The climate risk reporting regime is changing and financial institutions have 12 months to prepare. We take a look at the new landscape, leveraging governance and transparency to embed climate risk accountability in business.
Climate change has been on the international political agenda for almost 30 years. The international climate regime dates from 1992 with the adoption of the United Nations Framework Convention on Climate Change (UNFCCC). In 1997 the Kyoto Protocol was adopted, bringing with it national commitments to reduce greenhouse gas emissions, and the Paris Agreement (PA) adopted in 2015 recognised the threat of a global temperature rise and created a framework for risk mitigation. The parties to these international instruments come together every year in what is referred to as the Conference of the Parties (COP). The next meeting is COP26 to be hosted by the UK in 2021, after being postponed due to the current COVID 19 pandemic.
The PA establishes a five year cycle for countries to come forward with national commitments on climate change mitigation and adaptation. COP26 is a crucial meeting given that it marks the end of the initial five year period from the adoption of the PA. Countries now have to come forward with their renewed climate commitments. Consequently, COP26 is an ambition raising moment and seen as crucial for the goal of limiting temperature rise to 2ºC.
As part of this focus, national and subnational governments have been issuing declarations of climate emergency. Some, including the UK, Sweden and New Zealand, have adopted legally binding targets of net zero emissions by 2050 or sooner and it is clear that the pandemic has also focused minds even more closely on environmental risk around the globe. The building political pressure, both from the top and at grassroots level, is filtering through to economic actors in a number of ways, with one spotlight firmly focused on financial institutions.
Finance is rightly seen as a key driver to achieving broader environmental, social and governance goals, and our systemically significant financial institutions and large corporate organisations have a major role to play. Broader political pressures are now converging to bring this accountability to bear in the corporate realm, with reporting and transparency high on the agenda. As far back as five years ago, the Financial Stability Board launched an international industry led Task Force on Climate related Financial Disclosures (TCFD) to develop recommendations on how to approach the need for climate related information. Since 2017, when the Task Force published its recommendations, we have observed the steady strengthening of climate related disclosure requirements on businesses and the EU is now taking further legislative steps.
The Non Financial Reporting Directive (NFRD) covers reporting requirements and standards on a multitude of non financial matters and the EU brought suggested updates, including new minimum obligations for climate risk and environmental reporting (expected to be based on the TCFD framework), to a full public consultation during 2020. Themes identified during the consultation include the high costs of compliance in general, exacerbated by difficulties in complying with wide variations in reporting standards across industry, and the resulting lack of comparability and weight in the information provided. As a result, unified reporting standards are now on the table. These are expected to set out new minimum requirements, and the scope of applicability of NFRD may be extended beyond the current scope of large public interest companies with more than 500 employees, to capture businesses down the chain, including SMEs.
In the UK, the Bank of England is leading by example and has undertaken a number of relevant activities already in 2020, including:
- publishing its own climate related disclosure report in June;
- chairing the working group of the Network for Greening the Financial System (NGFS) (a network of central banks and financial supervisors sharing best practice for development and enhancement of best practice for development and enhancement of environmental and climate related risk in the financial sector) which published the NGFS Climate Scenarios earlier this year;
- writing to all PRA regulated firms on managing climate related financial risk – clarifying plans and expectations, noting that all firms should have fully embedded their approaches to managing climate related financial risks by the end of 2021; and
- facilitating the Climate Financial Risk Forum (industry body) which has produced a practical guide including recommendations for industry focused on:
- risk management (embedding climate related financial risk into governance and risk management processes);
- scenario analysis (creating resilience and understanding opportunities to support transition to net-zero carbon economy through modelling and analytics);
- disclosure (best practice on effective disclosure); and
- innovation (looking at adaptability and delivering the change required to meet climate goals).
In our view, this concentration of activity is part of the significant build up to the UK's hosting of COP26 where we expect that finance will be one of, if not the, key theme. As well as EU initiatives, including the NFRD consultation already highlighted, we also expect to see more national governments increasingly adopting mandatory climate related disclosure measures, aligned to the TCFD, as the reference standard for climate risk disclosure, in the coming months.
In our experience, clients are welcoming legal support in becoming more familiar with their obligations, both present and upcoming, and keeping abreast of the rapidly developing regulatory horizon in this area. Updating governance models for integration of climate related risk into the business, stress testing against climate scenarios and preparing adequate reporting frameworks to support the upcoming new disclosure obligations are all immediate priorities for the boardroom and beyond in the run up to COP26 being held in Glasgow on 1 12 November 2021.