At the beginning of April, Chair of the International Accounting Standards Board (IASB) Hans Hoogervorst gave a speech expressing his views that sustainability reporting is insufficient to incite change, and that more concrete steps need to be taken to address climate change. The IASB is the premier private-sector entity establishing and governing the widely-recognized International Financial Reporting Standards (IFRS). When the IASB speaks, accountants, sustainability professionals, and ESG-attuned investors across the private sector listen – and the IASB is one of the foremost global authorities on accounting standards, which are directly upstream of corporate disclosure, lending weight to its leadership’s messages on the subject. In his remarks, delivered at a climate risk conference in Cambridge, England, Mr. Hoogervorst highlighted two problematic issues in particular: the proliferation of sustainability reporting standards, and greenwashing.
Greater disclosure in sustainability and climate risks are frequently referenced as crucial steps in ‘greening’ the financial system. To be clear, ESG reporting and climate risks are interrelated but not the same. Physical climate risk refers to the environment’s impact on an entity, while ESG, as well as most transition risk factors, frequently refer to the reverse – an entity’s impact on the environment around it. Corporate management and investors alike frequently overlook or neglect both climate risk and material ESG factors, which leads corporations to face high risk exposure and the market to misprice assets, thus threatening market stability.
Where ESG and climate risk considerations frequently intersect is in the lack of full transparency in risk management and disclosure. Michael Bloomberg recently wrote about the importance of transparency, noting, “We are flying blind when it comes to the serious economic costs we face from climate change,” and urging improved transparency, which would allow climate risks to be factored into asset prices and spur increased investments climate solutions. The 2015 formation of Task Force on Climate-Related Financial Disclosures (TCFD) and the delivery of its recommendations in 2017 are two significant landmarks in the evolution of corporate governance and financial management. Yet while greater disclosure is an important step, there are several issues that must be overcome before financial actors – from corporations and investors to policymakers and asset managers – can reap the full benefits.
First is the lack of unified standards and clear definitions. While ESG reporting has exploded in recent years and significant progress has been achieved, this very growth has given rise to confusion and opacity over what the ESG reports actually mean. Mr. Hoogervorst noted that “there are at least 230 corporate sustainability standards initiatives across more than 80 sectors.” Investors and asset managers still call for “stronger benchmarking… [and] clearer terminology.” In fact, different ESG rating systems give different weights to each of the Environment, Social, and Governance factors, resulting in wildly different scores for the same companies; Tesla was ranked first by MSCI ESG Ratings, but last by the FTSE. In many ways, ESG performance metrics are still in their infancy, and are plagued by defective data. More challenging still is teasing out the material ESG factors – which have been shown to give rise to alpha, i.e. returns uncorrelated with financial markets – from the immaterial ones.
Terminology governing ‘green’ and ‘sustainable’ finance is no better – a 2016 S&P Global article on green bonds noted that there were numerous taxonomies that list potential projects for green bond financing, but that the approaches “face problems defining what is green” due in part to the rapid pick up of new climate change mitigation and adaptation technologies. Climate risk reporting is newer still. Defining climate resilience and adaptation brings another level of complexity to the problem, just as the context-specificity of adaptation (different projects and locations face different adaptation needs) brings further challenges to standardization.
Secondly, greenwashing – a form of false advertising to promote the perception that an organization is environmentally friendly – is, in Mr. Hoogervorst’s words, “rampant”. Volkswagen, Amazon, and Walmart have all settled lawsuits due to false environmental claims for their products and packaging. A 2018 report by Ceres, a sustainability-focused nonprofit representing an investor network, found that less than 10% of reporting companies provide third-party verification of their sustainability disclosures. Some investors are even devising their own proprietary ESG assessments to determine the truthfulness of a company’s claims. Investors’ employment of in-house ESG assessments do not solve and can even exacerbate the problem of harmonization; proprietary assessments only make standardization more difficult and prevent investors from drawing clear comparisons. These issues are likely to persist as reporting of climate risks becomes more widespread.
Numerous organizations and initiatives around the world are already collaborating to improve the reporting and disclosure of climate risk. Various global initiatives are currently working to standardize a robust set of guidelines for climate disclosures, including the Sustainability Accounting Standards Board (SASB), the TCFD, and in Corporate Social Responsibility (CSR) reporting for initiatives like the Principles for Responsible Investment. The TCFD disclosure framework, focusing on four pillars of corporate action – governance, strategy, risk management, and metrics and reporting – is an important response to both the lack of reporting standards and the greenwashing issue as concerns climate-specific risks. Developed by an industry‑led task force, the TCFD was developed to assist financial sector participants (ranging from investors, lenders, insurers, rating agencies, etc.) to use and understand the materiality of climate change risk. This reporting framework not only helps corporate disclosure to converge around certain terminology and practice, but it requires robust responses across all areas of corporate climate considerations – not just those that might paint the company in the best light. Furthermore, the TCFD also provides a strong foundation for future growth of climate-related financial disclosures.
Other transnational entities are demonstrating leadership. The European Commission has put together a Technical Expert Group on Sustainable Finance, with the aim to develop an EU classification system to determine whether an economic activity is environmentally sustainable. Further, the Network for Greening the Financial System also just issued recommendations that include the “development of a taxonomy of [green] economic activities” (see our recent blog post).
The good news is that progress is being made. The TCFD’s 2018 Status Report indicated that a majority of companies reviewed disclosed some climate-related information (usually incorporated into sustainability reports or as part of ESG reporting). Yet it is clear that climate-related financial disclosures are still in a nascent stage of development; few companies disclosed the financial implications of any climate risks, and there was little information on resilience strategies. There is hope that these high-powered initiatives will provide the leadership to develop clear, comprehensive, and harmonized guidelines for climate risk disclosure, and in turn, pave the way for the scaling of investment capital directed to those entities best managing their risks and seizing climate change-related opportunities. Innovative and savvy investors are already well out of the starting gate with climate-oriented investment strategies (which we will revisit more extensively in a future post). The evidence suggests that Mr. Hoogervorst’s speech not only identifies problems related to corporate climate change disclosures and risk management, but also foreshadows their solutions.