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Commentary

Climate Reporting: Emerging Challenges and Opportunities

David Harrison, Partner at Fladgate, outlines the risks and opportunities for UK companies as climate-related reporting rises up the agenda.

The UK government has set a target of achieving net zero emissions by 2050. To help achieve this, it has introduced mandatory climate-related disclosure requirements for large UK companies. These requirements are expected to be extended to medium-sized and small companies by 2025. 

The UK’s commitment to achieving net zero in general is enshrined in the Climate Change Act of 2008 (as amended). The government has since produced additional legislation which supports this objective in specific respects, and this has resulted in a framework of climate-related disclosure requirements.  

These are already relatively complex but are designed to help companies and their stakeholders understand and manage their climate risks and opportunities. The requirements cover a range of topics including greenhouse gas emissions, climate-related financial risks and climate-related adaptation plans. Of particular importance are the regulations described below: 

  • Streamlined Energy and Carbon Reporting requirements

Introduced in 2018, these mandate reporting by larger listed and unlisted companies/partnerships on energy efficiency and greenhouse gas emissions. They require that reporters provide a narrative risk assessment of the impacts of climate change, together with a statement of the alignment of their current activities with specific climate goals. 

  • Taskforce of Climate Related Financial Disclosures (TCFD) requirements

These are international standards which are intended to embed climate-related financial reporting into mainstream corporate reporting cycles across the wider global economy.  In a world of globalised commerce and investment, if climate-related disclosures are to be informative and of true value, it is difficult to see how this can be achieved under anything other than a global framework, such as that offered by the TCFD. 

These standards are now applicable in the UK, which has followed its customary approach to international regulations by being an early and fulsome adopter. While many of the UK’s peer economies are still considering implementation of TCFD reporting guidelines, the UK government has made TCFD or TCFD-aligned disclosures a mandatory requirement for larger public and private companies (and LLPs) along with certain larger banks, insurance companies and asset managers. 

This followed on the heels of steps previously taken by the UK’s Financial Conduct Authority (FCA) which had required companies with a London Stock Exchange (LSE) premium listing (generally the largest and best resourced listed companies) to include TCFD climate-related financial disclosures in annual reports for financial periods commencing after 1 January 2021, albeit on a ‘comply or explain’ basis. 

While there has been an understandable range of responses to this requirement within the universe of companies with an LSE premium listing, the FCA’s review of FY2021 reporting by these companies identified a “significant” increase in companies providing reporting “partially or mostly consistent” with the TCFD framework, when compared to previous financial periods. Perhaps unsurprisingly, the FCA noted that there were substantial variances in the levels of reporting provided and that the largest reporting gaps were found in respect of the more qualitative requirements of TCFD reporting.

TCFD’s key requirements 

The TCFD recommends that reporting companies should disclose their approach to dealing with climate-related financial risks across each of the four below areas: 

  • Governance – Describing how the board and executive team work together to oversee and manage (respectively) climate-related factors;
  • Strategy – Explaining the climate-related risks and opportunities that the organisation has identified over the short, medium and longer term, describing how these have been assessed and considering how resilient their strategies are;
  • Risk management – Describing how risks and opportunities are identified and managed and how these considerations are incorporated into overall management processes; and
  • Metrics and targets – Providing detail on the key metrics which are being used to assess climate-related risks and opportunities and the targets which are being used. 

The TCFD includes a body of guidance for the approach to be taken in respect of each of the above areas.  

Taken together, these are intended to result in companies disclosing the climate-related risks and opportunities that they expect to be most relevant and impactful for their business, while giving investors the information necessary to understand how these factors have been assessed and considered.  

While the governance-related aspects of this reporting framework may have a tendency towards being somewhat more narrative in nature, much of the reporting on strategy, risk management and the attendant disclosures relating to metrics and targets is generally more qualitative in nature. 

The current lack of standardisation in reporting by companies makes it difficult for investment managers to accurately aggregate data and report at the portfolio level. This is a key challenge facing the investment management industry in terms of TCFD reporting and industry bodies have identified issues around data quality and consistency as key barriers to meeting TCFD requirements.  

Clearly, the transition to greater transparency in the world of climate-related disclosures is creating considerable additional risks for reporting companies.

