Has the rush to deliver Task Force on Climate Disclosure reporting opened the door for misleading corporate risk data?
While transition reporting is at a mature level, most physical risk analysis isn’t even close to good enough, says Rohan Hamden, chief executive officer of XDI – Cross Dependency Initiative.
Understanding physical climate risk can be a complex process, particularly as it’s an emerging topic and best practice analysis is still being established in the finance sector.
Several recent Task Force on Climate Disclosure (TCFD) reports provide generalised exposure analysis. But while these provide insight, they also show that the sector is failing to resolve the differences between hazards, trends and risks.
Indeed, in the stampede to carry out TCFD reports containing something about physical risk, the quality risk analysis developed for insurance and infrastructure has so far been trampled underfoot.
This raises questions about the metrics by which we assess climate impacts, and how we gauge real, complex and integrated risk, to enable investors, regulators and planners to understand and prepare for climate change impacts in a meaningful way.
More specifically, how do we incorporate this into TCFD Physical Risk reporting?
A new report by the BlackRock Investment Institute highlights how little we understand the risks of climate change to investments.
The report, released a few weeks ago, Getting Physical: Scenario analysis for assessing climate-related risks, details economic impacts from climate change across several areas in the United States. It warns that investors are not incorporating sufficiently detailed climate change risk in investment analysis.
As the world’s largest asset manager, it’s worth paying attention to what BlackRock thinks is needed to understand climate risk.
Since the TCFD released its recommendations in 2017, the discussion around conducting climate-related financial disclosure at high standards has expanded rapidly.
Stakeholders are committing to TCFD
Finance organisations, corporations and investor companies around the world have stated their commitment to TCFD.
Expert groups have formed in Europe and North America to further develop how these recommendations can be implemented.
So far very few countries have mandatory reporting requirements, but influential organisations like UNPRI have announced their signatories must disclose their climate reporting by 2020.
The trend is on the rise; so can we can take heart that this new language will deliver increased societal and economic resilience?
Exposure versus vulnerability
Most climate risk analysis to date has focused on some form of trend analysis: will climate change make it more exposed to flood, wind, heat risk and so on.
These studies offer basic comparative indices that show the relative impacts of climate change to an asset or range of assets according to their general location.
Some – like Blackrock – go a little further to check how many assets are actually in hazardous zones.
This is called exposure analysis and is useful for entities seeking a broad-brush understanding of climate change impacts to existing extreme weather risk – for example, to rank asset municipalities or companies.
But trends and exposure are not risk – at least not as insurers (the experts in risk) would compute and cost risks. Trends and exposure tell us nothing about the degree to which each asset is vulnerable to the hazard, nor about the consequences of impact or the adaptability of the portfolio.
Yes, an insurer would want to know about exposure and probabilities of events occurring. They would also want to know about construction materials, engineering design and values. At what wind speed does the roof blow off? Is the structure rated for fire? If flood waters get in, how much damage occurs?
Without this side of the equation, it’s impossible to turn exposure information and climate projections into financial risk.
In the utilities sector this is the bulk of what XDI does, so it comes as a surprise to see the financial sector accepting such a limited view of physical climate risk.
Is an exposed investment always bad?
Think about it this way. Exposure analysis on a power plant in Miami will tell you that sea level rise is a problem. Of course, it’s in Miami! This we already know; some places are more hazardous than others.
Does that mean you should walk away from the investment? Not necessarily; the power plant might in fact be your most productive asset.
It’s possible the plant has been built to withstand the known and projected hazards of coastal flooding for the 40 years of its design life. What if its long-term upgrade plan will make it flood proof? A simple exposure analysis in this case would be quite misleading.
This situation is exacerbated when shareholders are involved, who are likely to get more diluted information which could lead to incorrect market sentiment.
Maybe investors should be jumping on board rather than being scared away by generalised exposure statements.
The ability to adapt
Deeper intelligence is also needed for facility owners to quantify the relative impacts of adaptation options available to help avoid projected impacts of climate change.
To truly build resilience in our investments, we need quantified insights into vulnerability, and the ability to test the cost benefit of adaptation measures before we make expensive decisions.
From an investment angle, this is crucial. A facility that may be exposed but has adaptation options to reduce vulnerability is very different to an asset cornered by climate change that has nowhere to go.
A two-tier TCFD?
Our recent experience indicates two types of physical risk clients are emerging: those driven by reputation or those driven by performance.
The former want enough information to say they have met the expectations of reporting and the requirements of defacto policing organisations such as PRI or CDP – very finance sector.
The latter want to optimise decision making to reduce risks and costs and to maximise resilience – very infrastructure sector.
It’s not hard to see why; if you are in the finance sector you may be exposed to a company’s risk for just a few years, if you’re a utility you will wear the consequences of an ill-informed decision for most of the century.
The current state of TCFD physical risk reporting does not contribute enough to quantifying climate change impacts in ways that can be monetised into cash flow and asset value.
Complex, integrated, large-scale, asset driven climate risk analysis is already being done for utilities and infrastructure based on actuarial methods – but rarely for TCFD. This will have to change if TCFD is to be more than a box ticking exercise.
Rohan Hamden is the chief executive officer of XDI – Cross Dependency Initiative that provides quantitative climate risk and vulnerability analysis for government and business.
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