What is climate risk? TCFD series part 1

The TCFD is charged with delivering a set of recommendations for voluntary company financial disclosures of climate-related risks. The TCFD’s Phase 1 report tells us that, provided they are used by investors, creditors and underwriters, disclosures on climate-related risk can:

• Improve market pricing and reduce the potential or large, abrupt corrections in asset values that can destabilize financial markets;
• Reveal underlying system wide exposures; and
• Help market participants and other stakeholders assess to what extent companies are considering and managing climate-related risks.

These statements from the TCFD’s Phase 1 report raise a number of questions that will be considered in this series of blogs, in particular:

• What is climate risk?
• What are “financial” disclosures of climate risk?
• What is needed to encourage investors, creditors, underwriters and others to use information about climate-related risk?
• What are the characteristics of information designed to signal system-wide risks to financial markets in addition to entity-specific risk?  

What is climate risk? Is it like other risks?

Companies have been reporting the risks they face for decades, often as a statutory responsibility to do so. Generally, risks are understood as possible negative outcomes that affect different “risk targets” as I call them here, including the liquidity, capital resources, net sales, revenues, income from continuing operations, future operating results, future financial condition, future operations, economic position or achievement of strategic objectives. Climate change is predicted to have possible negative outcomes that could affect any or all of these risk targets, so why isn’t it reported on like any other sort of risk and why aren’t current risk reporting practices capable of being extended or adapted to apply to climate risk?

This blog is a short exposition of some of the concepts I have encountered in trying to answer these questions, but readers, beware! I simply share these thoughts as a layperson seeking to untangle the meaning of climate risk.

A paper by the Institute of Chartered Accountants in England and Wales suggests that climate is not a risk at all. It refers to the distinction attributed to economist Frank H Knight between risk and uncertainty. Risks, he argues, can be measured, so that a risk “proper” is a measurable one. By contrast an un-measurable one is an uncertainty. The example of measureable risk given in the ICAEW’s paper is a game of chance involving casting of dice, drawing of cards or spinning of roulette wheels where the odds against any particular outcome can be stated with mathematical precision. The ICAEW contends that such calculable risks are relatively rare for business and that in practice their risks are usually un-measurable uncertainties so that disclosures about them are necessarily qualitative or quantified based on subjective and possibly restricted bases.

Climate risk is arguably distinguished from existing types of business risk because of the:

• Degree of uncertainty about the timing, scale and location of the risks and therefore the extent to which, when and how it might affect the business.
• Associated difficulty in determining whether the risk is sufficiently material to warrant disclosure;
• Decision-usefulness of information about risks that necessarily involves subjective judgement and assumptions;
• Diversity of risk targets affected by climate change including supply chains, the business operating context and consumers, all of which are beyond the reporting-entity’s control.

Finally and arguably most importantly, the characteristics of climate risk are both entity-specific (i.e. they potentially affect the performance of the reporting entity) and systemic. This might be why those dealing with financial system stability, including G20 Finance Ministers and the Financial Stability Board are also now involved in the development of reporting recommendations on climate risk.

There are ostensibly parallels between financial system and climate system stability. After years of reporting on risk, most well run companies know what their entity-specific risks are – the difficulty for companies is reporting on risks that also threaten the wider system. How should they confine their reporting to “material” risks, what should they report and how much?

In a recent article in the Financial Post, Governor Carney is reported as having said that corporations and financial institutions should reveal all climate risks in order to allow “feedback between the market and policymaking, making climate policy a bit more like monetary policy” and thereby avoiding “a climate Minsky moment.” This is a reference to the work of economist Hyman Minsky who tried to understand the causes of sudden massive financial collapses and crashing asset values.

Governor Carney’s predecessor at the Bank of England, Lord Mervyn King, has also written about Minsky’s work in his book “The End of Alchemy: Banking and the Future of the Global Economy’ where he identifies two potential problems with Minsky’s theory. First that it is based on the assumption that there will always be a boom before a bust, which excludes the possibility of a wholly unexpected event or “the gradual build-up of an unsustainable position where one more apparently modest addition to the pile of credits and debts is the straw that breaks the camel’s back” or simply bad judgement. Secondly, Minsky’s theory depends on the “idea that people have a psychological propensity to underestimate the probability of events that have not occurred for some time and so underestimate the chances of crisis”, but this, as Lord King says, this does not improve our ability to predict crises. He proposes an alternative approach to potential crises, which involves embracing radical uncertainty and limiting assumptions about rational expectations as they have no clear meaning in a world of radical uncertainty.

Having read this far in my research into the nature of climate risk, I am starting to feel the symptoms of psychological overwhelm! It seems that climate risk might not be a risk as we currently understand risk, that theories of predicting system-wide crises are themselves in crisis and therefore involve raising questions about existing models, embracing radical uncertainty and dismissing rational expectations.

How might we report future climate risk?

What, in the circumstances are companies to report on climate risk? The philosopher and economist Bertrand de Jouvenel suggests that even where the future is unknown, plural and fan-wise (which he describes as “futuribles”), it is possible for businesses to supply information on which reasoned conjectures can be made about the future. In order to bring myself back from the brink of overwhelm, I’m therefore going to turn to consider what types of information could reasonably be provided to financial market participants to enable them to make reasoned conjectures about the possible risks to which reporting companies and wider systems could be exposed in the future. I’m going to concentrate now on what we do know and how that might help climate risk reporting.

First, we know something important about the future as far as climate change is concerned. We know that we must aim for the 2 degree pathway. It follows that climate risks are exacerbated by activities that threaten achievement of that target. Emissions of greenhouse gases jeopardise the 2 degree target and thus represent a risk and should therefore be reported in all cases as they contribute to both entity-specific risk (to a greater or lesser degree) and, in aggregate, to system-wide risk. I would therefore argue that companies do not need to decide whether or not it is material to report greenhouse gas emissions, they should simply be reported because they exacerbate climate risk and their effect needs to be considered by financial market participants in aggregate as well as at entity specific level. A similar approach could be taken to other “sources of environmental impact” as the CDSB Framework calls them.

Second, we know that using scenario and sensitivity analysis can help focus evaluations of portfolio and business model resilience against a range of possible events (rather than limitless futuribles)!  There are a lot of developments that can help the TCFD to formulate guidance on climate risk scenario and sensitivity analysis including the IASB’s financial reporting standards IFRS 7 and 9, both of which deal with sensitivity analysis and “expected” events in the context of financial instruments. NGOs and others also offer a range of resources including the Science-Based Targets Initiative, the Institute and Faculty of Actuaries’ work on climate change, the Carbon Tracker Initiative and the World Resources Institute’s recommendations on calculating and reporting the potential greenhouse gas emissions from fossil fuel reserves.

Third, we seem to be getting better at thinking about the time horizons over which risks should be assessed and extending those horizons. The 2014 UK Corporate Governance Code encourages management to assess the company’s prospects over a period of “significantly longer than 12 months” for the purposes of considering (and reporting on) the future viability of the business model. The Sustainability Accounting Standards Board recommends assessing prospects over a “five year time horizon, the typical basis for a discounted cash flow analysis.” These signals help companies to break free from the “tyranny” of short-termism.

Ending this first blog on a positive note then, the TCFD has some helpful developments to work with in order to devise their recommendations. Having considered climate risk in general terms, in the next blog, I’ll look at what the TCFD might mean by “financial” disclosures of climate risk.

Image source: Kolitha de Silva/Flickr