One of the (unexpected) consequences of the COVID-19 pandemic has been a growing recognition that companies which ignore potentially catastrophic external risks, such as climate change, are unlikely to have the resilience to deliver financial returns over the long term.
That, together with the impetus provided by the forthcoming COP26 climate summit and the recent adoption of net zero targets by various countries, including China, has accelerated the emergence of a consensus around the need for larger companies to implement (as a matter of urgency) the recommendations of the Task Force on Climate-related Financial Disclosures (‘TCFD’), rather than wait for a common international climate-related reporting standard.
This article provides an introduction to the recommendations of the TCFD for companies in the UK and includes some commentary on implementation, based on the TCFD’s all-sector guidance.
What is the TCFD and what are its recommendations?
The TCFD was established in 2015 by the Financial Stability Board (at the request of the G20) in order to focus specifically on climate change. It was noted that, in general, inadequate information about risks poses a threat to financial stability because the resulting mispricing of assets and misallocation of capital can leave markets potentially vulnerable to “abrupt corrections”. The broad consensus was that, when it came to climate-related issues, there was a need for better information.
In June 2017, the TCFD published a final report setting out its recommendations, following an 18-month consultation. These comprise four pillars: (i) Governance, (ii) Strategy, (iii) Risk Management and (iv) Metrics and Targets. Under these pillars, there are 11 recommended disclosure obligations (considered in detail below).
Notably, the TCFD recommendations are only focused on climate-related issues and do not require companies to make disclosures on wider ESG or sustainability issues.
The TCFD’s recommended disclosure framework is intended to satisfy two objectives:
- To influence internal decision-making within organisations regarding the identification, assessment and management of climate-related risks and opportunities, thereby strengthening policies, programmes, practices and behaviours.
- To ensure that the climate-related financial information disclosed is decision-useful for financial market participants, especially investors, lenders and insurance underwriters.
Importantly, in addition to disclosing some backward-looking sustainability metrics (e.g. greenhouse gas emissions data), a company is also required, under the TCFD recommendations, to take a forward-looking approach and disclose the financial impacts of climate-related risks and opportunities on its business model (see the Strategy pillar in particular). Indeed, what arguably sets the TCFD recommendations apart from other sustainability reporting frameworks is the requirement to focus more on the impact of the climate on the company than the impact of the company on the climate.
The two key types of climate-related risk which companies need to consider for these purposes are:
- Transition Risks: These are the risks relating to the transition to a lower-carbon economy, which may entail extensive policy and legal, technology and market changes to address mitigation and adaptation requirements related to climate change. Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to companies.
- Physical Risks: These are the risks relating to the physical effects of climate change itself and can be event-driven (acute) or longer term shifts (chronic) in climate patterns. Physical risks may have financial implications for companies, such as direct damage to assets and indirect impacts from supply chain disruption. Companies’ financial performance may also be affected by changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting companies’ premises, operations, supply chain, transport needs, and employee safety.
Climate-related opportunities might include resource efficiency and cost savings, adoption of low-emission energy sources, development of new products and services, access to new markets and building resilience into the supply chain.
In order to make it easier for market participants to assess climate-related risks and opportunities, such disclosures should be made in a company’s ‘mainstream financial filings’ (i.e. the annual report), rather than in a separate sustainability report or stand-alone climate-related risk report (although supporting detail might sit outside the annual report).
Which UK companies have to implement the TCFD recommendations?
Historically the implementation of the TCFD recommendations has been a voluntary step for UK companies, often taken in response to investor or customer pressure in sectors where climate-related risks are most obvious (e.g. energy, materials and buildings).
However, on 9 November 2020, HM Treasury published an interim report (and UK joint taskforce roadmap) confirming the UK Government’s intention to roll out mandatory TCFD-aligned climate disclosures across the economy by 2025, with a significant portion of mandatory requirements in place by 2023.
