Building a TCFD With Teeth

What the Markets Need to Price Climate Risk

Financial markets and climate change are two topics which were traditionally seen by some as only vaguely related. However, parts of financial markets are and will continue to be profoundly affected by climate change in one way or another. Furthermore, financial markets are increasingly considered to play a key role in the transition of economies to lower emissions states — a process which will ultimately reduce the human and economic risk presented by climate change. These interactions have prompted regulators, governments, and investors the world over to focus increasingly on climate change — the futures it might present, the risks and opportunities embedded in these futures, and the impacts of these on the many companies, projects, and activities which make up any given economy.

In response to this attention, the information available regarding the market impact of climate change has improved markedly, which in turn helps drive improving visibility of the problem. Historically, the quality of information on climate change (regarding both its possible impacts and the exposure of market participants to said impacts) has been very poor. As such, a number of initiatives are under way to improve information access and thinking on the topic. Not least among these are the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD), which outline ideal disclosures regarding climate risk. Thanks in part to these recommendations, the information available to market participants is improving rapidly.

However, we argue that markets are still a distance from being able to think properly about climate-related risks and opportunities. In our view the TCFD recommendations have two goals: to prompt companies to manage and reduce their individual risk (company risk reduction), and to allow the market to price risk (market risk reduction). However, we think that at present only one of these two goals is being satisfied. The current highly-flexible approach to TCFD disclosures supports the first goal (reducing company risk), as companies can demonstrate their competence by selectively choosing what to assess and disclose. However, disclosures are not presently comparable, and as such the second goal (reducing market risk) is in our view a long way from being satisfied. A holistic system-level picture of risk (including, for example, the sovereign level) is still well out of reach given existing disclosures.

In this report, we outline the disclosures which need to be improved to achieve the market risk management goal, noting that specific financial disclosures with specific timelines and outputs are important if market risk is to be managed. We outline a set of disclosures principles which we think satisfy both goals, an endeavor we hope will contribute to more clarity and comparability among TCFD disclosures. We are aware that we are merely one of a score of organizations opining on the topic, and we expect that best practice will change. However, the list we have included here specifically targets improvement on the goal which is presently least served — market risk.

Finally, we note the ultimate underlying goal for an increasing number of market participants is decarbonization — the transition of global and regional economies to less carbon-intensive modes of operation. Smooth decarbonization is widely considered to be the lowest climate risk scenario available — minimizing the risk presented by economic change, while also minimizing climate change impacts themselves. At present, we think a growing number of stakeholder and disclosure requests are driven by a desire for companies and investors to take some responsibility for decarbonization. As a larger portion of the financial and regulatory system becomes focused on this goal, we expect market emphasis on decarbonization among investors and companies will only grow.