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It is now understood that climate change poses a significant risk to business and the global financial system, alongside the negative impact on ecosystems and society. As such, investors are increasingly asking companies to manage their risk exposure and mitigate their contribution to climate change. Managing Director of EcoAct, Stuart Lemmon, talks to Sonya Likhtman, Associate for Hermes EOS, Hermes Investment Management, about what investors are looking for.
In 2017 the Task Force on Climate-related Financial Disclosures (TCFD) released a set of recommendations intended to help companies to better disclose climate-related financial risk to investors and other stakeholders. As of February 2019, over 580 organisations, including Hermes Investment Management, had publicly pledged their support for the TCFD.
Stuart Lemmon: What have the TCFD recommendations contributed beyond other disclosure frameworks?
Sonya Likhtman: The TCFD recommendations create a structure through which companies can better identify, manage and disclose climate-related risks and opportunities. This exercise produces useful information for companies themselves, investors and other stakeholders. The TCFD helps companies to make the link between climate change and the resulting financial impacts to their business, specifically encouraging the quantification of associated risks. The recommendations are not prescriptive like some other reporting frameworks. Rather, they enable companies to engage in a constructive exercise that aids internal decision-making. We also recognise how the TCFD facilitates a more forward-thinking, strategic approach, as opposed to retrospective data reporting. Many investors will agree that the quality of sustainability reporting is currently inadequate. Often, the problem isn’t the lack of information, it’s that the information provided isn’t relevant, consistent or comparable. When done thoughtfully, reporting in line with the TCFD recommendations can begin to address that problem.
Stuart Lemmon: How much of a risk is climate change to investors today?
Sonya Likhtman: The physical impacts of climate change are already being felt by many companies. Evidence suggests utilities that are more resilient to the impacts of climate change trade with a price premium. Investors are beginning to take climate risk into account, with the price gap likely to increase as extreme weather events become more frequent and severe. Companies that are lagging behind in terms of addressing these risks will find themselves exposed financially, legally and reputationally. For some sectors, including the extractive and automotive sectors, a low-carbon future poses an existential threat to companies in their current form. Growing regulatory pressures are likely to increase costs, while changing expectations about corporate responsibility may impact some companies’ licence to operate. In the most extreme cases, the customer base may dwindle and attracting talented employees is likely to become a significant challenge. Given these developments, investors are looking for companies to demonstrate how they will remain productive, competitive and profitable throughout the transition to a low-carbon economy.
Stuart Lemmon: What is the most important information that you are looking for from a company in relation to climate risks and opportunities?
Sonya Likhtman: Investors are more likely to feel confident that companies are on top of climate-related risks when they are transparent about their risk management process and findings. Materiality assessments play an important role here – companies should be bolder in explaining what they consider to be most relevant and how this informs their climate change strategy. We look for companies to assess the ways in which climate change poses significant risks to their operations. For instance, coal companies may face transition risks associated with regulatory developments, reputational challenges and market changes through decreasing demand. Companies with an agricultural supply chain, including super markets, clothes retailers and tobacco companies, may face chronic physical risks to parts of the supply chain exposed to drought or flooding.
Scenario analysis, as recommended by the TCFD, encourages companies to consider a range of potential regulatory, climate and market possibilities. We expect to see risk management and mitigation plans for the key identified risks, including a business adaptation plan where relevant. A similar story applies for the opportunities. We expect companies to set out how they can thrive under these changing conditions, such as by innovating to provide low-carbon products and services. Having identified the opportunities, companies should outline a clear plan for how these can be realised, including a timeline and allocated budget.
Stuart Lemmon: What advice would you give to businesses grappling with the current demands of sustainability disclosures, including cost and resource, that are wondering whether to align to the TFCD recommendations?
Sonya Likhtman: We completely empathise with the ever-growing demands of reporting. The TCFD recommendations are not intended to be another tick-box exercise. They offer flexibility so that companies can interpret them in a way that improves internal processes, culture and strategy. For example, there is no prescription for which metrics and targets to use, so companies can implement what suits them. Ideally, we would like to see TCFD disclosures as separate documents, as well as accompanying TCFD summaries in annual reports. HSBC’s annual report disclosure offers an example (page 29), while Citi’s Finance for a Climate-Resilient Future report provides a comprehensive TCFD disclosure. Reports can also be short and to the point, such as this disclosure from Imperial Brands. Many reporting frameworks, including the CDP, have aligned with TCFD reporting, which will hopefully ease the burden of reporting.
Stuart Lemmon: Why should companies pay particular attention to climate change governance, as outlined in the TCFD recommendations?
Sonya Likhtman: If companies are well governed, climate change will be raised and addressed at companies where it poses a material risk or opportunity. Such a complex and multidisciplinary issue requires co-ordination between departments, including legal, business development, human resources, R&D and compliance. A company board is in a unique position to elevate climate change as a strategic business priority, so that management can in turn instruct the relevant departments. To further demonstrate their commitment to the issue, boards can systematically include climate change on the board meeting agenda, with a regular review of key performance indicators (KPIs). Capturing sustainability targets within remuneration schemes is another indicator of strong climate change governance. For companies wishing to learn more, the World Economic Forum recently published a report outlining principles for effective climate governance on corporate boards.
Stuart Lemmon: What progress has been achieved since the TCFD recommendations and where do we think the focus will be going forwards?
Sonya Likhtman: We are still in the formative years for the TCFD. Companies are experimenting and improving their understanding of the process, with support from investors. We encourage disclosures to explain the challenges of fully implementing the TCFD recommendations, as articulated in the Citi report mentioned above. Having said that, some progress is already visible. We are pleased that it is much more common to see climate change as a board-level issue. Having raised the profile of climate change, we expect the focus to turn to more challenging areas, including scenario analysis and long-term strategic planning.
The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.