Disclosing climate-related risk: Let’s get it right the first time

  • The G20 meets in Germany in July and climate change will be a key topic.
  • World leaders will receive advice on setting guidelines for firms disclosing risk related to climate change.
  • It's important to get these guidelines right the first time or risk misleading disclosures and confusion.
Daniel Yergin
Cameron Costa | CNBC
Daniel Yergin

Germany will host the world's largest economies at the G20 summit in Hamburg in a few weeks. The global response to climate change was always going to be a key agenda topic—even before President Trump's recent decision to leave the Paris Agreement—and now probably even more so.

In Hamburg, as part of that agenda, G20 leaders will receive a report from the Financial Stability Board (FSB), an international financial oversight organization composed of central banks, finance ministries and financial regulatory authorities from the G20 countries. The report responds to a request from G20 finance ministers to review how climate-related issued are accounted for by the financial sector. These recommendations are meant to become the template for financial regulators in the United States and other countries to implement. Initially, they are meant to be "voluntary," but the trajectory of the exercise is for them to become mandatory.

A draft of this report was published last December. We expect the final FSB report will recommend that all entities with public debt or equity make disclosures about their climate-related financial risk in their mandatory regulatory filings using a standard framework.

"It is important for investors to think about how climate change and climate policy may affect portfolios in the years ahead and how to benefit from climate-related opportunities."

But, if adopted, the recommendations will not provide the certainty that they are likely to imply. The Task Force has been reviewing comments and hopefully will have made important modifications in the report. Otherwise, the recommendations could lead to misleading disclosures and confusion about their interpretation, mispricing of risk and market distortions. The goals of the task force are reasonable. It is important for investors to think about how climate change and climate policy may affect portfolios in the years ahead and how to benefit from climate-related opportunities. And companies already report much about these questions in their strategy presentations, sustainability reports and through independent sustainability reporting programs. But those are not the same as mandatory reporting, which is about the recent past and near-term future.

The findings of a recent IHS Markit report (of which we were among the co-authors) makes clear that the FSB approach, at its core, represents a radical departure from the concept of "materiality" in financial reporting. "Materiality" has been a basic principle of required financial disclosures for the last eight decades – a foundation of the financial reporting upon which the entire investment system depends. This is the communication by managements and boards of information needed by reasonable investors seeking financial returns. It provides the opportunity for companies to describe issues and risks, based upon their judgement as to what is important.

But the Task Force has singled out one type of risk—climate change—for separate treatment using a universal disclosure framework. In so doing, it sets aside managerial judgment and promotes those risks to automatic materiality status. It risks politicizing financial disclosure by directing it to specific topics rather than material information. This directly conflicts with the established principles that management and boards must decide what information is material. It also risks impairing informed decision-making by — as Supreme Court Justice Thurgood Marshall cautioned against —burying investors in an avalanche of information.

Disclosures in financial statements are poorly suited to the problem of climate-related financial risks. These risks are much more complex than interest rate or exchange rate risk exposure in a financial portfolio. Climate-related risks will impact different sectors in different ways. They will unfold over many decades, not in the immediate future. They could involve technologies that have not yet been developed. And they will affect assets and business lines that companies do not yet have. Financial statement disclosures are not designed for assessing such complex unknowns. Instead, they are designed to provide comparable access to current information to ensure that reasonable investors can make their investment decisions.

The Task Force recommends the use of scenarios and metrics in their draft report. But this would be a misuse of such tools, transforming uncertainties about the future into "certainties." This will have the effect of distorting markets rather than improving them.

We have used scenario analysis widely in our work, creating multiple plausible futures based on divergent assumptions about future policies, technologies, political-economic trends and other factors (for instance, we are currently applying scenario analysis to the future of cars and mobility). The analysis helps companies explore uncertainties, challenge internal bias, anticipate change and develop resilient strategies. But scenario analysis should not be confused with financial forecasting. Scenarios and forecasting are quite different and have different purposes. Disclosing the financial implications of scenario analysis would inappropriately suggest that management has reliable information about the unknowable future and suggest certainty about future pathways that simply reflect hypothetical assumptions made to test strategic thinking. Scenarios from different companies will use different assumptions and therefore cannot deliver information that can be compared.

Distortion will also arise from disclosing metrics that are not correlated with climate-related financial risk. The report encourages companies to disclose investments in "climate-related opportunities" as though these were indicators of reduced risk. But companies operate and deliver financial results in real-world markets where there is no guarantee that such opportunities will deliver positive or lower-risk financial outcomes. Diversification from fossil fuels to renewables may be interesting to some stakeholders and sought politically, but is a poor indicator of financial risk, as recent performance of some renewables investments has shown.

The FSB assignment reflects a time of change and uncertainty in the global energy ecosystem. These changes are driven by a complex interplay of technology, geopolitical, economic and social factors as well as by policies relating to climate change and energy security.

Companies must communicate thoughtful strategies that will create value and protect against risk in a complex, uncertain future; and it is in their interests to report information and metrics that demonstrate superior performance and positioning on climate change as on other topics. But information disclosures in regulatory statements can no more inoculate investors against climate-related financial risks than against many other future risks -- including, but not to limited to, technology disruptions, changing consumer preferences, demographics, shifting values, central bank actions, electoral outcomes and the effects of decisions that managements will make five, 10 or 20 years from now.

Commentary by Daniel Yergin, vice chairman of IHS Markit and author of "The Prize" and "The Quest." Antonia Bullard is vice president of IHS Markit. They are among the co-authors of the report, "Climate-Related Financial Risk and the Oil and Gas Sector." The analysis and conclusions of the report are solely those of IHS Markit.

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