What is TCFD?
The Task Force on Climate-related Financial Disclosures (TCFD) is an industry-led initiative providing a framework for helping businesses across the globe disclose clear, comparable and consistent information about their risks and opportunities in the face of climate change.
The recommendations essentially present an overarching framework, uniform across all sectors and corporations, that can be adopted globally to catalyse the standardization of climate risk disclosure practices and bridge the information asymmetry that is currently prevalent.
TCFD is a voluntary framework, but with the growing concerns around climate risk, it is becoming essential for companies to adhere to global benchmarks in this area.
“We believe that better information will allow companies to incorporate climate-related risks and opportunities into their risk management and strategic planning processes. As this occurs, companies’ and investors’ understanding of the financial implications associated with climate change will grow, empowering the markets to channel investment to sustainable and resilient solutions, opportunities, and business models.” - Financial Stability Board on the Task Force on Climate-related Financial Disclosures
Why was TCFD set up?
Globally, we have observed a marked amplification of extreme climatic events in the past few years. Undoubtedly, as the rising GHG emission levels fuel the rise in temperatures and ultimately steer climate change for the worse, the occurrence and potency of extreme climatic events like floods, fires, droughts, etc., will also increase. According to the recent Global Assessment Report (GAR2022), released by the UN Office for Disaster Risk Reduction, between 350 and 500 medium to large-scale disasters have taken place every year over the past two decades. More worryingly, the report suggests that the number of disaster events is projected to reach 560 a year – or 1.5 each day, statistically speaking – by 2030.
These extreme climatic events are having direct as well as indirect impacts on business. Estimates indicate a sevenfold increase in economic losses due to extreme climatic events from the 1970s to the 2010s, going from an average of $49 million to $383 million per day globally. According to a 2018 Center for Disaster Philanthropy report, 215 of the world's 500 largest companies risk losing an estimated one trillion dollars within five years from the impacts of climate events unless action is taken.
Owing to the acute financial risks posed by climate change—to companies, investors, and the financial system as a whole, there is a growing demand for decision-useful, climate-related disclosures by a range of stakeholders in the financial markets. There has also been increased focus, especially since the financial crisis of 2007-2008, on the negative impact that weak corporate governance can have on shareholder value, resulting in increased demand for transparency from organizations on their risks and risk management practices, including those related to climate change.
In the recent years, just a few of the stakeholders demanding these disclosures are as follows:
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Creditors and investors: With the rise in unanticipated financial losses due to climate change and the inherent mispricing of assets due to undervaluation of risk, considering ESG metrics to evaluate credit and investment opportunities is making its way to the forefront. Estimates suggest that the value at risk, as a result of climate change, to the total global stock of manageable assets as ranging from $4.2 trillion to $43 trillion between now and the end of the century. Hence long term investors and creditors are increasingly demanding access to climate risk information that is consistent, comparable, reliable, and clear.
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Banks: Climate change poses a dual risk for the banking industry. On one hand, due to the surmounting physical risks associated with extreme climatic events, banks may face higher credit losses. For instance, the European Central Bank’s recent climate stress tests showed that more than 60% of bank loans in Greece, Portugal and Spain are exposed to high physical risk. On the other hand, banks may face the impact of a feedback loop set in motion due to extreme climatic events as the value of assets declines, reducing their collateral value. Therefore, it becomes crucial for banks to have access to meaningful and decision-useful climate data.
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Exchanges: The financial impacts related to climate have led investors, policymakers and financial service providers to request additional data from issuers in order to effectively assess risks and price them in the market. Stock exchanges have an important opportunity to prepare their markets for the growing demand for climate-related information in a systematic and globally consistent manner hence requiring consistent and reliable climate data.
The growing demand for disclosures has led to various businesses across the world adopting their own climate-related disclosure practices. However, such climate-related disclosures have had the following shortcomings:
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Lack of information on the financial implications of the climate-related aspects of an organization's business.
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Inconsistencies in disclosure practices, a lack of context for information, use of boilerplate, and non-comparable reporting.
