Climate Risks

The SEC has issued a proposed rule that would require public companies to improve and standardize climate-related disclosures in their periodic filings.¹ The disclosures will include information about climate-related risks that may have a material impact on the company, as well as specific climate-related financial statement metrics in a note to the financial statements. Although this rule is yet to be approved in its current state, it is very likely that some form of climate-related disclosures will be required soon.

The proposed SEC Rule recognizes the financial risks that climate risks can pose to companies and emphasizes the importance of identifying and quantifying such risks. This article discusses four specific types of climate risks that could have a material impact on a company, thereby requiring disclosure under the proposed rule: physical risks, transition risks, reputation risks, and compliance costs. 

Physical Risks

Companies across various industries face physical risks that arise from the potential impact of climate change or extreme weather events. These risks can cause damages that disrupt business operations and affect financial results and conditions. This article focuses on two specific types of physical risks: acute and chronic. Acute risks are triggered by sudden events like fires, floods, or hurricanes, which can result in property damage for businesses. On the other hand, chronic physical risks are associated with long-term shifts in climate patterns, such as sustained higher temperatures, rising sea levels, or persistent heat waves.² These gradual changes can have a lasting impact, for instance, affecting a farmer’s ability to cultivate crops in the future.

According to the Climate Risk Technical Bulletin from the SASB, a group that develops sustainability accounting standards, when climate change poses material risks to a company’s financial condition, operating performance, or market valuation, a generally accepted approach would be for the company to disclose such risks to investors.³ However, companies are currently looking for guidance from the SEC regarding the methods and processes they should use to identify, assess, and manage physical risks. In the same bulletin, the SASB reported that four out of five companies acknowledge facing physical risks related to climate change; however, only about one out of five have attempted to quantify the financial impact or implications of these physical risks.⁴

Some of these companies that already voluntarily report on climate/ESG data are interested in what will be different under the SEC’s proposed rule. According to Deloitte professionals, “[i]f the proposed rule goes into effect, for the first time in the United States, public companies will be required to disclose specific information on governance, risk management, targets, and goals, and report and obtain assurance on their impact on climate through mainstream financial filings.”⁵

Walmart has released a more comprehensive assessment of climate-related physical risks compared to most other companies. In its climate change report, Walmart conducts periodic scenario-based climate risk assessments, aiming to align with the scenario guidance set forth by the Task Force on Climate-related Financial Disclosure (TCFD).⁶ The following table presents Walmart’s evaluated climate risks, identifies the areas of its business most affected by these risks, and outlines the considerations for mitigating or adapting to these physical risks.

Like Walmart, companies that voluntarily disclose details about climate-related physical risks are using the methods, processes, and guidelines outlined in the TCFD and other ESG frameworks. Those frameworks include Global Reporting Initiative (GRI) Standards, Greenhouse Gas (GHG) Protocol Standards, and/or Sustainability Accounting Standards Board (SASB) Standards. Experts at PwC report that the number of organizations that support reporting of climate-related risks and opportunities in line with the Task Force on Climate-related Financial Disclosures (TCFD) has nearly doubled within the last year.⁷

The TCFD recommends specific disclosures based on industry and risk. For example, the TCFD suggests that most organizations conduct a scenario analysis to examine how a company’s “climate-related risks and opportunities may evolve and the potential implications under different conditions.”⁸

While the TCFD’s recommendations report is extensive, other organizations have developed even more comprehensive frameworks based on the TCFD’s recommendations to help companies delve deeper into physical risk analysis. For example, the European Bank for Reconstruction and Development (EBRD) and the Global Centre for Excellence on Climate Adaptation (GCECA) noticed that the TCFD “recommended that metrics on physical climate risks and opportunities should be included in financial disclosures but did not provide concrete guidance on what the appropriate metrics would be.” The EBRD-GCEA report is “intended to inform and support early efforts to adopt the TCFD recommendations.”⁸ The recommendations in the EBRD-GCEA report go beyond the TCFD’s report by offering additional guidance. For example, the EBRD-GCEA report discusses the differences in reporting first-order physical climate impacts, which directly affect the corporation, versus second-order physical climate impacts, which “include all impacts of climate change on economic, human and ecosystems beyond the boundaries of the corporation.”⁹

Naturally, risk models, frameworks, and recommended disclosures regarding physical risks do not align perfectly across each standard. In fact, they can sometimes contradict each other. Even if the standards were perfectly unified, the guidelines vary by industry. Eventually, the ultimate decision regarding the physical risk reporting rules and processes rests with the Securities and Exchange Commission (SEC). As a result, many companies are waiting for further guidance from the SEC before reporting on physical risks.

