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September 6, 2016

Should You Bank on Climate Risk Disclosures?

Climatographer Team

Companies increasingly face pressure from investors and others to disclose their “climate risks.” One example of the trend is the Task Force on Climate-Related Financial Disclosures, which recently released its Phase 1 Report. Unfortunately, the Task Force seems to be treating climate change as “just another risk” for purposes of risk disclosure. But it’s not. Climate risks can’t be directly measured the way other risks can be, and they are so idiosyncratic that they almost defy standardized risk disclosure. But there is a path forward.

Some companies started climate risk disclosures more than a decade ago. When American Electric Power —the first electric utility to issue a climate risk report — concluded that climate change posed no material business risk to the company, we learned some important things about climate risk disclosure. The first is that the term is almost meaningless unless you are careful to first specify what you mean by “climate change” and by “risk.”

For starters, to interpret company-specific climate risk assessments we have to know:

  • Scope of the risk assessment: Policy risk only, or physical impact risks as well? Operational risks only, or supply chain risks as well? What about brand and liability risks?
  • Timeframe of the risk assessment: Today, 3 years into the future, 5 years, 20 years?
  • Key assumptions being made about climate policy, carbon pricing, public opinion.
  • How risk averse is the assessment? Based on “expected” outcomes, 1 in 10 probability outcomes, or perhaps 1 in 100 probability outcomes?

In today’s risk disclosures, we often see none of this information. This creates a serious dilemma for investors and other stakeholders. Should they accept the risk disclosure at face value, or totally discount it? The problem is that there are so many potential risk variables in play, and their assessment can be so subjective, that one can arrive at almost any climate risk conclusion and one can defend that conclusion as “plausible.”

Approached this way, climate risk assessment is “in the eye of the beholder.” Who is to say that one beholder’s conclusions are necessarily better than the next? What is clear is that one beholder’s climate risk conclusions do not necessarily give other beholders (including investors) the information they need.

One way to deal with this problem would be to standardize the risk scenarios. This includes the variables listed above, against which all companies would report risk. Arguably, this would make disclosures more meaningful and comparable. However, getting agreement on standardized scenarios of this kind would be almost impossible — with good reason. Companies have different business models, with widely ranging vulnerabilities and sensitivities to climate risks that standardized scenarios would not work well.

That does not mean that the status quo is the best we can do when it comes to climate risk disclosure. There is just not that much that investors and other stakeholders can learn from today’s risk disclosures. There is an option, however, that would provide interested stakeholders with more insight. That option is Scenario Disclosure.

Scenario Disclosure means disclosing not only any results of the risk assessment, but the scenarios used in the risk assessment. The variables and assumptions behind the scenarios should be consistent and clear, probably in a standardized table format. That information (including timing, scope, assumptions, and risk-adversity behind the risk assessment) would give investors and others more of the information they need to interpret the risk disclosure conclusions. Investors would be in a better position to ask questions about the choice of scenario variables or apparent discrepancies between the scenario and the disclosed risks.

Scenario Disclosure would do more than make it easier to penetrate and interpret corporate risk disclosures. It also would encourage companies to pay more attention to their choice of scenarios, if only because the scenarios would be disclosed. It might also result in more in-depth climate risk assessments, which today often remain distinctly superficial.

Scenario Disclosure is a relatively simple step towards meaningful climate risk assessment and disclosure. It’s easy to implement. Unfortunately, the Task Force on Climate-Related Financial Disclosures does not even mention this option in its recent Phase 1 Report. That has a lot to do with the Report’s implicit assumption that disclosing climate change risk is analogous to disclosing any other risk. It’s not.

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Climatographer Team

  • Thanks for this thinking, Mark. There are, as you know, a bunch of players in the Climate Risk Assessment business. I think we’ve named more than I can remember, but it’s something we’re looking at in an article MM and I are writing on the driving forces of Green Business Strategy. I’ve spent a lot of time in the private sector and a lot of these folk are resistant to disclosure, not so much because they don’t want to disclose but because it takes time away from more core functions. Positioning the capacity to think in scenario terms and then to evaluate risks in that way could frame the activity as strategic thinking driven by good business practice rather than responding to the demands of external players, many of whom aren’t private sector fans. Your thoughts?

    • Michael, that tracks very well with what I’m suggesting. Right now most disclosure isn’t truly business-based, it’s driven by external pressures. Business best practice risk analysis should be business-driven. And I really do think that when we see companies doing serious risk analysis we’ll see them becoming a lot less forthcoming with the information, since it could have competitive implications. But right now as you note there’s not really a lot of attention to climate risk analysis because business leaders don’t understand the potential risks, even when looking through a business rather than a societal “frame.” If companies do move in the direction of serious risk analysis, how can they do that without thinking about scenarios? And how can anyone interpret any climate risk conclusions or disclosures without some idea of the scenario in play?

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