the UK economy
The government is committed to building a UK financial system that is both resilient to the risks from climate change as well as supportive of the transition to Britain’s net-zero target.
Since leaving the EU, Rishi Sunak has spoken of the financial services sector entering a new chapter, whereby the “full weight of private sector innovation, expertise and capital must be put behind the critical global effort to tackle climate change.”
As part of this, new climate risk disclosures are to be made mandatory for large companies and financial institutions by 2025, with many requirements coming into force from the FCA by 2022. These reporting rules are likely to be aligned with the TCFD recommendations, which were developed in 2017 for more effective climate disclosures that provide enhanced information about climate risks and opportunities faced by financial firms within their portfolios.
Ultimately, the TCFD is aiming to standardise disclosure requirements to assist organisations and their investors in making informed decisions in a rapidly changing global climate. More robust environmental disclosures will not only help to highlight the material financial impacts of firms’ exposure to climate change but also enable more accurate pricing of climate-related risks.
The risks imposed by climate change
Climate change presents different risks to the stability of the financial sector, which are primarily broken down into three key categories:
- Physical risks – Frequent or severe weather events linked to human-driven climate change such as storms and flooding are becoming more prevalent and can wreak havoc on the economy, causing an increase in weather-related insurance claims. As the number of claims rise, so too do the pay-outs from insurance companies and, thus, everyone’s premiums.
- Transition risks – As Britain moves towards a greener economy at pace, there may be resulting shifts in asset values, investments and the cost of doing business in certain sectors as they work towards decarbonisation.
- Liability risks – These will come into play when individuals or organisations seek compensation for losses due to the physical or transition risks of climate change. Whether it’s a company directly polluting the environment or one that didn’t provide full information about their exposure to climate-related financial risks, someone must always be held accountable.
What is the impact of the new climate risk disclosure regulations and who will be affected?
As mandatory climate risk reporting is enforced by the FCA, businesses will be required to formally identify and disclose details of their material risks and opportunities resulting from climate change under differing future climate scenarios.
These scenarios may range from changes in the physical environment such as chronic rising temperatures to the transition environment where carbon taxation may be introduced to help reduce emissions.
The following organisation types will be required to disclose their financial risks to climate change as the new regulations are instated:
- Banks and building societies
- Insurance companies
- Listed commercial companies
- Life insurers and FCA-regulated pension schemes
- Occupational pension schemes
- UK-authorised asset managers
- UK-registered large private companies (defined in the Companies Act 2006 as meeting at least two of the following criteria: more than 250 employees, a turnover of more than £36m or a balance sheet total of more than £18m)
How can financial institutions prepare for the impending climate risk disclosure rules?
With only 40% of FTSE companies referring to climate change risks and opportunities in their annual reports as of June 2020, it is clear that UK businesses still have some way to go.
In the Disclosures Chapter of the latest Climate Financial Risk Forum Guide, the CFRF outline some key steps for best practice when it comes to climate-related financial disclosures to help businesses align with the TCFD recommendations. In summary, these include:
Establishing the objectives of disclosure
Financial organisations are encouraged to consider the purposes of their climate risk disclosures in relation to what their respective audiences are interested in seeing. Armed with the right information, investors and other stakeholders will be able to make far better decisions in future. Therefore, financial firms should be mindful of the differences in perspectives between disclosure preparers and their users.
Acknowledging the requirements of different audiences
A one-size-fits-all approach is not an option when it comes to climate risk disclosure. The ‘disclosure ecosystem’ can be complex and relies on preparers identifying the unique needs of each user. For example, an audience in the regulatory community will need different information from those of the broker community. That said, many crossovers will occur, where essential data such as the potential for financial loss, as well as a firm’s likelihood of mitigating risks and adapting to future developments through effective governance and strategy will be key insights for all groups.
Managing evolving expectations for disclosure
As climate change will continue to pose different risks over time, firms should take a dynamic approach to their disclosures. Quantitative data may be added as the disclosures evolve to complement the qualitative input and deepen the decision-useful information provided. In addition, targets and metrics should be easily comparable from one disclosure to the next to help users understand the organisation’s general trajectory.
Selecting the most useful metrics and targets
With so many new and emerging risks to report on, recipients of climate-related financial disclosures can become easily overwhelmed. It is suggested that firms are given a chance to experiment in this area in the short-term, whilst adhering to guidelines set out by industry bodies such as the TCFD. Broadly speaking, there are three categories of metrics that have been recommended:
- Basic metrics, using methodologies available today
- Stretch metrics, using methodologies that are still at an early stage of development
- Advanced metrics, using methodologies not yet developed
Regardless of the metrics disclosed, their purpose and methodologies must be included, as well as instances of assumptions/analytics and how these conclusions were reached.
Choosing where to report
With a wide range of audiences interested in climate risk disclosures, the suggested route is to disclose information in a publicly available report. If included as part of an organisation’s Annual Report and Account, for instance, this may have the added benefit of disclosures being passed through the audit department, where auditors can provide assurances over accuracy. Whichever reporting mechanism is used, however, the TCFD is explicit in its recommendations for disclosures to adhere to the same rigorous governance processes as any financial information publicised in a company’s annual report.
High quality disclosures will be imperative in helping financial firms to build resilience in the face of climate change, and will provide a crucial basis for discussions about how business strategy and risk management must evolve to respond to the changing risks and opportunities in the global environment.
Likewise, it is only through continual risk assessments that financial organisations can adequately identify, assess and manage the risks necessary for disclosure to aid future decision making and support the UK's net-zero target.
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