Defining 'material' climate risks

This post was co-written with Professor Robert Eccles and first appeared in the MIT Sloan Management Review

Most national governments and their regulatory agencies recognize climate change as a material risk to society, the natural environment, and economic and financial stability. These agencies want companies that contribute to their economy’s financial stability to factor in climate change as a material risk, thereby aligning the material concerns of society and economy. But, encouraging such alignment is easier said than done.

Companies know that climate change is relevant to their businesses. If they don’t address it in corporate reports, however, it’s because corporate leaders don’t believe climate change is material to their business: Either they think the effects of climate change are beyond their planning horizon or it’s just not clear whether or how climate change might be a material business risk.

Enter the Financial Stability Board (FSB), one of the most influential international agencies focused on addressing vulnerabilities in the financial system and developing and implementing strong regulatory, supervisory, and other policies to assure financial stability in the global economy. The FSB counts among its members the Bank of England, the U.S. Treasury, the U.S. Securities and Exchange Commission, the People’s Bank of China, Germany’s Bundesbank, the International Monetary Fund, and others.

This august group set up a new initiative, the Task Force on Climate-related Financial Disclosures (TCFD), to develop a set of recommendations to help companies identify and disclose climate-related risks that are material to their business and report this information to their investors.

The TCFD spent one year consulting companies, investors, and key financial players from different countries before delivering the much-awaited result: three reports, over 200 pages, outlining what, where, why, and how companies should report what they call “climate-related financial information.”

We stress the word “financial” because the Task Force seeks to move the issues related to climate change out of sustainability departments and into the boardrooms of every corporation in the world, no matter how big or small. To achieve this, it is necessary for companies to understand what financial risks and opportunities climate change creates for their business.

But how do companies understand what constitutes a material business risk? How can organizations categorize the unpredictable, long-term impacts of a changing climate as specific financial risks?

The Task Force’s Approach to Materiality

A preliminary version of the report asserts that “any disclosure recommendations by the task force would need to incorporate the principle of materiality” — which seems a clear indication that the recommendations would clarify once and for all how materiality should be applied in relation to climate-related financial disclosures through mainstream channels. So, what does TCFD’s materiality principle look like?

Three references in the early chapters of the report heighten our sense of hope that a sophisticated approach to materiality is forthcoming:

• First, the TCFD indicates that its work is likely to be useful for compliance with existing legal obligations to disclose material risks in financial filings, given that climate-related risks are material for many organizations;
• Second, the all-sector guidance on disclosure recommendation relating to risk management encourages organizations preparing information to describe the processes they use for prioritizing climate-related risks, including how materiality determinations are made within their organizations;
• Finally, users are encouraged to use the reported information to “provide a source of data that can be analyzed at a systemic level to facilitate authorities’ assessments of the materiality of any risks posed by climate change to the financial sector and the channels through which this is most likely to be transmitted.”

How to Define Material Climate Risks

Many in the corporate reporting world have tried applying the concept of materiality to climate-related issues, with different outcomes. In their recommendations, the task force simply states that “organizations should determine materiality for climate-related issues consistent with how they determine the materiality of other risks affecting their business and consistent with their financial filing requirements.”

This recommendation presupposes, incorrectly, that climate risks are like other risks that businesses typically face. Consequently, applying “standard” risk techniques might lead companies to conclude that climate risks are not material to their businesses. An analysis by the CDSB of the FTSE 350’s response to the U.K. legislation requiring mandatory greenhouse gas emissions disclosure found that 44% of companies that did not disclose information cited materiality as the main reason.

The need for clarity on this issue is crucial for the success of the recommendations. The good news is that the TCFD is not alone in helping companies understand how to identify and deal with material climate risk, given that it primarily affects future periods with uncertain timing. Several NGOs, including the CDSB, the International Integrated Reporting Council (IIRC), and the Sustainability Accounting Standards Board (SASB), as well as accountancy bodies, academics, and others have produced a wealth of guidance on this issue. The TCFD has a great opportunity between now and the publication of their final recommendations to leverage this experience.

Another element that the TCFD should take into account in upcoming months is the need to move the materiality discussion from being a management issue, as it is treated today, to being a board issue.

As one of us has argued elsewhere, defining material issues, including climate risks, is ultimately the responsibility of the board of directors. Which is why having an annual “Statement of Significant Audiences and Materiality” declaring the boards’ views on their audience and time frames for decision-making purposes, would be an important achievement for the success of the Task Force.

Boards that regard short-term shareholders as the only significant audience — something common in practice although rarely acknowledged — would be unlikely to consider climate change as a material risk for reporting purposes. It is legally within their right to make this decision.

Alternatively, boards that regard long-term shareholders and future generations of employees as a significant audience would likely consider climate change a material risk. Boards that take this more expansive approach can benefit from scenario analysis — a TCFD recommendation in which companies are encouraged to explore different scenarios that might affect their business, assess risks and opportunities, and develop plans accordingly.

Suggestions for Scenario Analysis

The development of scenario analysis is another key element in the quest for material climate change-related financial information. Understanding when the potential outcomes of climate change will pose a material risk is crucial for companies to understand how to report the relevant information.

This last point depends, to some extent, on what investors and other financial market actors believe to be material to their decision making, as well as the judgment of corporate boards and executives. Investors and others might not always agree with the judgments made by companies, but this can be the basis for a constructive dialogue. Encouraging companies to disclose the process they use to identify and prioritize climate-related risks presents a further opportunity for the TCFD. If companies explain their materiality determination process, users of information can understand and scrutinize the decisions that have been made about what constitutes a material climate risk.

In short, as currently drafted, the recommendations run the risk of presenting companies with a series of issues and unsolved challenges that inadvertently encourage them to report information that is not useful to their audience, because it does not help them to identify what constitutes a material climate risk.

However, leveraging the existing work that NGOs, accountants, academics, and others have produced; giving the board the ultimate responsibility for materiality determination; further developing approaches to scenario analysis; and giving more emphasis on the materiality determination process, will ensure the Task Force recommendations can make a material difference.