Transition Risks

The process of transitioning to more sustainable business practices is a significant undertaking that requires significant changes to a company’s operations, creating transition risks. While these risks can vary across industries, operational changes can be expensive, and their impact can be uncertain. To minimize these costs, companies must carefully identify transition risks.

Correctly identifying the risks that arise from a major business transition is crucial. If a company identifies the wrong risks, resources may be diverted to mitigating the wrong risks, leading to negative impacts on the income statement. Managing the Execution Risks of Change Initiatives¹⁰, an article written by Deloitte and featured in The Wall Street Journal, lists twelve elements that effective businesses consider when implementing change. Regarding correctly identifying transition risks, the two most important elements listed in the article are “Data Systems” and “Talent”, as highlighted below.

A shift in business practice can have a pervasive effect on a company’s business cycles. Reliable, accurate, and comprehensive data systems surrounding these business cycles can help identify relevant transitional risk factors. For example, if a delivery company wants to replace its current fleet of gas-powered delivery trucks with electric delivery trucks, a sophisticated and comprehensive data infrastructure will provide information about the costs of maintaining the existing fleet, the current depreciation levels, and the current market values of the vehicles. With this information, the company can identify the risks that come with replacing the fleet. Without well-maintained data, transitions can become more costly than necessary. 

Although robust data can assist in identifying internal risk factors resulting from transitions, there are still external risk factors that even the best data and data analyses can’t identify. Therefore, companies often hire consultants who specialize in sustainable business practices to help with the transition process. PwC highlighted the high demand for these consultants when they announced on June 15th, 2021, their five-year plan to invest $12 billion in creating 100,000 new jobs “aimed at helping clients grapple with climate and diversity reporting.”¹¹ Consultants’ knowledge of the process of transitioning to sustainable business practices can help companies identify major obstacles they will likely encounter. While it is almost impossible to identify every transition risk, maintaining accurate and comprehensive data and hiring experts in the field can help companies identify and mitigate transition-related risks.

Reputation Risks

Reputation risks are defined by the Carbon Disclosure Project (CDP) as "all risks tied to changing customer or community perceptions of an organization’s contribution to or detraction from the transition to a lower-carbon economy."¹² In other words, it is the risk to a company's public reputation based on its decision to adopt sustainable practices or not. Although limited documentation exists for specific methods of identifying these risks, organizations such as the SASB offer some recommendations. Many market-present forces influence this risk, including customer perceptions, financial institution pressure, and more indirect supply chain risks.

The SASB provides industry-specific standards to aid in identifying risks. For example, the guide for appliance manufacturing¹³ lists various risks and methods used to identify them. The guide helps identify risks in general as well as specific reputation risks, although they are not necessarily labeled as such. Section CG-AM-250a.2 of this guide aids in identifying the risks associated with using hazardous products, which could have negative impacts on a company’s reputation. By effectively identifying such shortcomings, a company can improve its sustainability efforts to mitigate risks. While this discussion referred specifically to appliance manufacturing, many industries have similar guides provided by the SASB with more specific recommendations for risk identification.

Reputation risks can also arise from customer sentiment. Customers’ negative perceptions can lead to declines in a company’s brand value, revenue growth potential, and market share, and may even increase the potential for litigation. Some economists and business experts believe that a company's main purpose is to pursue business for the good of its stakeholders. According to this belief, if stakeholders become dissatisfied with a company's sustainable practices, they may take legal action to replace management or sue the company for failing to fulfill previous commitments regarding environmental sustainability. Such legal actions could be detrimental to the company’s reputation the likelihood of legal action increases, which can be detrimental to the company’s reputation.

