European companies, as well as the finance sector, are facing mounting pressure to report regularly on their climate-related risks in the future. As the European Union is stepping up its game in the expectations for mandatory reporting by companies in the coming years, it is key for corporate leaders to understand, quantify and manage their companies’ and financial portfolios’ risks, says economic research consultancy Cambridge Econometrics.
At the end of November, the latest draft for planned sustainability reporting standards was submitted to the European Commission with the final versions scheduled to be adopted in June 2023. The new, mandatory reporting standards will have to be used by companies subject to the Corporate Sustainability Reporting Directive (CSRD). The standards are expected to ensure that companies are fully transparent about their impact on people and the environment, as well as the risks they face from climate change and other sustainability issues.
As a result of direct and indirect climate change impacts and the related regulatory changes, environmental, social and governance (ESG) criteria will play an increasingly important role in the valuation of companies and their assets, says consultancy Cambridge Econometrics, which has collected the key steps companies and financial organizations can do now to prepare for meeting enhanced reporting requirements facing them very soon.
Understanding climate-related risks
Investors as well as regulators will need to have a clear picture of how the revenues and costs of firms, as well as the financial valuations of their assets, will be affected by climate-related risks. This may vary largely by geography and sector and by the strategic position and preparedness of individual companies.
Climate-related risks can impact financial assets in many ways and there are two major categories of them. Physical risks directly threaten physical assets and value chains, while transitions risks are related to regulatory, legal, technological and market responses given to the physical threats. While the growing threats of chronic and acute physical risks may seem to be a problem only in the long term, there are risk factors which will be material in the short term.
In the short term, transition risks are primarily of a major concern. The transition risks largely depend on the answers companies give to the climatic challenge and are exposed to potentially large swings in policy and market sentiment. On a practical level, understanding companies’ exposure to climate-related risks involves three broad tasks: collecting data on a company’s greenhouse gas emissions, predicting its market exposure at a product or sector level and assessing potentially stranded assets.
Quantifying and disclosing climate-related risks
Once a company’s exposure is well understood, it needs to be quantified in a way that it can be incorporated into regular risk analysis and asset valuations. The best tool is performing informative climate stress tests that are based on well-designed and detailed macroeconomic climate scenarios. The tests should assess credit risks, market risks, liability risks, as well as operational and liquidity risks.
Since there are many possible climate transition pathways ahead, stress testing should be based on several climate scenarios, covering a wide range of regulatory interventions and technological advances. Models used for climate scenario analysis must consider the fact that the economic pathways depend on what policies will be implemented, which may include new taxes and subsidies, technology phase-out regulations and emissions standards.
“Investors should keep in mind that this forward-looking method of climate scenario analysis should replace traditional risk management techniques. Traditional approaches lack the right data to make good and sound projections when it comes to coordinating a successful climate stress test because historical data do not reflect the climatic events that lie ahead,” said János Hidi, sustainable investment manager of Cambridge Econometrics in Budapest. “Instead, a truly forward-looking methodology can quantify the impact of various regulatory, technological and market changes on the performance of economic sectors and regions.”
Manage the climate-related risks
Once an organisation has understood the risks and opportunities it faces and has quantified its impact on its future revenues and cost, balance sheet and financial valuation, it needs to establish a process and organisational setup which will be able to manage this exposure.
The investment portfolios may need to be reallocated, or investors need to actively engage with the boards of companies currently in their portfolios to adjust their long-term strategies, making sure they are resilient to the physical and transition risks.
Organisations should avoid relying excessively on long-term sustainability goals and instead turn their attention to carrying out a short-term action plan.
Announcing that the company will be carbon neutral by 2050 is easy to say now but may not be convincing to investors and the public who know that members of the current management may not be in their positions by then. Instead, it is more credible and attainable if companies make clear pledges such as reducing their carbon footprint by 10 per cent by 2025 and by 40 per cent by 2030; auditing their supply chains in 2023 and replacing their carbon-intensive suppliers within five years with more sustainable sources; shift to fully electric company fleets by 2026 and install solar panels on the roofs of their buildings. Furthermore, companies must support such commitments with clear internal actions, such as creating management positions and organisational units responsible for monitoring and achieving progress in the planned transformations.
Given the occurring market volatility, it is increasingly less likely that we will experience a smooth transition. Both climatic and economic research shows that delaying action will only increase the cost of transition because delay not only risks the escalation of physical damages but can also lead to a disorderly response by regulators and the financial markets. Companies and financial organisations thus must act swiftly and start assessing and evaluating their climate-related risks, as their efforts early on will benefit them already in the medium run.
