The European Commission's climate-reporting guidelines encourage good risk management, but need fleshing out to address comparability and uncertainty, argues Typhaine Beaupérin
European risk managers have welcomed the latest European Commission guidelines on disclosure of companies' principal climate change-related risks - but with some reservations, according to the Federation of European Risk Management Associations (FERMA).
On 18 June, the Commission published new guidelines on reporting climate change-related information for listed companies, banks and insurance companies under the Non-Financial Reporting Directive 2014/95/EU. They consist of a new supplement to the existing Non-Financial Reporting Guidelines, and include a section on principal risks and their management.
There has been progress on climate risk reporting since the guidelines were published by the Commission earlier this year. At the same time, there is room for improvement in the quantity, quality and comparability of disclosures, which would make the information more helpful for capital allocation by investors.
The guidelines now
The Commission's aim is to encourage companies to show how they are adapting to climate change, and to better report their activities' climate impacts, so that investors can direct capital into businesses that are supporting the transition to a carbon-neutral economy. The guidelines ask companies to:
- Categorise the principal risks of climate change for the financial performance of the company according to whether they arise from the transition to a low-carbon economy or are physical risks from the direct effects of climate change
- Disclose any risk mapping that includes climate-related issues
- Provide definitions of risk terminology used or references to existing risk classification frameworks used
- Describe links between climate-related risks and financial performance indicators.
FERMA believes the guidelines would be more effective if they asked companies to refer to standard risk management methods, such as enterprise risk management (ERM), COSO or ISO standards. This is important because the guidelines are non-binding, with no audit requirement.
We support the use of a company-wide risk management policy, including non-financial aspects of risk, as a decision-making tool for the company's board. Considering the full range of risks allows management to set their risk appetite according to the full scope of possible impacts and to prepare a response, such as mitigating impacts.
This process applies to climate-related risks, especially in the context of potentially greater or more changeable exposures in the future. Climate change has many business implications, such as disruption to supply chains from extreme weather, increased energy costs for data centres, and mandatory changes to product specifications. An appropriate methodology will allow businesses to evaluate the risks and opportunities of sustainability investments.
Corporate reporting has evolved in response to demands for transparent conduct - including non-financial aspects. The aim of the guidelines is to help companies disclose relevant non-financial information in a consistent, comparable manner.
When it comes to making the disclosure of principal climate change risks meaningful for investors, there are still areas for the Commission to address. These include:
1. The current absence of agreed methods for assessing the effectiveness of climate-related risk mitigation that are commensurate with financial sustainability. This is another challenge to the comparability of disclosed information, especially in terms of:
- Increased unpredictability. Climate change exacerbates the uncertainty underlying companies' assessments of the likely frequency and severity of weather-related events. Investors will want to know how well the company assesses and manages these shifts in exposure. Risk managers are also concerned with how companies can communicate this uncertainty
- Wider impact evaluation. Climate-related risk assessment requires an evaluation not only of the direct economic-financial consequences on the business, but also more widely. It needs to consider the potential effects on the company's stakeholders, the local community, suppliers and customers. Such an evaluation is not easy in terms of the criteria and assumptions.
2. Different timescales. Enterprise risk management is designed to follow the corporate strategic planning approach. This mainly takes place on a three-to-five-year basis, with an annual update according to the corporate accounting process. Climate change will manifest itself over a longer period. The guidelines acknowledge that longer term horizons will be needed.
- Reporting on the implications of the most gradually emerging risks will require additional input from the risk manager and senior management. They may need new approaches, and there will be resource implications
- It is difficult for the risk manager to convince the corporate management to allocate capital effectively to mitigate risks that have a very long-term horizon of occurrence and high level of uncertainty.
In the meantime, FERMA suggests that companies refer to their ERM frameworks and standards. This will help investors and stakeholders to compare the quality and maturity of different companies' risk management processes.
ERM methodology helps identify the principal risks across an organisation and rank them in terms of their likely frequencies and potential impacts. It makes sense, therefore, to connect climate-related risks with other reported risks, taking into account the difference in time scales. Other risk management methods can be used to refine analysis of the relative significance of specific risks, as the reporting guidelines set out.
We believe it will be helpful for companies to explain the roles and responsibilities allocated to the management of principal risks in the organisation and the presence of a formalised ERM function. This provides an assurance that company policies have been implemented for investors and stakeholders.
In the absence of more quantitative methods, using scenarios can allow businesses to estimate the implications of certain weather patterns or events for their operations and investments. The Task Force on Climate Related Financial Disclosures, for example, is devoting attention to business-relevant climate-related scenarios. In the UK, the Prudential Regulatory Authority is asking insurers to examine three climate change scenarios to discover the implications for their business models and balance sheets.
Enhanced corporate reporting is one element in the EU's expectations for businesses as part of its goal of cutting CO2 emissions by 50% or more by 2030. The new Commission president Ursula von der Leyden has said all sectors must contribute to the effort and emissions must be priced in a way that changes behaviour.
The risk manager can play an essential role in the risk reporting process. Because of their role's cross-functional nature, they can work closely with colleagues and outside experts to provide the information that the board will need to complete the disclosures specified by the guidelines.
Events such as the 2010 Gulf of Mexico oil spill and 2015 diesel emissions scandal show that ESG issues generate economic-financial and reputational impacts. Companies must now balance financial performance with social-environmental risks.
Companies need a structured approach that maximises expertise in risk management and is adapted to their sustainability requirements. Knowing this is in effect will support investors in their decision making.
Greening the EU
The new European Commission president, Ursula von der Leyen, has made clear that sustainability will be a key policy pillar for the next European Commission 2019-2024. She has called for a reduction in CO2 emissions of at least 50% by 2030, and for carbon neutrality by 2050. To accomplish this, she plans:
- A Green Deal for Europe in her first 100 days in office, including a biodiversity strategy for 2030
- The first ever European Climate Law, which will enshrine the 2050 target in law, as well as the introduction of a carbon border tax
- A Sustainable Europe Investment Plan that will turn parts of the European Investment Bank into a Climate Bank. This will unlock 1trn of investment during the next decade.
Typhaine Beaupérin is the CEO of the Federation of European Risk Management Associations.