This article reflects the author’s personal opinions and are in no way supported or condoned by any of the companies that he is associated with.

Summary

• There is significant pressure on companies to enhance and perhaps even standardize climate risk disclosures, but useful regulatory guidance is thin
• Actual climate risks and current regulatory requirements are relatively limited and/or too far in the future and/or speculative to really impact most companies
• Potential future changes in regulation or changes in consumer or investor sentiment are likely much more important than actual climate change to corporations
• Uncertain timing and depth of regulation and sentiment make climate risk disclosure difficult
• Companies may tend to over-disclose in order to be seen to be on the forefront of climate risk. Such over-disclosure (similar to greenwashing) is not useful for investors and may result in inappropriate equity discounts

There is a keen interest amongst investors, regulators, and corporations to address climate risk disclosure. The current structure of risk disclosure derives little useful guidance from regulators and thus a number of competing and perhaps contradictory approaches have been suggested. At the same time corporations are developing their own approaches, which often do not allow for easy comparison between corporations and invite many charges of “green-washing”. There are two main issues that public disclosure seeks to address:

1. The reporting of the impact of the corporation on CO₂, CH₄ and other GHG emissions under the three-scope approach[1] as set out by the GHG Protocol Corporate Accounting and Reporting Standard; and
2. The risks to the well-being of the corporation due to the impact, both directly and indirectly, of climate change.
3.  

This paper discusses the latter risk focus of public disclosure[2]. I note that the CSA in Canada produced Staff Notice 51-358 in August 2019 “Reporting of Climate Change-related Risks”. While lengthy, this staff notice does not add to clarity.

It is in every corporation and investor’s interest to try to improve the comparability of risk disclosures such that the key interests of investors can be addressed. My contention is that while it may be possible to develop useful global disclosure standards around at least Scope 1 and Scope 2 emissions, I believe that useful standards around climate risk disclosure (and Scope 3 emissions) will be much more difficult.

It is best to start with why and how companies make risk disclosure. Regulators have discussed risk disclosure for many years, but due to the extreme level of judgement that is required by the issuer most regulators fall back to the “you should know it when you see it” advice. Appropriate risk disclosure is the risk disclosure that might make a potential investor invest or not in the company’s securities. The OSC’s Annual Report of the Corporate Finance Branch in 2020[3] gives this additional and perhaps not terrifically helpful advice that risk disclosure should be “specific about the material risks and uncertainties applicable to the issuer” and should disclose “the anticipated significance and impact those risks may have on the issuer’s financial position, operations, cash flows and future prospects” and should explain “how the issuer is mitigating the risks”.

All sound advice but difficult when applied to risks that are in the words of the CSA[4] “…impacts may be uncertain and are expected to develop over time.” One of the most difficult judgements with respect to risk disclosure is the impact of timing and materiality. All humans and companies are to some extent impacted by climate change, but the touchstone for company disclosure should be those impacts that disproportionately effect the company—i.e., the impact is beyond that upon all human endeavours, including all companies. In my view, due to elements such as the time value of money and cost of capital, probability and time horizons are an important part of proper risk disclosure. In net present value terms, a catastrophic loss of a facility or a plant one hundred years from now might just as well be worth zero. Assuming that a risk that is both remote and immaterial in a present value sense should be disclosed as a risk makes risk disclosure much less useful. However, I believe that this is exactly what is happening with risk disclosures, thus rendering the process less useful for investors.

In my view climate risks for corporations fall into three buckets:

1. The risk that climate change per se will affect the future profitability and cash flows of the business in a material way within the investment horizon. For example, a tour company that focuses on the Great Barrier Reef.
2. The potential that future regulatory change will negatively impact the future revenues or costs of the corporation in a material way. For example, an oil and gas explorer and developer or owner of gas stations.
3. The risk that consumer or other stakeholder sentiment will directly or indirectly affect the revenues or costs of the corporation in a material way. For example a manufacturer of fast fashion using mostly new plastic fabrics.

I discuss each of these in turn:

The risk that climate change per se will affect the future profitability and cash flows of the business in a material way.

One might think that this would be the easiest of risks to articulate for investors. However, most of the climate change impacts on the natural environment have three factors that make risk disclosure difficult: they are difficult to articulate with respect to the specific companies; difficult to apply to specific business lines and locations; and, have hugely uncertain timing aspects. For example, while there is consensus that climate change will impact rising sea levels over time, the pace of this change is slow, sea levels impact coastal areas of the world in vastly different ways and the effects of which can be counteracted in many cases by efforts over the next few decades.

