This article first appeared in Insurance Day, March 2021
The global challenge to transition to a carbon neutral economy increasingly dictates that climate conservation becomes an integral part of decision making in the private and public sector. The Climate Change Act (2050 Target Amendment) Order 2019 has legislated the UK target to reduce greenhouse gas emissions by 100% (net zero) by 2050.
Accordingly, expectations around the reporting of climate-related issues have grown in recent years, particularly the expectations of investors and other stakeholders. Insurers will be aware of the increasing focus on sustainability reporting, which requires companies and financial organisations to assess, quantify and manage climate related risks and to transparently report on such.
The 2017 recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD), are considered key in improving climate-related disclosure of financial risks. The TCFD recommendations prescribe “a foundation to improve investors’ and others’ ability to assess and price climate-related risk and opportunities appropriately” by reference to four core elements: (i) governance (ii) strategy (iii) risk management and (iv) metric and targets.
Following a 2020 status report by the TCFD indicating more progress is needed, many regulatory agencies have recently responded to indicate their support. The Chancellor has stated that climate-related disclosures in line with the TCFD recommendations will become mandatory for large UK companies and financial institutions by 2025. Other developments include:
- The FRC’s Thematic Review of climate-related considerations of November 2020 which urged businesses to improve corporate reporting standards on climate change and referred to investor support of TCFD-aligned disclosures.
- The FCA recently introduced new Listing Rule 9.8.6 (8) which requires commercial companies with a UK premium listing to include a statement in their annual financial report on whether they have made disclosures pursuant to the TCFD recommendations. Currently, only one-third of premium listed companies were making the relevant reports. This Listing Rule has been in force since 1 January 2021.
- As for UK-registered large private companies, the BEIS has proposed to issue a public consultation in early 2021 on a new regulation in the Companies Act 2006, to require that companies make TCFD-aligned disclosures in their annual reports by 2022.
A new FCA consultation will open in the first half of 2021 with a view to extending the scope of TCFD obligations for asset managers, life insurers and pension providers.
These announcements indicate that UK regulatory bodies are taking steps to ensure that climate change risks are properly understood and addressed. UK firms will be required adapt to the shifting regulatory environment. Organisations must consider how they will be impacted by these new disclosure requirements and the steps that need to be taken to comply.
How to disclose climate-related risks
Currently, there are no agreed global reporting standards, and thus there is no consistency in sustainability reporting. This leads to uncertainty not only for the companies concerned, but also for investors and insurers.
Against this background, the International Financial Reporting Standards (IFRS) Foundation issued a IFRS Consultation Paper on Sustainability Reporting, which proposes a Sustainability Standards Board (SSB) to provide a global platform for consistent sustainability reporting practices. The consultation closed on 31 December 2020 and it will be interesting to see whether this process will lead to clear rules for the inclusion of climate-related risks in impairment calculations in financial reporting, and ultimately achieve consistency in sustainability reporting.
This will not only benefit investors, but also give insurers more clarity in assessing risk. The intention is to produce a definitive proposal by the end of September 2021, possibly leading to an announcement on the establishment of a SSB at the United Nations Climate Change Conference (COP26) in November 2021.
In the meantime, insurers will have to develop an understanding of where the key climate-related risks of their insured organisations lie, and put a financial value on such risks. There are in particular three risks which insurers will be interested in when reviewing a financial institution’s exposure to climate risk:
Insurance is widely considered as a sector with sophisticated models and tools with which to estimate current risk and future losses caused for example by floods and storms. These analytics can be used for assessing the climate resilience of financial institutions, in so far as their investment and loan portfolios include assets that are based in areas where extreme weather events are more prevalent, or if they are dependent on suppliers in high risk areas.
In relation to a bank’s loan portfolio, it is also important to recognise potential credit losses, if their borrowers operate in high risk areas that might be affected by physical risks of climate change.
Transition risk represents the costs a company incurs in moving towards a more climate-resilient economy. These costs include the effects of Risk 1 and Risk 2, and could include divestment of companies from their portfolios that represent high physical and/or high litigation risk. This might have an impact not only on the institution’s balance sheet, but also on their business model and might include an entire restructuring process.
Transition risk also includes the operational cost of e.g. greener buildings, less air travel for staff, less use of plastic, water and paper, generating less waste, and all other carbon footprint reducing changes to the organisation.
The less effort a company puts into transition, the higher the risk will become in the future, and the delay or failure to transition is also a cost that falls under transition risks and may cause reputational damage.
Insurers should, going forward have access to insureds’ disclosures and key information provided on climate-related risks when underwriting policies, which should provide greater insight into risk and potential exposures.
Failure to comply with climate-related disclosure obligations might serve as a red flag to underwriters as well as potentially leading to regulatory action against an insured for failure to comply with regulatory obligations. Insureds will need to take great care to ensure not only that climate-related disclosures meet the required standards, but also that information provided is accurate and is not actionable by investors or shareholders, where for example measures are not taken as promised and, if the value of a listed company is affected as a result.
Boards need to take particular care to ensure that they put in place adequate governance to actively review and consider climate-related risks and opportunities and ensure that such are managed and reported accordingly. Boards falling short in this regard are likely to be called to account, not only by regulators, but also by stakeholders.