When an environmental externality is no longer external Opinion Article

Dec 22, 2016 - 1:00pm

This article first appeared in The Fifth Estate on 14 June, 2016.

Kate Mackenzie
Head, Finance and Investment

You may remember Mark Carney spoke about climate change and the “Tragedy of the Horizons” in September 2015, and copped some flak from some quarters and defense from others (including me, here).

That speech outlined how climate change can manifest as a financial risk, and in particular, as a risk to financial system stability.

Carney pondered how central banks and other financial authorities might address this risk, especially as it will unfold over time horizons beyond that of monetary policy, and because much of it is shaped in the realm of public policy.

He opined that the most suitable approach, therefore, was for authorities to facilitate more useful and comparable risk disclosure from market participants. “The right information allows sceptics and evangelists alike to back their convictions with their capital.“

His speech – and the PRA report that was published on the same day – articulated much of the thinking which led to the Financial Stability Board creating a private sector task force to make recommendations on how companies should disclose climate risks.

The task force’s draft recommendations were released on Wednesday, and they look like this:



There are also related principles, such as: climate risk should be disclosed in “mainstream financial reports” and should be “timely” — ie, annually.

So. Why would this be a game changer? It’s not, after all, a brand new idea that climate change is a material risk.

There’s already a fairly well-established “responsible investment” scene featuring numerous disclosure initiatives, methodologies and products, many of which refer to climate change or “sustainability”. It’s a mini industry of sorts — and that’s before you even get into corporate sustainability reporting, which is not at all new.

On top of that, the disclosure framework recommended by the FSB task force (again, assuming it is ultimately approved by the FSB and G20) will only be voluntary. It does make me wonder how effective the FSB taskforce might actually be in bringing on a new era where climate-related risks (and opportunities!) are increasingly well understood, measured, and priced in.
There are a few reasons why it could be quite significant, however. Here’s my list:

It’s backed by the FSB
A key difference with the FSB task force is that it’s, well, supported by the FSB (or will be, assuming it is approved). Other methodologies for assessing climate-related risk are either proprietary, or administered by poorly resourced organisations.

It will provide a ready-made way for investors who are concerned about climate risk to raise concerns — and there are a decent quantity of them explicitly committed to reducing climate risk, whether through investment decisions or direct engagement or shareholder resolutions — not to mention the campaign groups who will stand up and ask questions at AGMs.

It’s specific enough (probably)
The recommendations are reasonably clear, particularly in the supplementary recommendations for specific sectors. For example, this is from the supplementary guidelines for insurers:

Insurance companies should describe key tools or instruments, such as risk models, used to manage climate-related risks in relation to product development and pricing. Insurance companies should also describe the range of climate-related events considered and how the risks generated by the rising propensity and severity of such events are managed.

That is fairly clear: which risk model/s do you use to estimate your exposure to weather-related claims? In-house, External? if the latter, from whom?

Of course you can also quickly see how, in the case of an insurer which conducts in-house modelling, even a perfectly candid and thorough disclosure could be less than helpful.

Which is probably a realistic risk: a complex issue continues to be bogged down in, well, complexity.

Thinking about the financial, rather than the ethical, implications of climate change is still relatively new. Look at what’s happened with the coal industry and the cost of renewables. Some investors – and particularly those with a long-term view – do not want to be caught out by shifts that are plausible and foreseeable.
Carney’s original point was simply that if the information was good and adequate, then these risks and likelihoods could be priced in, which reduces the risk of a market upheaval where, for example, everyone suddenly wants to reduce carbon exposure but no-one is quite clear on where it is concentrated.

Even with the best disclosure possible, however, there’ll still be uncertainty – in fact, increased uncertainty and volatility is probably one of the most predictable effects of climate change. So, get used to it, (if you’re not already).

Kate Mackenzie

Kate is Investment & Governance Manager at The Climate Institute. Prior to joining the Institute in 2014, she worked primarily as a financial journalist, winning awards for her work at the Financial Times and the Australian. Earlier, she was a technology and business reporter for the Australian, and online editor of Australian IT. Kate is a veteran of new media, and was one of the first online journalists to be hired by the ABC in the late 1990s.

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