In December 2020, the Financial Conduct Authority (FCA) published a policy statement confirming that, under a new Listing Rule (in LR 9.8), commercial companies with premium listings must state in their annual reports for accounting periods beginning on or after 1 January 2021 whether they have disclosed in line with the TCFD’s recommendations (with reference to the various TCFD guidance documents). To the extent they have not, they must explain why and describe the steps that will be taken in order to make the relevant disclosures in future and the associated timeframes (comply or explain).
The FCA has confirmed that there is currently no requirement for third party assurance in respect of climate-related disclosures (or statements of compliance) on the basis that such reporting practices are still evolving.
The Department for Business, Energy and Industrial Strategy (BEIS) is currently consulting on how and when to extend climate-related disclosure obligations to other companies in the UK (including standard listed companies, large private limited companies and asset managers). So, the expectation is that TCFD disclosures will, over time, become mandatory for more companies in the UK – although the FCA does acknowledge in its December 2020 policy statement that TCFD is not a corporate reporting standard and notes that the International Financial Reporting Standards (IFRS) Foundation is currently consulting on a proposed common international standard (a Sustainability Standards Board to sit alongside the International Accounting Standards Board).
Detailed consideration of recommended disclosures
Each of the recommended disclosures under the four pillars ((i) Governance, (ii) Strategy, (iii) Risk Management and (iv) Metrics and Targets) is considered below.
In its 2020 Status Update, the TCFD published research showing that expert users found the forward-looking disclosures under the Strategy pillar and the disclosures under the Metrics and Targets pillar most useful for making financial decisions. However, these two pillars are generally considered to be the most challenging of the four to implement (these are also the only pillars which require an assessment of materiality). So the TCFD recommends that companies start with the Governance and Risk Management pillars, thereby providing a ‘foundation’, before then enhancing their disclosures by moving on to implement the Strategy and Metrics and Targets pillars in subsequent years.
The TCFD has developed seven principles for effective disclosure, so each disclosure should:
- present relevant information;
- be specific and complete;
- be clear, balanced and understandable;
- be consistent over time;
- be comparable among companies within a sector, industry or portfolio;
- be reliable, verifiable and objective; and
- be provided on a timely basis.
Together, the recommended disclosures should ‘tell a story’ of how the company is managing its climate-related risks and opportunities on a ‘holistic’ basis.
1. Governance
Under this pillar of the TCFD, the overarching recommendation is for a company to disclose “how climate-related risks and opportunities are assessed by the company’s management and overseen by the board” so that market participants can assess whether climate-related issues are receiving appropriate board and management attention. The principal implementation issue flagged by companies regarding this pillar is that because climate is so embedded in their processes, it is challenging to discuss it separately in governance disclosures.
There are two specific disclosures required:
(a) Describe the board’s oversight of climate-related risks and opportunities
This should set out the processes and frequency by which the board (and its committees, e.g. the audit committee) are informed about climate-related issues and the extent to which these are considered when reviewing and guiding strategy, major plans of action, risk management policies, annual budgets, and business plans, as well as when setting performance objectives, monitoring implementation and performance, and overseeing major capital expenditures, acquisitions, and divestitures. Further, this should describe how the board and its committees monitor and oversee progress against goals and targets for addressing climate-related issues.
(b) Describe management’s role in assessing and managing climate-related risks and opportunities
This should explain how the company has assigned climate-related responsibilities to management (including a summary of the company’s associated organisation structure) and how management, in turn, reports back to the board on such issues. The process by which management is kept informed of climate-related issues and how it actively monitors such issues (e.g. through specific positions or management committees) should also be explained.
2. Strategy
Under this pillar of the TCFD, the overarching recommendation is for a company to disclose “how the company’s strategy and financial planning will or may be impacted by climate-related risks and opportunities based on different climate scenarios”, for example by affecting demand for its products and services or its supply chain, which, in turn, would have financial consequences for the company. The principal implementation issue flagged by companies regarding this pillar is that disclosing scenario analysis assumptions is difficult because they might include confidential business information.