There is also consensus that extreme weather events are more likely under future climates. However, those extreme weather events are assumed to be both droughts and floods and it may be difficult to ascertain how a generalized planetary risk might affect a specific company in a specific location. However, some companies will be able to tie a specific risk, even to an uncertain weather effect. For example, tailings dams at mining sites, no matter how well engineered will be under increased risk if there is a significant change in the water balance in the specific area. Factories built in flood plains will have an increased risk of flooding on a sporadic basis even if the effects of climate change are difficult to determine for that specific area.

One of the classic examples of weather risk has been the property and casualty insurance business. Recent hurricanes have increased in intensity if not in frequency. Coupled with unfortunate siting of properties close to flood plains and coasts, insurance payouts have been high. This is similar to forest fires that have increased in frequency due to dry conditions coupled with poor forest management practices and again unfortunate siting of properties near risky forests. However, as more experience is developed for the impacts of climate change, insurance companies have particularly good ways of matching the increased risk, especially since they tend to price on an annual renewal basis. They can either increase the rates for counterparties generally, or specifically in higher risk zones. Or they can simply stop covering risks as they have in a number of higher risk hurricane zones in the world. A risk that becomes fully priced in margins and applicable to all of the competing firms or is no longer assumed is really not a significantly disclosable risk. It’s a cost of gaining the revenue. The risk is that a currently expanded view of risk due to climate change is not dire enough or that it may be too dire, in which case profitable activity is not undertaken.

In my opinion, risk disclosure, to be effective, should be focused on risks that are indeed material, by which I mean that if they were to be realized they would be  impactful and that they have a reasonable chance of being realized with in a short to medium period of time. To the extent that companies stray from these principles, the value of risk disclosure becomes significantly reduced. No one includes the potential for meteor damage in their risk disclosure (unless they own satellites) as the risks are not subject to calculation, are too rare and would be applicable generally to all human endeavour. For most companies in Canada and the United States, for example, the risks of sea level increase due to climate changes are not relevant.  This puts a strong onus on the disclosing corporation to make its risk disclosure realistic and to carefully consider that each risk disclosed will suggest to the reader that a meaningful/material mitigation strategy is in place or that all avenues to mitigation have been exhausted, if indeed no plausibly effective mitigation exists. A set of vague or excessively expansive risks can be less useful than no risk disclosure at all or indeed actually materially misleading. I believe that unless a company has an active and substantial mitigation strategy that has a reasonable chance of reducing the severity or frequency of adverse events (or the company has meaningfully turned their mind to mitigation, if no such plan is possible), its not really a risk where the reader of disclosure is any better off.

The potential for future regulatory change will negatively impact the future revenues or costs of the corporation in a material way.

Existing enforced regulation tends not to be a significant risk to the corporation in OECD jurisdictions. The regulation exists and the corporation must have a plan to comply. Risk disclosure in this context relates mainly to the uncertain costs of compliance and the potential effect of existing regulation on the markets of the company. Increasingly, however, some regulatory environments are subject to substantial differences in interpretation as we have seen in the Trump administration takeover from Obama and the Biden takeover from Trump. The increasing use of “executive order” in the US over the course of the last twenty years has increased the risks of what used to be considered established regulation. I would expect to see increased disclosure around the implications of current regulation with likely a trend of “it will likely be worse than we currently think”. I expect that political risk disclosure will increase globally, not just in jurisdictions where risks have been more obvious in the past (corruption, expropriation etc.). The difference will be that political risk is no longer solely the purview of developing nations.

The bigger issue around regulation risk is the potential for future regulation. To date there has been a large disconnect between the rhetoric of politicians and the regulatory “teeth” behind the rhetoric. We can recall both the Kyoto Protocols and the Paris Agreements. Significant commitments had been made, but little real progress has been measured, both in the form of significant regulatory intervention as well as real impact on CO₂ emissions[5]. For companies who predicted in their risk disclosures in 1997 or 2015 that the international agreements would have significant and near-term effects upon their business, investors were arguably mis-led.

However, this time it may be different. While it does not seem likely that the next round of talks in Glasgow in November of 2021 (COP26) will lead to a significant change in the binding nature of global emission controls[6], the rhetoric around “net zero” continues to increase with governments and corporations seeking to outdo one another with pledges. While some of us may be skeptical that “this time it is different”, corporations must take the possibility seriously and try to develop responsive risk disclosure that is more valuable than it has been since the Kyoto Protocols.