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Lack of consistent information hinders investors and others from considering climate-related issues in their asset valuation and allocation processes.
Recognizing these concerns, the G20 Finance Ministers and Central Bank Governors requested that the Financial Stability Board (FSB) “convene public and private-sector participants to review how the financial sector can take account of climate-related issues.” In response to the G20’s request, the FSB held a meeting in September 2015 to consider the implications of climate-related issues for the financial sector. This discussion narrowed down to a common theme: the need for better information.
Therefore, the FSB established the industry-led Task Force on Climate-related Financial Disclosures in December 2015 to design a set of recommendations for consistent disclosures that will help financial market participants understand their climate-related risks.
Climate-related business risk
The increased intensity of the effects of climate change in recent years and their increased overall impact has resulted in the conversion of climate risk from non-systemic risks into systemic risks that can stress entire sectors and—from a macroeconomic lens cause market failures.
Climate change invariably has the potential to cause another global financial crisis!
A business’ vulnerability to the impacts of global climate change goes well beyond the physical exposure of its facilities. It includes an indirect risk to their supply chains, distribution networks, customers and markets, thus creating a risk to their bottom lines. Climate-related financial risk may hence be classified into two broad categories:
Physical Risk
Physical Risks are typically defined as risks which arise from the physical effects of climate change and environmental degradation. Physical risks resulting from climate change can be event-driven (acute) or longer-term shifts (chronic) in climate patterns:
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Acute Risk refers to those that are event-driven, including increased severity of extreme weather events, such as cyclones, hurricanes, or floods.
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Chronic Risk refers to longer-term shifts in climate patterns (e.g., sustained higher temperatures) that may cause sea level rise or chronic heat waves.
According to estimates from S&P Global, Almost 60% of companies in the S&P 500 (market capitalization of $18.0 trillion) and more than 40% of companies in the S&P Global 1200 (market capitalization of $27.3 trillion) hold assets at high risk of physical climate change impacts.
Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations’ financial performance may also be affected by changes in water availability, sourcing and quality; food security; and extreme temperature changes affecting organizations’ premises, operations, supply chain, transport needs, and employee safety.
Transition Risk
Transition risk is the risk inherent in changing strategies, policies or investments as organizations work to reduce their reliance on carbon and impact on the climate.
Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to organizations. Transition risk may be classified as follows:
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Policy and Legal Risks: Policy actions around climate change continue to evolve. Their objectives generally fall into two categories—policy actions that attempt to constrain actions that contribute to the adverse effects of climate change or policy actions that seek to promote adaptation to climate change. The risk associated with and financial impact of policy changes depends on the nature and timing of the policy change.
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Technology Risk: Technological improvements or innovations that support the transition to a lower-carbon, energy-efficient economic system can significantly impact organizations. For example, the development and use of emerging technologies such as renewable energy, battery storage, energy efficiency, and carbon capture and storage will affect certain organisations' competitiveness, production and distribution costs, and ultimately the demand for their products and services from end-users.
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Market Risk: Climate change could affect markets through shifts in supply and demand for certain commodities, products, and services as climate-related risks and opportunities are increasingly taken into account.
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Reputation Risk: Climate change has been identified as a potential source of reputational risk tied to changing customer or community perceptions of an organization’s contribution to or detraction from the transition to a lower-carbon economy.
According to Mckinsey & Co.’s estimates, a transition to net-zero would require capital spending on physical assets for energy and land-use systems amounting to about $275 trillion, or $9.2 trillion per year on average between 2021 and 2050, an annual increase of as much as $3.5 trillion from today.
“Businesses can’t manage what they can’t measure. Yet, in relation to climate change risk, they are operating in a fragmented data landscape with missing or unreliable data points.” - EY Global
What are the TCFD Recommendations?
The four core recommendations of the TCFD are governance, strategy, risk management and metrics. They are as follows:
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Governance: Disclose the organisation’s governance around climate-related risks and opportunities.