There are three specific disclosures required:
(a) Describe the climate-related risks and opportunities the organization has identified over the short, medium and long term
This requires an explanation of what the company considers to be its relevant short, medium and long-term time horizons, taking into consideration the useful life of the company’s assets and infrastructure. For each such time horizon, a description of the specific climate-related issues that could have a material financial impact on the company is then required, along with some explanation of the basis upon which such issues are considered to be financially material for the company. Such issues should also be broken down by sector and geography.
(b) Describe the impact of climate-related risks and opportunities on the organization’s businesses, strategy and financial planning
This requires some discussion of the impact of the climate-related issues identified in (a) on the company’s businesses, strategy and financial planning. Detail should also be provided regarding the impact of such issues on the company’s products and services, supply chain and/or value chain, adaptation and mitigation activities, R&D investments and operations. Further, a summary should be provided of how such issues are integrated into the company’s financial planning process and, in particular, the impact on its operating costs and revenues, its capital expenditure and capital allocation, its acquisitions or divestments and its access to capital. Any use of climate scenarios in strategic and financial planning should also be described.
(c) Describe the resilience of the organization’s strategy, taking into consideration different climate-related scenarios, including a 2°C or lower scenario
This recommended disclosure requires a company to carry out ‘scenario analysis’ on a future 2°C (i.e. global average temperatures at 2°C above pre-industrial levels) or lower scenario and at least one other scenario (e.g. a 4°C scenario) in order to demonstrate the company’s resilience to climate-related issues. This should include a discussion of how the company’s strategies may be affected by such issues and how such strategies might need to change under each scenario.
The TCFD notes that such scenarios are hypothetical, “what if” narratives (similar to stress tests) – not predictions or forecasts.
This has been the single most challenging recommended disclosure in the framework. One of the key findings of the TCFD’s 2020 Status Report was that only 1 in 15 of the companies reviewed had disclosed information on resilience under this recommended disclosure (significantly lower than any of the other recommended disclosures).
The TCFD has acknowledged both the complexities of undertaking scenario analysis and also that there are possible confidentiality issues involved in disclosing the results of such an analysis. In its guidance, the TCFD confirms that a company is not expected to disclose information which provides it with competitive advantage (and which is unknown to competitors) where such a disclosure might cause considerable economic loss. Instead a “stepwise” approach is recommended with broader, qualitative information being disclosed initially by such companies and more specific, quantitative information then being disclosed over time.
As a consequence the TCFD recognises that this will necessarily be a qualitative exercise for many companies, but stresses that companies which are particularly exposed to transition or physical risks should take a more rigorous approach. To further assist, the TCFD has published ‘Guidance on Scenario Analysis for Non-Financial Companies’ and additional resources on this recommended disclosure are also provided at the TCFD Knowledge Hub website.
3. Risk Management
Under this pillar of the TCFD, the overarching recommendation is for a company to disclose “the company’s processes to identify, assess and manage climate-related risks”, including “both physical risks from climate change and transition risks to adapt the business to a low carbon economy” so that market participants can understand how a company’s strategic thinking on climate-related issues is integrated into its day to day risk management processes. The principal implementation issue flagged by companies regarding this pillar is that climate is integrated into risk management processes and so does not require separate disclosure.
There are three specific disclosures required:
(a) Describe the organization’s processes for identifying and assessing climate-related risks
This should include an explanation of how the company determines the relative significance of climate-related risks in relation to other risks and whether the company considers existing and emerging regulatory requirements related to climate change (e.g. limits on emissions) as well as other relevant factors. The company should also disclose its processes for assessing the potential size and scope of identified climate-related risks, its definitions of risk terminology used (or references to existing risk) and the classification frameworks used.
(b) Describe the organization’s processes for managing climate-related risks
Companies should describe their processes for managing climate-related risks, including how they make decisions to mitigate, transfer, accept, or control those risks. In addition, they should describe their processes for prioritising climate-related risks, including how materiality determinations are made.
(c) Describe how processes for identifying, assessing, and managing climate-related risks are integrated into the organization’s overall risk management.