The issue with future regulatory change is highlighted by the 2020 report from the International Energy Agency (IEA). In their Global Energy Outlook from 2020, they postulate that total global CO2 emissions will recover from pandemic lows to about the 2019 level by 2030 under what they call the Stated Policies Scenario. The IEA indicates that  “This scenario reflects all of today’s announced policy intentions and targets, insofar as they are backed up by detailed measures for their realisation”. For example, this would include Canada’s intention to increase its carbon tax level over time. Obviously current and proposed regulation will do almost nothing for global emissions and therefore the current business model risk to corporations is likely not that significant outside of some sectors and some countries. The risks (and opportunities) lie more likely within what the IEA labels the Sustainable Development Scenario. This scenario requires a significant expansion of renewables (including nuclear) beyond the Stated Policy Scenario as well as very substantial changes in industry and consumer behaviour that are unlikely to occur without substantial intervention by legislators. This Sustainable Development Scenario is still a huge leap away from the policy and demand framework that the IEA postulates in its Net Zero Emissions by 2050 scenario, which would require significant additional demand moderation.

In 2021 the IEA has gone a long way further and published “NetZero by 2050”[7]. This is an especially useful roadmap which attempts to quantify and cost the number of issues that would have to be addressed by governments, corporations, and individuals in order to achieve NetZero by 2050. This is a huge piece of work and for the most part is comprehensive and detailed. The IEA, in this publication goes further in comparing what would be required to achieve the goal in contrast to the Stated Policies Scenario (as they did in 2020) as well as what they now call the “Announced Pledges Case” which reflects the projection of the various government pledges to be “Net Zero by “fill in the date” ” which have been made over the last few years. The benefit of the most recent IEA report is that it makes clear how far away various government and corporate pledges are from what would really need to be done (starting immediately) to meet the potential for Net Zero by 2050. The astonishing breadth, scope, and cost of what the IEA lists (but does not clearly recommend) re-emphasizes the political and economic absurdity of the various pledges.

I raise these scenarios in order to emphasize the difficulty in risk disclosure. The Stated Policies Scenario is what is known or at least knowable. The other two 2020 scenarios are possible, but the timing and depth are not. Previous global agreements do not give any useful track record in this respect. The NetZero by 2050 scenario in the 2021 IEA report is so far away from being feasible to accomplish[8] that it provides no real basis for risk evaluation.

Consider how this might affect an oil and gas producer or a service company to that industry.  Without significant investment, oil production very quickly falls globally due to the productive horizon of existing fields. In the report IEA predicts that oil prices need to rise to US$75 per barrel by 2030 (US $89 per barrel by 2040 and US$185 per barrel by 2050) in order to entice the investment into existing fields under all circumstances; into new fields to support oil demand in the Sustainable Development Scenario, and even more investment into new fields under the Stated Policies Scenario. This set of scenarios would suggest that disclosure of excessive risk in existing proven and probable reserves is mis-placed and that even risk inherent in possible resources maybe overstated. Further, given the amount of investment required to develop oil even in the Sustainable Development Scenario, it is likely that the risks inherent in the oil service industry are being overstated. In their new NetZero by 2050 scenario, no new exploration is allowed, thus likely making the existing reserves worth even more.

It is easy to get carried away with the various doomsday articles about stranded assets and “dying” industries, but even as one might agree with the sentiment over a long period of time, once cash flows have been discounted at a reasonable cost of capital, it is easy to overstate such risks.

As I noted above …”Generally speaking, risk disclosure, to be effective, needs to be focused on risks that are potentially material, that are proximate and that have a reasonable chance to be felt within a reasonable period of time.” Corporations must pay careful attention to what are really risks and what are speculative changes in regulation. It is clear that regulation will become more stringent over time. But the depth and speed of change will always be held back by practical economic and political considerations, as it was in Switzerland. Thus far, the relatively limited climate change laws (especially in Canada)have been sold to taxpayers on the back of rhetoric that slowing climate change is costless or “positive” for the economy. It is very unlikely that this pretence can survive for long.

The risk that consumer or other stakeholder sentiment will directly or indirectly affect the revenues or costs of the corporation in a material way.

I believe that consumer and stakeholder sentiment will be the most difficult risks for corporations to calibrate. There is a significant groundswell of interest in having corporations reduce their “carbon footprint”. There is a much smaller degree of interest in consumers modifying their own actual buying behaviour. However, at the same time as consumers do not alter their consumption of carbon-producing products, they will be adamant that corporations be seen to do more about the issue and especially to say that they are doing more.

Consumers can have a significant effect on corporations as we can see by the pipeline issues in Canada. There is no requirement for consumers to be logically consistent between consuming more gasoline and propane and wanting Enbridge’s Line 5 through Michigan to be closed down.

A number of very influential institutional investors, such as Blackrock are also turning significant attention to companies that they believe add to climate change. These investors are required because of their ETF and closet indexing strategies to own the entire market and thus will wish to have general influence to reflect their own particular sentiments. Because they are such significant shareholders, corporations must pay attention or risk having the previously passive shareholders become active, as they recently have with Exxon. In some ways, it now appears that institutional investors are acting in the place of governments, who would be aware that attempting to legislate what the institutions are suggesting would be either impossible politically or potentially not constitutional.

