By Mike GulletteThe Biden administration’s emphasis on climate change has many believing that the Securities and Exchange Commission will soon require 10-K disclosures on climate risk, including discussions of physical risks from climate-related events, transition risks from market changes and reputation risks from financing greenhouse gas (GHG) emissions.
While the election brought the disclosure issue front and center, the dramatic increase in the demand for climate and other ESG disclosures by investors over the past year indicates that the Biden administration is merely speeding up the expectation that all companies will eventually disclose their climate risks.
Unfortunately, measuring how a bank is positioned on climate risk can be extremely tough and, while there is wide support from large companies around the world, no company is close to full compliance with the recommendations of the Financial Stability Board-initiated Task Force for Climate-related Financial Disclosures that were issued in 2017. In fact, full compliance could take many years.
Why is that?
The basic TCFD requirement is to disclose an individual company’s estimated amount of GHGs it has emitted over the past year. GHGs take several forms, but carbon and methane are the two most well-known. As a service industry, banks themselves normally don’t emit a lot of GHGs. The problem is that their borrowers might, and that is the challenge. TCFD disclosures not only include GHGs emitted by the companies, but also what emissions are financed through their investments and lending portfolios. Further, when those borrowers’ GHGs are measured, the GHGs of both their downstream and their upstream value chain partners are counted.
This inventory of financed GHGs assists an investor in understanding a bank’s commitment to reducing emitted GHGs. TCFD is even expanding this notion to require an estimate of “implied temperature rise” in a bank’s portfolio. As you can imagine, this is an enormous amount of work, requiring participation from many companies. It could be years before banks could accumulate such information, and doing so is likely to be very costly.
Such information, however, is critical for an honest assessment of physical climate risks.
Many understand physical climate risks in light of tornados, floods and wild fires, and the increase of credit risk to borrowers located in those areas is a good starting point to assess physical risks. However, as COVID-19 has taught us, value chains are critical—knock out a critical business partner in a flooded area, and you might put many other companies at risk thousands of miles away.
With that in mind, TCFD also recommends a measurement of climate transition risk. While many focus on the risks of lending to energy producers, the real climate risks may lie in energy users. Think yoga pants: yoga pants are made almost totally of petroleum products that are shipped back and forth for manufacturing around the world prior to arriving in a store. Climate transition risk estimates a loss in the value of assets that results in the transition to a sustainable economy. If a national carbon tax was imposed to speed up the transition, what would that do to the yoga pants seller? Would you buy yoga pants if the seller passed the taxes onto the consumer and the cost went from $100 a pair to, say, $400? Of course, all this includes significant and speculative forward-looking assumptions covering very long periods of time. So, explaining all this to investors will be a challenge for anyone.
Climate risk disclosures appear to be on the horizon—at least for SEC registrants. While safe harbors over forward-looking statements will likely exist, implementing internal controls to report GHGs appears to be a daunting task and will need coordination across many operational areas.