Tuesday, July 4, 2017

Climate-related financial disclosures: Task Force seeks to nudge-rock the system

TCFD Chaired by Michael Bloomberg
On 29 June 2017 the FSB Taskforce on Climate-related Financial Disclosures (FSB-TCFD) published its final Recommendations, on the eve of the 2017 G20 Summit in Germany. The recommendations build on climate-related guidance from various voluntary initiatives and standards developed since the 2000s. The Recommendations are voluntary, yet have been defined in a standardised and conservative way so as to be easily taken up by regulators for introduction at national level.

Since its establishment in late 2015 the FSB Task Force would have hoped the G20 would eventually endorse its Recommendations in mid-2017, yet by the time of finalising the Recommendations a welcoming statement from the G20 was questionable due to expected opposition from the US Government under a Trump Administration. It was probably preempting this that BoE Governer Mark Carney claimed (see Environmental Finance) that the Recommendations will gain traction even if they are not officially backed by the G20. The final Recommendations received early statements of support from over 100 businesses globally, the World Business Council for Sustainable Development (WBCSD) as well as investors with some US$ 25 trillion in assets under management (AuM).

One of the five themes of clarification and changes made to the final Recommendations based on public consultation feedback (since December 2016) has been that of materiality and disclosure location. It is important to note that these are Recommendations for climate-related "Financial" disclosures. This has two important consequences.

  1. The Recommendations ask for the disclosures to be included in annual financial reporting or financial filings. The disclosures involved should reflect correct pricing of climate-related risks, avoiding destabilizing effects on capital markets as the financial impacts of climate change progressively become more clear.
  2. The Recommendations employ an interpretation of "materiality" that is focused on "financial materiality" or significance in terms of likely financial consequences. For this reason, the Recommendations provide guidance (for example on metrics and KPIs) related to certain financial categories. Reflecting core Elements of financial statements, these categories are Revenues, Expenditures, Assets & Liabilities as well as Capital & Financing.

The Recommendations include special focus on Financial Institutions and Non-Financial Sectors, in the case of the latter especially those sectors "potentially most affected by climate change".   The non-financial sectors given special attention are the following four heavy industry groups: energy, transportation, materials and buildings, as well as agriculture, food and forest products. These imply what researchers have often identified as the most impactful and resource intensive industries or value chains out there, i.e. fossil-based energy industries, metals and car manufacturing, building and construction, as well as agrifood and forest products. For the four industry groups, its clarifications also encourage large companies (ones with annual revenue over 1 billion US$ equivalent) to consider disclosing information related to strategy, metrics and targets "in other official company reports when the information is not deemed (financially - ed ) material and not included in financial filings". The 1 billion US$ threshold captures over 90% of scope 1 and 2 emissions of the four industry groups involved (about 2250 companies).

The final Recommendations specified that those related to Strategy and Metrics & Targets are subject to materiality assessment. The implication is that the other two levels of Recommendations, those related to Governance and Risk Management are not subject to a materiality assessment since it is assumed that the climate theme is by definition material for disclosure (confirming due process) in these two areas. With its focus on financial materiality, the TCFD also clarified that "disclosures related to Governance and Risk Management recommendations shall be included in annual financial filings, independent of an assessment of materiality" (emphasis added - ed). It is therefore assumed that all sectors need to have Board oversight and defined management roles as well as processes for integrated risk management in place addressing climate change. In the domain of Strategy and Metrics & Targets, materiality assessments will determine the focus and level of detail of such elements.

Relations with other standards and Integrated Reporting <IR> 

In its comments on the earlier draft Recommendations, The CFA Institute encouraged the TCFD to pursue alignment with other major initiatives, refering in particular to the US-based Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC). The CFA Institute is naturally concerned about possible confusion among issuers and investors, and wishes to counter duplication and non-comparable reporting. It encouraged the TCFD to pursue the goal of a mandatory standard in the longer term.

Considering the TCFD's focus on annual financial reporting, it may be asked where does this leave Integrated Reporting <IR> as per the IIRC's Framework, one that seeks precisely to speak to the providers of financial capital. On closer examination it is evident that the TCFD's Recommendations and the IIRC's <IR> Framework speak the same language. The two frameworks have the same spirit and intent, and the disclosure content recommended by the TCFD can feed into mainstream annual financial reporting as well as <IR>. This was evident from a panel discussion I joined in March 2017 with Axa Insurance and Total S.A. at the ProDurable Conference in Paris.

On Strategy, the TCFD's guidance on Recommended Disclosure (b) on the impact of climate risks and opportunities, states that: "Organisations' disclosures should reflect a holistic picture of the interdependencies among the factors that affect their ability to create value over time". This reflects exactly the approach of the <IR> Framework, with its emphasis on integrated thinking, interconnections between different types of capitals involved and the ability to create value in the longer term. Highlighting the value of scenario planning is the way in which the TCFD underlines the need for a forward-looking, longer-term focus. In its comments, The CFA especially hoped that the TCFD guidance would help companies to be more specific in breaking down climate impacts in terms of the short, medium and long term, considering different maturity periods of climate risks and describing the risk management horizons they work with.

Both the TCFD and <IR> frameworks are aware of the potential shortcomings of only focusing on quantitative information, and the need for qualitative information including description of the context within which the performance of an enterprise needs to be assessed. The structure of the TCFD Recommendations around four thematic areas, starting with Governance and Strategy before looking at Risk Management, Metrics and Targets reflects the need for putting performance metrics in appropriate context, including broader organisational, market and socio-economic context. The Recommendations recognise the need to understand the "governance and risk management context in which financial results are achieved", mindful of how global financial crisis showed the need for greater transparency on governance structures, strategies and risk management practises.