As consumer and institutional sentiment grows, however, there will be a natural turn to the political process and the current Stated Policies Scenario may be overtaken quite quickly by events.

This is a difficult time for corporations both in their risk disclosure and in their actions to be taken in respect of climate change. It is quite clear that elements of society and consumers in general are increasingly interested in ensuring that they purchase products from “responsible” corporations. And that being responsible does not stop at following regulations – it must go far beyond that. Investors, particularly large investors with index mandates as well as a rapidly increasing number of funds with “ESG” mandates are pressing companies hard on both climate change action and climate risk disclosure.

A good example is that of the banks and other financial institutions. Banks and other financial institutions have almost no Scope 1 and Scope 2 emissions. There is a significant focus on banks and other financial institutions since they “enable” emitters to emit and thus are scope 3 carbon emitters. As lenders and investors banks are a terrific leverage point for constituencies that wish to reduce the carbon intensity of the economy. There is a school of thought that if banks and other investors could be shamed into not financing carbon intensive industries those industries would gradually fail and carbon supply into the atmosphere would reduce. Banks are subject to intense regulation and therefore it is easier to translate investor and consumer sentiment into regulation and action.

There is some evidence that banks are responding to this kind of pressure and may curtail lending and investment activity. The risk to their business is that if this pressure is successful, whether or not it turns into regulation, growth and profitability will decline and disclosure to this effect must be made. In some ways governments are complicit in this pressure since it is far easier for governments to entice institutions to reduce financing for cement plants than to outlaw the production of cement. It is fashionable for regulators of financial institutions to also believe that the purpose of regulation is to “do good”, rather than simply ensure soundness of financial institutions. And because regulators of financial institutions do not really have to answer to legislators or voters it is extremely easy to introduce climate control policies through regulation that would never have the chance of being introduced through the legislative front door. It is this pressure above and beyond regulation that makes risk disclosure for this third kind of risk so difficult.

It is interesting that commentators usually do not go that “extra mile” and note that personal and mortgage lending leads to individuals having enough money to heat their homes and drive SUV’s, surely a huge source of scope three emissions. Thus far there appears to be no groundswell to eliminate personal credit.

In this respect it is likely that companies might be tempted to provide excessive risk disclosure in order to cover the great uncertainty as to how constituent pressure might change the business plans or even model of the corporation. It is very unclear to me that such risk disclosure will be useful to shareholders given the wide range of potential impacts of such pressure and indeed may in fact be harmful as it misleads investors into believing risks are greater than they actually are.

Footnotes:

[1] GHG Protocol emissions scopes

The GHG Protocol Corporate Accounting and Reporting Standard classifies corporate GHG emissions into three ‘scopes’.

Scope 1 emissions are direct GHG emissions from operations that are owned or controlled by the reporting company

Scope 2 emissions are indirect emissions from the generation of purchased energy consumed by a company

Scope 3 emissions are all other indirect emissions(not included in scope 2) that occur in the value chain of the reporting company.

[2] There are many competing standards available in the market as well as more general standards for risk disclosure such as those set out by the SEC, the OSC and the Financial Conduct Authority (UK). There are also standards outside of the regulatory arena; Task Force on Climate-Related Financial Disclosure (TFCD), the Global Reporting Institute (GRI and the Sustainability Accounting Standards Board (SASB) just to name a few.

[3] https://www.osc.ca/sites/default/files/2020-11/sn_20201119_51-731_corporate-finance-branch-annual-report_1.pdf

[4] CSA Staff Notice 51-358 “Reporting of Climate Change-related Risks” August 1, 2019

[5] Canada’s greenhouse gas emissions have increased 5.6% since the Kyoto Protocols and 1.0% since the Paris Accords.

[6] The results of the most recent Swiss referendum of June 13, 2021, with respect to additional climate related taxes and restrictions is instructive. While the Swiss overwhelmingly believe that climate change is real, manmade and bad, they are apparently reluctant to have their own lifestyles or pocketbooks charged with mitigation.

[7] “NetZero by 2050 -A Roadmap for the Global Energy Sector” IEA May 2021

[8] The assumptions made in the report are legion, but amusingly include: “… in 2050, almost half the reductions come from technologies that are currently at the demonstration or prototype phase”;” Around USD 90 billion of public money needs to be mobilised globally as soon as possible to complete a portfolio of demonstration projects before 2030”;” We estimate that around 55% of the cumulative emissions reductions in the pathway are linked to consumer choices such as purchasing an EV, retrofitting a house with energy efficient technologies or installing a heat pump;” Making net‐zero emissions a reality hinges on a singular, unwavering focus from all governments – working together with one another, and with businesses, investors and citizens.”