TCFD requirements – key risks 

Some of the key risks which are already becoming apparent are the: 

  • Trend towards increased alignment with climate goals and demand for additional ESG reporting:

The imposition by governments of increasing levels of climate-related disclosure requirements intersects with an increasing awareness of climate issues and risks and the growing demand among investors for investment opportunities and products which are more closely aligned with the types of goals and aspirations that they might have with regards to the climate and conservation. This increasing focus is driving an increase in demand within the investor community for additional ESG reporting, together with increasing levels of scrutiny of the information that has been provided.

This is in turn increasing the regulatory burden on companies and requiring them to allocate increased levels of resource to their regulatory and reporting functions.

  • Requirement to integrate increasingly sophisticated, forward-looking considerations into climate reporting:

These disclosure standards are creating a complex layer of additional requirements for reporters and investment managers alike. They require companies to assess and disclose their climate-related risks, and investment managers to assess the resilience of their portfolios under a range of climate scenarios. These requirements are challenging to meet, as they require companies and investment managers to make subjective assumptions about future climate risks and impacts.

The intention behind these requirements is to help investors understand the resilience of their investments in the face of climate-related challenges. This is an important objective, but the quality of the output of any such analysis is always going to be heavily dependent on the quality and completeness of the input data used and assumptions made.

These concerns amplify the need for investment managers to engage with portfolio companies to seek alignment in approach where possible, with the expectation that the agenda here will be set by the largest investment managers and then followed by the wider community.

  • Heightened levels of reputational and litigation risk:

Reporting companies are now operating against a backdrop where both consumers and investors are willing to take a significantly more active stance on a range of topics, including ESG matters.  

Research produced by the Grantham Research Institute on Climate Change suggests that the incidence of ESG claims has doubled on a worldwide basis since 2015. High profile claims such as the one against the board of Shell plc which has been threatened by Client Earth demonstrate that activists have a higher appetite for litigation, or the threat of it, as a viable route to force their preferred agendas. 

Although the reporting requirements set out above are understandably well intentioned, with the provision of increased regulatory disclosure, it necessarily follows that there is an attendant increase in risk, both reputational and legal for those doing the reporting. Such risks could result in action taken by consumers or investors who are dissatisfied with the actions which a reporting company has taken or claims from investors relating to defective or inaccurate disclosure.

Additionally, in a world where sustainability is becoming an important feature for many investors, it is possible that failings or inaccuracies in the reporting of climate-related disclosures could have an adverse impact on company valuations, which could in turn lead to claims from shareholders who have lost money as a result.

Such risks may be heightened for investment managers who will necessarily be aggregating and analysing larger pools of data, which, in some cases, may not have been compiled on an entirely consistent basis or prepared using common modelling assumptions. 

The increasing complexity of climate-related risks is likely to lead to increased demand for consultants who specialise in assessing these risks. This could lead to an increase in the outsourcing of climate-related modelling and analytical work by reporters, both large and mid-sized. Large reporters may outsource this work for risk management purposes, while mid-sized reporters may do so because they lack the internal resources to fully engage with these disclosure requirements. 

TCFD requirements – opportunities

While there is no doubt that climate-related disclosure requirements will present additional reporting challenges and risks for those they apply to, on a more positive note, for those reporters that are able to adapt to these requirements rapidly and efficiently, opportunities will be created. 

In the short to medium term, high standards of compliance should be good for business and an effective means of differentiation.  

For some, this may be as simple as the discipline of working through the necessary assessments which will help them to identify and allow for the earlier mitigation of specific risks.  

For others, high quality disclosure and reporting may present a competitive advantage in the investor relations space and present a stronger overall investment proposition when seeking to attract new capital.  

The production of TCFD reporting will require the gathering of substantial amounts of company and industry data. When this data is aggregated correctly, it can be used to create larger and more diverse datasets that can be used by reporters and investment managers who are able to leverage AI to generate business insights or enhancements. This could lead to faster innovation and a more competitive market. 

In a global economy where innovation is continuing to accelerate, the most immediate climate-related threats to the business models of many companies are less likely to result from climate change itself, but rather from competitors who are innovating faster. Companies that are able to rapidly adapt to the changing environment as we transition to net zero and identify new opportunities will be more likely to succeed. 

David Harrison and Sam Tye, the co-authors of this article, are Partners in the Corporate Department at Fladgate,  and co-lead the firm’s Green Energy Group.

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