Policy and legislation

The reporting ratchet: Prepare for successively tougher climate-related financial disclosures

Climate policy watchers refer to the “ratchet mechanism” in the Paris Agreement – the five-yearly cycle of national target-setting that requires each country’s new target to be more stringent than its previous one.

Less regular but just as visible is the ratchet in climate-related financial reporting.

Submissions closed 17 February on Treasury’s consultation on mandatory climate-related financial disclosure. Many participants called (see IGCC, ACSI submissions as examples) for alignment with the yet-to-be finalised Climate Disclosures Standard developed by the recently formed International Sustainability Standards Board (ISSB).

The draft ISSB standard builds on the Taskforce for Climate-related Financial Disclosures (TCFD) framework but represents a significant step up in terms of prescriptiveness and detail. Elements that the TCFD politely presented as things “organisations should consider” are now itemised requirements. But the ISSB standard is also explicitly a baseline for further development.

Will Treasury go further?

Where Energetics believes the ISSB draft is inadequate is its treatment of physical climate risk. Treasury needs to recognise that Australia’s unique combination of physical risk exposures means we cannot afford for financial actors to keep focusing on decarbonisation alone. In our observations of climate-related disclosures to date we see:

• Poor understanding among climate disclosure preparers and users of how to conceptualise, assess and quantify physical climate risks, particularly as they relate to Australia. The non-stationarity of future climates, the differences in predictability of different climatic variables, the complexity of their interactions with each other and with social and natural ecosystems mean that traditional probability-based risk methods and approaches of the past are unable to produce meaningful assessments of potential futures[1].

• Insufficient attention among some providers of consultancy and assurance services to the capabilities and limitations of physical climate risk data. We have seen the provision of physical risk scores for Australian companies that do not take account of Australia’s specific physical risk profile (for example, excluding bushfires), event probability distributions (where normal distributions can be wrongly assumed), and the need to assign different levels of confidence to each climatic hazard, as is standard practice in the IPCC process[2].

• Lack of established approaches to investigate physical climate risks across all sectors. Methodologies and tools have been developed for specific projects (for example, analysis of risks to agricultural productivity undertaken for the CBA[3]), but these are very resource-intensive exercises, and cannot be scaled. Valuable guidance[4] has also been developed by the Climate Measurement Standards Initiative[5], but this work needs to be expanded and updated on an ongoing basis.

• Lack of appetite or imperative to properly investigate physical climate risk, in part because there is little external pressure to do so. We see among investors[6] and financial regulators[7] globally a prioritisation of transition risk over physical risk. While this may reflect a reasonable judgement that transition risk is a good place to begin practices of climate-related financial risk disclosure, it may also entrench low expectations and poor practice with regard to physical risk.

• Following from the points above, disclosures that present confident claims of resilience to climate risk may be based on inadequate assessment and may in fact be “greenwash” [8]. In a report by the Financial Stability Board and the Network for Greening the Financial System on climate-related scenario analyses conducted by financial supervisors – among the most sophisticated efforts at climate-related scenario analysis globally – “many respondents highlight that measures of exposure and vulnerability are likely understated. One of the reasons is that, in many cases, metrics are not capturing second-round effects, potential climate non-linearities, and the costs and potential further externalities from risk management measures taken by financial and non-financial firms. The scarcity of available data and modelling limitations and uncertainties are other key reasons mentioned by authorities to suggest that these preliminary results might significantly understate actual climate-related risks and impact”[9].

• Missed opportunities to capitalise on Australia’s national capabilities in both climate change science and meteorology, which are considerable. It is worth noting that Australia is the only country in the Southern Hemisphere (and one of only three countries east of India) with the capabilities to run global earth system coupled models.[10]

All these weaknesses make it more difficult for Australia to successfully adapt to climate change by impairing the market’s ability to allocate capital based upon risks and opportunities. This inevitably produces suboptimal economic outcomes and increases the risk of maladaptation (likely to be occurring already in the residential property sector[11]). Australia is already facing higher costs for and more restricted access to, reinsurance[12]. The physical risks of climate change present a significant and growing threat not just to the Australian economy but to national security as well.

For these reasons Australia needs both to establish a disclosure regime that raises expectations and standards of physical risk analysis, and develop a strong public capability that supports this analysis. This is necessary to provide disclosing entities, disclosure users and other major stakeholders (e.g. governments and civil society) with the ability to adequately assess and respond to climate risk.

Energetics works closely with CSIRO and other physical risk practitioners on developing and applying scientifically robust physical risk analyses for a wide range of businesses.

Through these workstreams we have come to the conclusion that Australia’s physical risk analysis capability needs to comprise:

• National climate science capability, including the development and provision of data and approaches to analyse decarbonisation and physical climate risk – and the interactions between these two stressors – at multiple levels (individual organisation, system, sector, economy, region)

• High quality guidance – robust frameworks and tools for climate risk assessment, scenario analysis, and interpretation of results

• Accounting and assurance approaches that can appropriately address the new complexities of climate-related risk information

• Education and skills development across all of these areas so that company management and governance functions, as well as service providers, can understand and use the scientific data, guidance and assurance resources currently available and under development.

A copy of Energetics’ submission to the Treasury’s consultation can be accessed here.

Later in the year, when we evaluate Treasury’s proposed approach to climate-related financial disclosure, we will consider how it contributes to these needs.