This requires a description of how the company’s processes for identifying, assessing, and managing climate-related risks are integrated into its overall risk management.
4. Metrics and Targets
Under this pillar of the TCFD, the overarching recommendation is for each company to disclose “the metrics and targets used to assess and manage relevant climate-related risks and opportunities” so that market participants can access whether these are aligned with the risks and opportunities that company has identified as being material to its business. This also provides a basis upon which companies can be compared within a sector or industry. The principal implementation issue flagged by companies regarding this pillar is a lack of standardised metrics for their industries.
There are three specific disclosures required:
(a) Disclose the metrics used by the organization to assess climate-related risks and opportunities in line with its strategy and risk management process.
Metrics might cover climate-related risks associated with water, energy, land use, and waste management and, where climate-related issues are material, an explanation of how related performance metrics are incorporated into remuneration policies. Where relevant, a company should provide its internal carbon prices as well as climate-related opportunity metrics such as revenue from products and services designed for a lower-carbon economy. Metrics should be provided for historical periods to allow for trend analysis. In addition, where not apparent, the company should provide a description of the methodologies used to calculate or estimate climate-related metrics.
(b) Disclose Scope 1, Scope 2 and, if appropriate, Scope 3 greenhouse gas (GHG) emission and the related risks.
The company’s GHG emissions should be calculated in line with the ‘Greenhouse Gas Protocol’ methodology to allow for aggregation and comparability across organisations and jurisdictions and, if possible, related, generally accepted industry-specific GHG efficiency ratios should be provided. Historical metrics should be provided to allow for trend analysis and a description of methodologies used to calculate or estimate the metrics should be provided. Notably, of course, a high level of GHG emissions might, itself, be an indication that a company is exposed to significant transition risk.
Under the Greenhouse Gas Protocol, Scope 1 emissions are direct emissions from owned or controlled sources. Scope 2 emissions are indirect emissions from the generation of electricity, steam, heating and cooling purchased by the company. Scope 3 emissions are all indirect emissions (not included in scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.
(c) Describe the targets used by the organization to manage climate-related risks and opportunities and performance against target.
This should include the company’s key climate-related targets such as those related to GHG emissions, water usage, energy usage, etc., in line with anticipated regulatory requirements or market constraints or other goals. Such other goals may include efficiency or financial goals, financial loss tolerances, avoided GHG emissions through the entire product life cycle, or net revenue goals for products and services designed for a lower-carbon economy. Regarding each such target, the company might also disclose whether the target is absolute or intensity based, time frames over which the target applies, base year from which progress is measured and key performance indicators used to assess progress against targets. The methodologies used to calculate targets and measures should be disclosed.
Useful Sources of Information
- “Recommendations of the Task Force on Climate-related Financial Disclosures” published in June 2017 by the TCFD (defined as “TCFD Final Report” in the Listing Rules).
- “Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures” published in June 2017 by the TCFD (defined as “TCFD Annex” in the Listing Rules).
- “The Use of Scenario Analysis in Disclosure of Climate-related Risks and Opportunities” published in June 2017 by the TCFD (defined as “TCFD Technical Supplement” in the Listing Rules).
- “TCFD Implementation Guide” published in May 2019 by SASB and CDSB.
- “TCFD Good Practice Handbook” published in September 2019 by SASB and CDSB.
- “Guidance on Risk Management Integration and Disclosure” published in October 2020 by the TCFD (defined as “TCFD Guidance on Risk Management Integration and Disclosure” in the Listing Rules).
- “Guidance on Scenario Analysis for Non-Financial Companies” published in October 2020 by the TCFD (defined as “TCFD Guidance on Scenario Analysis for Non-Financial Companies” in the Listing Rules).
- “2020 Status Report” published in October 2020 by the TCFD.
- TCFD website: https://www.fsb-tcfd.org/.
How can we help?
If you would like to discuss the TCFD recommendations or corporate ESG reporting in general, please speak to your usual contact at Burges Salmon or Pete Dunn.
This article was written by Pete Dunn.