Risks, opportunities and business model resilience 

While the TCFD Recommendations address both risks and opportunities, inevitably its entry point and greater interest is risk. The whole creation of the Financial Stability Board (FSB) comes against the background of global financial crisis of the late 2000s and the attempt to effectively address systemic risk. When one looks at the mandate of the TCFD and its Recommendations, this special interest in systemic risk, consistent categorization of climate risks and the appropriate pricing of such risks is evident.

The <IR> Framework lends itself to a balanced focus on both risks and opportunities, in particular a proper reflection on opportunities. At the heart of the <IR> Framework is the business model. The main TCFD Recommendations do not refer to business model (only to strategy and value chain). Its technical "Supplement on Scenario Analysis" recognises as part of the scenario analysis process the consideration of responses that include changes to the business model, as well as changes to portfolio mix and investments in capabilities and technologies. The <IR> Framework on the other hand centrally expects an organisation to describe its business model.  The description of a business model starts by describing how your enterprise will help its customer to solve a certain problem that she or he has. That description of the solution offered through a defined value proposition and business model means that the whole reflection kicks off with opportunity in mind.

A further note on difference yet complementary between the TCFD Recommendations and <IR> Framework can be added with respect to intangible assets. The TCFD expects enterprises to consider their assumptions underlying cash flow analysis used to assess asset impairments. It refers to goodwill, intangibles, and fixed assets. Inevitably the Recommendations show greater interest in tangible assets and physical risk. Here again the <IR> Framework is highly important in enabling more nuanced discussion of intangible assets across all industrial sectors. An important driver behind the birth of the <IR> Framework was the desire to better define and assess intangible assets, including reasons for the difference between book value and market value. With its recommendations to employ the six capitals model, the IIRC enables a more targeted coverage of intangible assets.

In its tracking of key material topics by the DJSI industry leaders since three years, the online site Materialitytracker has found repeatedly that the two top issues they report on are climate / energy and people / talent management. With its reference to for example Intellectual Capital, Human Capital, Social and Relationship Capital, the <IR> Framework provides an excellent tool for addressing the intangible assets implied by these key material topics. This is of special interest to service industry sectors such as ICT, one reason the ICT sector has shown such interest in taking up the use of the <IR> Framework. It would be interesting to see how the heavier industries focused on by the TCFD report in future on the possible impact of climate risks on their intangible assets, including their reputation. It is often in these areas where accounting is more of an art than an exact science, and where the strategy bullet bites the hardest.

Stewardship of directors, management as well as investors

Finally, a note on decision-usefulness of information and accountability or stewardship. In recent years discussion in the accounting community of the purpose of and a Conceptual Framework for Financial Reporting (IASB) has highlighted the need to focus not only on decision-usefulness (enabling investors to assess prospects for future cash flows) but also accountability (the accountability of directors for the broader performance of the enterprise ). The combination of decision-usefulness and accountability implies consideration of time frame (past, current, future events), scope of accountability (more holistic approach) as well as target vis-a-vis whom directors or management is accountable (the enterprise as legal person, key stakeholders including shareholders as owners).

The TCFD Recommendations focus mainly on decision-usefulness of information (with investors, lenders and insurance underwriters in mind). The final Recommendations include 11 references to decision-usefulness and mentions it upfront as one of the four Key Features of the Recommendations. It includes no reference to accountability or stewardship.  The objective of accountability or stewardship features much more prominent in the <IR> Framework. One of the key aims of <IR>, as stated in the <IR> Framework, is to enhance "accountability and stewardship" for a broad base of capitals. In this respect <IR> opens the way for a more two-way dialogue between enterprise (listed or unlisted) and its key stakeholders, targeting notably the providers of financial capital.

In its earlier comments on the draft Recommendations, the Network for Sustainable Financial Markets (NSFM of professionals and academics) urged the TCFD to emphasize also stewardship responsibilities on the part of investors. It argued that the investor fiduciary duty of impartiality also requires a balance (impartiality) in meeting current and future wealth generation needs. The NSFM further asked for an emphasis on longer-term strategic planning disclosures. In addition to describing scenario analysis, listed companies should disclose their longest planning horisons. The Network has in mind strategic plans with 10-20 year time frames, considering Future Growth Value in the face of climate change. It cites the example of Toyota that recently released a 35-year strategic plan.

Despite various requests for specification on time frames, the TCFD finally left this decision to reporting entities, arguing that it is dependent on the life of the assets of a company involved, the profile of the climate-related risks it faces, as well as the sectors and geographies in which it operates. It acknowledges that this may well go far beyond financial planning of up to 2 years or capital planning of up to 5 years. Consider that in many sectors large companies routinely work with time frames of several decades in capital expenditure planning and investment decision-making.

Wednesday, December 28, 2016

IIRC London conference makes the case for change in values and culture

Values, culture and the meaning of numbers and time were key themes of discussion at the annual conference of the International Integrated Reporting Council (IIRC) held in London on 6-7 December. The event was co-hosted with the International Corporate Governance Network (ICGN), helping the IIRC to boost its outreach to the investment community.

Tuesday, June 7, 2016

Materiality: Talking heads, talking numbers and talking finance...

Part II on the GRI Global Conference 2016
Materiality had some sober moments at the GRI Global Conference in Amsterdam this May. It was evident that established reporters are asking more pertinent questions about the value of the materiality determination process. Some are starting to do it less frequently (for example every three years, not annually). This raises three important questions: