Embedded carbon a better indication of markets’ climate risk than Scope 1 and 2 emissions

• Proposal Four of this consultation states that companies’ reporting of Scope 3 emissions will remain voluntary. Scope 3 emissions constitute the majority (typically 80-90%) of a fossil fuel company’s produced emissions.[2]
• Publicly-listed companies that explore for and produce fossil fuels are required to report their proven reserves because of the expected value that those reserves will obtain from being sold into the marketplace and consumed. The reduced consumption of fossil fuels would likely reduce the economic value of these reserves and, for the highest cost reserves, potentially make them economically unviable.
• Analysis has shown that the overhang of carbon embedded in fossil fuel reserves listed on the world’s capital markets compared to the quantity that can be combusted to remain within a 2°C budget could present real financial risk.[3] Bank of England Governor, Mark Carney, has verified this conclusion.[4]
• Disclosure across stock exchanges by relevant listed companies of the carbon embedded in their fossil fuel reserves (and potential reserves) would provide markets and investors with a better indication of stock exchanges’ relative exposure to future climate-related market risks.

The FSB-TCFD and beyond

The importance of the TCFD recommendations

• Proper adoption, implementation, and extension of the TCFD’s recommendations can ensure that capital markets are provided the information that they need to manage an orderly low-carbon transition.
• The TCFD recommendations provide a simple framework with novel tools to highlight the extent to which organisations’ forward-looking strategies are misaligned to global climate change targets.
• We believe that the most important component of the TCFD’s recommendations is the use of scenario analysis by companies as a tool to understand climate-related risks and seize opportunities.

Scenario analysis can be a useful tool for energy companies, but a reference point is required

• Carbon Tracker’s work has highlighted the trillions of investors’ dollars at risk if fossil fuel companies continue to plan for business-as-usual while the rest of the world heads in the opposite direction.[5]
• Resolutions from both UK- and US-based shareholders over the last three years have made clear that investors want to know the extent to which the business plans of individual companies diverge from international climate change obligations.
• This desire is well-grounded. Many companies profess to conduct scenario analysis and a subset of these suggest it has and continues to impact planning. This is effectively an acknowledgment that such analysis is material to corporate investment decisions.
• Despite the scenario analysis that many companies claim to undertake, the disclosure of that work is largely unavailable, making it difficult for markets to evaluate its robustness.
• Even if companies were to conclude that meeting the targets of the Paris Agreement would materially impact their businesses and investment decisions, many are sceptical of both governments’ ability to achieve those goals and the potentially disruptive effects of low-carbon technological developments. Where companies believe the impact might be material but highly unlikely, disclosure may be lacking—even where investors are demanding it.  The result is what obtains in regulatory filings today—a dearth of information on how established climate objectives will impact the business.
• Critically, the need for such disclosure is greater because management often deems climate targets unlikely to be achieved—as a consequence, they are far less likely to align business planning with them and, as a result, more likely to misallocate capital should governments do what they propose to do, or low-carbon technological development and deployment continue to surprise.
• The key solution to this impasse is to require disclosure against current climate targets, however those targets might be achieved and regardless of whether management has deemed them likely. Forward-looking scenario analysis can provide insight into the quantum of climate-related financial risk at macro- and firm-levels.
• As the TCFD recommendations note, for this disclosure to be made decision-useful the outputs need to be consistent and comparable. Comparability is necessary because investors need to understand the relative risks facing different companies. A consistent approach is needed to ensure comparability over time. Consistent and comparable scenario would then offer investors a means of assessing and pricing these risks.  In turn, this would send the necessary price signals to the market.
• This can be delivered but it requires use of a reference scenario.[6] A reference scenario, in turn, likely requires a regulatory structure that sets such a scenario.
• Further disclosure (for example, through existing forward-looking disclosure requirements found in the Strategic Report), could then supplement the reference scenario with management’s views on alternative scenarios and management’s view of the reference case.
• A reference scenario not only aids markets, it reduces costs to issuers by providing the building blocks for disclosure. The use of a reference scenario, built upon climate targets, would be the first of its kind for capital markets disclosure, setting the UK out as a leader in the field, whilst minimizing the costs of listing on the UK’s exchanges.
• As the UK works to implement the TCFD recommendations domestically, we encourage the Government to explore the utility of using a reference scenario within the most relevant sectors, at a minimum.

A need for mandatory disclosure of climate-related risks

• The UK Government’s endorsement of the recommendations is a positive first step, but it now needs to move from high-level government support to specific support and active involvement from financial regulators, such as the FCA.
• Within this context, we believe it important to understand both why decision-useful disclosure does not currently appear in registered reports and further why such disclosure is needed.
• We, and others have pointed out that, for some companies, compliance with the Companies Act 2006, which requires disclosure of principal risks and uncertainties, should result in the identification of climate change or the energy transition as a material risk.[7] Indeed, many companies have made precisely this general disclosure, which suggests broad agreement as to its materiality.[8]
• The problem is that the regulation requires risk identification but not risk assessment. For well-known macro trends like the energy transition, risk identification alone is of little utility.
• Companies could discuss implications of the energy transition through the Strategic Report’s requirement to discuss “the main trends and factors likely to affect the future development, performance and position of the company’s business”.[9] In practice, however, companies have been afforded wide latitude to make these determinations and chosen not to disclose—likely due to the representation that the companies deem that result unlikely.[10]
• It is a sound first principle for management to determine what it believes to be material. But for future trends where there is global agreement on the end goal, the response from the markets is that investors need a better understanding of the implications, regardless of management’s current view.
• The risk here is not of too much information being in the market, but of investors having to make decisions about these risks with blunter instruments. We are already seeing pension funds facing increasing pressure to demonstrate tangible progress on addressing these risks within their portfolios. Further, the response outside the UK, from Norway to New York, has been to consider whole cloth divestment from the energy sector. Better disclosure that allows differentiation between companies is essential to ensure that these risks are priced against the most exposed companies and not the sector as a whole.
• Can this happen with voluntary disclosure alone? We believe that to be unlikely. Too much latitude in how these disclosures are structured will encourage companies to select those metrics and assumptions that will set the business in the most favourable light and therefore fail to produce outputs that are comparable across sector competitors. Lack of utility will reduce investor interest in the disclosures and encourage the “laggards” to disclose nothing at all. Furthermore, voluntary regimes will not be assured, and potentially not assurable, further weakening the credibility of the disclosures made.
• Thus, while we recognize the value in initially affording organisations some flexibility to become familiar with subjects and tools that may be novel, we believe strongly that to deliver consistent, comparable and decision-useful disclosure, the UK should consider steps to making at least elements of the TCFD recommendations mandatory.

Identifying the material concerns for fossil fuel companies

• The consultation states that companies “will need to understand the impacts of climate change on the financial metrics of their business, and highlight what steps they have taken to manage these implications [emphasis added].” We believe that there are additional elements of disclosure for fossil fuel companies that get to the heart of these two important needs, as summarised in the table below.

[1] https://www.gov.uk/government/consultations/streamlined-energy-and-carbon-reporting.

[2] According to Royal Dutch Shell’s “Management Day” presentation from November 28-29, 2017, Scope 3 emissions constitute 85% of their total emissions produced. See https://www.shell.com/investors/news-and-media-releases/investor-presentations/2017-investor-presentations/2017-management-day.html.

[3] https://carbontransfer.wpengine.com/reports/unburnable-carbon-wasted-capital-and-stranded-assets/.

[4] https://www.bankofengland.co.uk/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.

[5] See https://carbontransfer.wpengine.com/reports/2-degrees-of-separation-transition-risk-for-oil-and-gas-in-a-low-carbon-world-2/ for analysis of the oil and gas sector.

[6] For further detail on how a reference scenario can be simply used, see https://carbontransfer.wpengine.com/time-machine-climate-risk-bringing-future-forward-2%CB%9Ac-scenario-analysis/ and https://carbontransfer.wpengine.com/wp-content/uploads/2017/02/TCFD-Phase-II-CTI-Response-FINAL.pdf.

[7] https://carbontransfer.wpengine.com/wp-content/uploads/2017/08/Joint-Letter-to-FRC-Final-2.pdf

[8] https://carbontransfer.wpengine.com/reports/no-rhyme-or-reason-eia-energy-outlook-coal-companies-risk-disclosure/

[9] S414C(7)(a) CA 2006.

[10] While many companies appear to believe that climate targets will not be met, we are unaware of any company (save Statoil) that endeavors to incorporate the physical and economic impacts of largely unabated climate change on the macroeconomic forecasts that drive their modeling, though that flows, ipso facto, from the suggestion that the world is likely to use far more fossil fuels than could safely be combusted whilst still achieving those targets.