The Task Force on Climate-related Financial Disclosures (TCFD) released its 4th Annual Status Report Update after reviewing the reports of 1,651 public companies and surveying preparers on their needs. As a result, the TCFD has introduced new recommendations to support cross-industry standardization and comparability, and has increased the level of detail within its recommendations.
The TCFD has 2,600 supporters globally, of which 1,069 are financial institutions responsible for $194 trillion in assets. Companies that report in line with the TCFD framework have a combined market capitalization of over $25 trillion — a 99% increase since last year. The top 5 countries supporting the TCFD are Japan, United Kingdom, United States, Australia, and France.
One of the ways in which TCFD reporting provides value to its supporters is by framing climate risk in financial terms. One preparer interviewee stated “moving the climate conversation into financial language has helped bridge the gap between finance and sustainability teams by creating common language between departments.”
The TCFD recommends reporting climate-related financial risk for the areas of Governance, Strategy, Risk Management, and Metrics and Targets. While the overall average level of disclosure increased by 13 percentage points from 2018 to 2020, resilience of strategy and management plans (governance) saw the lowest disclosure rates.
A key struggle supporters have in reporting on and planning for climate impacts is understanding what impacts to anticipate, where they will become material, and in what timeframe. Scenario analysis has been recommended by the TCFD as a valuable approach to understanding the different futures that climate change may bring. It makes the specific sources of climate risk more apparent, which will aid a smoother transition across the entire financial system.
Key Insights from the TCFD 2021 Status Report Update
Within the update, the TCFD has provided additional guidance in response to users’ implementation challenges, and the need for cross-industry standardization and comparability.
The update includes recommendations for 11 metric categories, inclusion of a transition plan, clarification on the role of scenario analysis, and additional details on reporting financial impacts.
The TCFD has identified the following metrics to aid standardization and comparison across industries:
- GHG emissions - Scope 1 and 2 emissions reporting are strongly recommended for all organizations, with the remaining metrics subject to materiality for an organization. Based on materiality, Scope 3 emissions reporting is strongly recommended for certain industries like banks, insurance, real estate, and energy. GHG emissions are the most widely adopted metric in TCFD reporting.
- Transition risks - The amount and extent of assets or business activities vulnerable to policy and legal, technology, market, and reputation risks.
- Physical risks - The amount and extent of assets or business activities vulnerable to direct acute climate impacts from storms, floods, extreme heat spikes, etc. or chronic climate impacts such as sea level rise or average annual temperature rise, etc.
- Climate-related opportunities - The proportion of revenue, assets, or other business activities aligned with opportunities such as resource efficiency, energy source, products/services, markets, resilience.
- Capital deployment - The amount of capital expenditure, financing, or investment deployed toward climate-related risks and opportunities.
- Internal carbon prices - The price on each tonne of GHG emissions used internally by an organization.
- Remuneration - The proportion of executive management remuneration linked to climate considerations - quantitative disclosures are preferred.
The TCFD encourages reports to include supporting information regarding the type of measurement used, the methodology and definition of the measurement, and greater context pertaining to the strategy.
Transition Plan Targets and Actions
The TCFD found two-thirds of respondents had already included or planned to include a transition plan by next year, while another 22% expect to develop one later. Notably, 96% of users responded that transition plans are useful.
Transition planning starts with defining clear targets, such as a Net Zero commitment by a certain date. The transition plan should include cross-industry metrics, a baseline, a time horizon, and interim targets.
In addition to targets, the company should report actions it is taking to implement the plan. This should have the backing of strong governance processes, outline clear initiatives, and strategic alignment across the organization.
The TCFD recommends reporting the actual and potential financial impact (based on future scenarios) of climate risks and opportunities in terms of financial performance and position. Financial performance reflects the income, expenses, and cash flow while financial position refers to the assets, liabilities, and equity of an organization.
Currently, potential financial impacts are the least reported recommendation of the TCFD. Transparency into climate-related financial risks through reporting helps financial institutions to improve the pricing of those risks and allocating capital in their investment strategies. Ninety percent of respondents said financial performance/position disclosure is useful for decision-making.
The TCFD recommends comparing the financial outcomes of a no action scenario with the financial outcomes of scenario analysis that entails actively managing climate risk as a part of the business strategy. Scenario analysis again is the recommended tool for unlocking these insights.
The Role of Scenario Analysis
Scenario analysis, one of the core elements of a comprehensive TCFD report, leads to highly valuable insights that could help financial institutions gain clarity on how to address climate risk in the financial system. Yet, it remains a challenging aspect of TCFD reporting.
First, organizations tend to declare climate targets using normative logic. For example, if they define their target based on a specific desired scenario, such as a 1.5°C pathway, they lose the strategic insights gained from an exploratory analysis. An exploratory scenario analysis is important for reviewing contingencies, assessing financial risks, and understanding a plan’s feasibility under less-than-ideal scenarios.
Within a transition plan, the financial implications of targets should be specified over the short-, medium-, and long-term within the scenario analysis. And the TCFD also recommends reporting on assumptions, uncertainties, and methodologies.
More broadly, scenario analysis is considered the most effective tool for financial institutions to address the need to make pricing, capital allocation, and regulatory decisions, as it provides the forward-looking context for unprecedented and hard-to-predict economic conditions.
Overcoming TCFD Reporting Challenges
Scenario analysis and its role in providing information on financial impacts remains one of the biggest overall challenges to TCFD reporting. It doesn’t have to be this way.
Of course, as we’ve written before, scenario analysis tackles a “wicked strategy problem,” but this may not be the main setback to reporting. Respondents have expressed concerns about disclosing confidential information that indicates details of a long term business strategy.
To address these concerns, the TCFD assures respondents they can still review everything they assess prior to disclosure and instead provide the larger context on any details that are deemed confidential in nature. In short, concerns over confidentiality and maintaining business competitiveness should not override the need for reporting and transparency on climate risk.