The PwC publication "Time to Get Serious About the Realities of Climate Risk"¹⁴ identifies specific reputation risks for financial institutions. According to PwC, many investment arms have begun cutting investments in companies with significant climate-related risks. Companies that inherently emit large levels of GHGs, such as those in the coal mining industry, are currently at greater risk of losing financial backing. However, all firms are subject to some form of climate-related risk. As financial institutions continue divesting from firms with heavy emissions, it is anticipated that "the pressure from financial institutions will soon start to touch everything from a company’s credit rating, valuation, and cost of capital to its ability to borrow and get insurance."¹⁵ If such investment practices continue, companies' reputations with such institutions are at increased risk.

In addition to the risk of losing market share, competitive pressures also exist as other companies that implement sustainable practices may attract investment and customers from companies that are not utilizing such practices. Furthermore, external vendors in a company's supply chain may also adopt more sustainable practices and eventually drop customers who are not actively practicing and improving sustainability measures. 

This risk to reputation can be mitigated by adopting sustainable practices that limit a company's exposure to reputation risks. As a company takes more sustainable actions, its public perception improves. Investors and creditors become more willing to support a company that has a stronger reputation in the market due to its adoption of sustainable practices. Staying up-to-date with current trends that limit climate-related risks is important to maintaining a good reputation with market participants. Of course, some companies cannot simply adopt new practices, such as coal mining and other emission-heavy industries. These companies will need to provide sufficient disclosures and communications to stakeholders regarding the reasons for their limited embrace of cleaner practices. However, there may come a time when simply explaining away environmentally disruptive practices will not suffice. 

Compliance Costs

Compliance with regulatory or legal requirements is essential to running a business in any industry. Failing to comply can cause severe penalties for a business. With increased sensitivity to climate change from consumers, businesses, and government authorities, more climate-related laws are being enacted worldwide, and more are expected to follow. Companies need to be aware of relevant laws and regulations and estimate the potential impact and costs of compliance. 

The majority of the world’s governments, as well as many US state governments, have pledged to achieve net zero carbon emissions in the next 20-30 years. This will be accomplished through the implementation of green tax policies, offering incentives for innovation, and enacting climate-friendly laws across all industries. Large companies are already being required by many governments to provide details of their plans for meeting net zero commitments. 

Companies in carbon-intensive industries, such as energy, manufacturing, and mining, have already faced significant climate-related regulations. For example, California has established renewable portfolio standards for electricity producers, with the initial target of 20% renewable energy production set in 2013, and increasing every few years. Such regulations and laws are becoming increasingly pervasive across different governments and industries. Non-compliance with these laws may result in substantial financial costs and reputational damage. 

Identifying potential compliance costs is an essential step in transitioning to a more climate-friendly economy. Because compliance risks vary greatly across different locations and industries, there is no comprehensive guide to climate laws and regulations. Therefore, each company needs to assess its exposure to compliance costs, both current and future, as a part of its regular compliance and risk functions. 

The Global Sustainability Standards Board (GSSB) offers guidance on how companies can identify material topics related to climate risk in the Global Reporting Initiative Sustainability Reporting Standards (GRI). This guidance is intended for companies that will be reporting in accordance with the GRI Standards, but it can also help all companies identify risks and start to mitigate them. In GRI 3: Material Topics 2021¹⁶, there are three steps to determining material topics: (1) Understand the organization’s context, (2) Identify actual and potential impacts, and (3) Assess the significance of the impact. 

In its ESG Report¹⁷, Walmart discloses the risks it faces related to regulations and provides insights into its approach to managing those risks. Among these risks are changes to carbon pricing regimes, energy targets, water efficiency standards, and vehicle emissions standards. The approach taken by the company is to monitor policies and integrate potential policies into its business and financial planning, as well as implement green initiatives within the company. By adopting policies and initiatives earlier than its competitors and before legislative deadlines, Walmart stays ahead of the curve and reduces the impact of compliance costs. If the potential costs of compliance are considered in the planning of business activities, some expenses may be avoided. 

With an increasing number of countries and corporations committing to the net zero goal, climate-related regulation will continue to rise. Consequently, all companies will need to have processes in place to identify relevant regulatory or legal requirements and assess the impact of compliance on their operations. By integrating these risks into financial planning and strategic decision-making, companies can avoid regulatory penalties and reputational damage.

Conclusion

Although the SEC Proposed Rule is not yet definitive, it is very likely that companies will eventually be required to identify, disclose, and mitigate material climate-related risks that impact their operations. Various types of risks are to be included in this disclosure, but all require similar methods to identify and manage the threats posed.