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Strategy: Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy and financial planning where such information is material.
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Risk Management: Disclose how the organisation identifies, assesses and manages climate-related risks.
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Metrics and Targets: Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.
The recommendations have a dual purpose. They seek to:
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Improve corporations’ understanding of their exposure and risk profile as well as opportunities arising from climate change.
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Provide clear signals for financial institutions to understand risks and opportunities implicit in individual holdings as well as portfolio-wide exposures.
Why should businesses care?
Operations Risk
The serious risks posed by climate change on global financial systems have made it clear to the current generation of financial leaders that ignoring this risk is no longer an option. The effect of these risks has started affecting the bottom lines of businesses, and the extent of these effects is only going to get worse.
For instance, when we account for the costs of California’s 2018 wildfire season, it amounts to a total of $148.5bn (0.7% of the country’s annual GDP) which includes, the state incurred damages of $102.6bn; indirect losses through economic disruption to 80 industries amounting to $42.7bn; and the indirect losses caused to the U.S. economy amounting to $45.9bn outside California due to economic links between California and the rest of the U.S. Indirect financial losses thereby accounted for 41.5% of the state-wide total damages.
Hence, climate-related disclosure practices are bound to become a business norm, making it imperative for businesses to adapt to survive. Moreover, the voluntary nature of these disclosure norms is bound to transition as countries start recognising the need for clear and consistent disclosure practices, making them a mandatory requirement. SEC’s recent climate risk proposal is a testament to this change.
Market and Reputation Risk
As climate-related disclosure practices make their way into organizational dictionaries, globally accepted disclosure standards like the TCFD framework are bound to be adopted as the standards. As the TCFD has support from the G20, the recommendations are held credible by companies around the world and have great potential to affect global change.
In fact, a number of leading organizations globally have already started disclosing their climate-related risk in their financial disclosures. For instance, the number of S&P 500 members citing climate change or GHG under risk factors in their annual 10-K filings with the SEC almost quadrupled in one year, from roughly 60 companies in 2019 to at least 220 companies in 2020, according to a Bloomberg Law analysis.
Regulatory Risk
UK’s recent move to make it mandatory for the country’s largest businesses to disclose their climate-related risks and opportunities, in line with TCFD recommendations, serves as a sign of things to come. It would become impossible for companies to ignore the TCFD framework as it becomes a compliance requirement.
With the TCFD framework destined to become a global norm due to its credibility and recognition among the G20 nations, organizations that heed the recommendations sooner rather than later will benefit from stability, resiliency and profitability. Early adoption and longer-term transition to the guidelines and disclosure practices in general, would allow organizations to seamlessly transition to the new norms, spreading the transition costs over a number of years.
The Way Forward
However, these disclosure regulations and efforts need to be supplemented by innovation and development in our data capabilities to efficiently satisfy corporate needs and ensure successful implementation.
Global modelling agencies, companies, and research institutes, currently have a long way to go to be able to achieve the level of efficiency and accuracy that we need today for the estimation and quantification of climate risks for various assets. There is substantial work required in the form of technological innovation, system optimizations, and data modeling and processing, before climate and environmental data of apt quality can be provided to different companies across the world.
The Climate Data market is in a very nascent stage, almost like the internet market in the 90s or early 2000s. It is not an easy task to provide climate data at the resolution required to be actually able to do the climate-based financial disclosure as advocated by groups like TCFD or as expected by SEC. There is still significant time, effort, and investment required to facilitate the technology development that can then build those environmental and climate datasets to provide to companies and organizations.
However, the amalgamation of modern technologies like satellite data, AI and ML has made it possible to bridge this gap. These technologies can be leveraged to develop datasets that provide more than 40 different parameters and earth signals that contribute to building a comprehensive understanding and quantification of climate risk.
Let's work together to simplify this complexity, measure carbon footprint accurately and reliably to comply with the TCFD recommendations, ease disclosures to your diverse stakeholders, and stay ahead of additional changes in regulations and standards!
