Companies are investing more and more time in producing climate-related disclosures, which are increasingly based on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). Yet their disclosures are still not translating into practical strategies to accelerate decarbonization. Why is that? This is the issue explored by the fourth EY Global Climate Risk Barometer (pdf), a comprehensive analysis of disclosures made by more than 1,500 companies across 47 countries.
These insights form part of the EY CFO Imperative Series, which provides critical answers and insights to help finance leaders reframe the future of their organization.
Coverage and quality are increasing, but gaps remain
The research, which was based on a robust scoring methodology, found that of the corporate reports analyzed, the score for coverage of TCFD recommendations was 84%, a steep increase from 70% in 2021. While coverage scored highly, the average score for quality was just 44%, a minimal increase from last year’s score of 42%. The wide gap between coverage and quality suggests that, while more companies are reporting on climate risk, they are not actually providing meaningful disclosures around the challenges they face.
Interestingly, one element of the TCFD framework that showed a marked improvement in quality of disclosures this year was strategy, with the average quality score for strategy climbing to 42% from 38% in 2021. This result likely reflects companies’ awareness of the changing political and regulatory landscape around disclosures. For instance, the first two proposed standards for sustainability disclosures from the International Sustainability Standards Board (ISSB) both feature strategy as an important component.
Leaders and laggards vary widely among sectors and regions
The research highlights that certain markets, and certain sectors, are clear leaders when it comes to climate reporting, while others are notable laggards. From a market perspective, the UK tops the list in terms of both coverage (99%) and quality (62%). It is followed closely by Japan, which has a coverage score of 96% and a quality score of 56%. These scores are indicative of the mandatory disclosure requirements of those markets. The Middle East performs worst on the Barometer in terms of both disclosure coverage and quality, reflecting its less mature regulatory framework for ESG reporting.
From an industry sector perspective, it is no surprise that the sectors with the most exposure to transition risk generally score higher for their disclosures. Energy has the highest coverage score — at 93% — and shares the highest quality score — 51% — with insurance. Energy companies are attempting to respond to the demands of their investors, who want greater transparency around their decarbonization strategies. “The energy sector should be viewed as an important low-carbon transition platform,” notes Matt Handford, Climate Change and Sustainability Principal, Ernst & Young LLP, “aligning to the expectations of investors and regulators, as well as those of the markets more broadly.”
The agriculture, food and forest products sector lags behind most others in terms of both coverage and quality of disclosures — which is a concern given its high vulnerability to the effects of climate change. This result suggests the sector is still wrestling with the sensitive issues of transition plans and the potential impact of climate-related risks and opportunities on its business.
The financial services sector is also heavily exposed to climate risk. Accelerated global warming could lead to a sharp fall in asset prices, hitting the balance sheets of banks and asset managers and potentially destabilizing the entire financial system. Furthermore, the insurance industry is subject to the risks of economic losses caused by extreme weather events.
The severity of the risks they face helps to explain why both insurers and financial asset owners and managers have recorded significant year-on-year improvements in both the coverage and the quality of their climate-related disclosures. Asset managers also realize that by setting a positive example themselves, they are effectively pushing the companies they invest in to produce more comprehensive reporting on climate risk. “Providing better climate-related financial disclosures is an opportunity for investors to ‘walk the talk’ when it comes to driving up the quality of climate reporting,” explains Emma Herd, EY Oceania Climate Change and Sustainability Partner.
Risk analysis activity reveals new opportunities
Nearly half (49%) of companies surveyed in this year’s Barometer disclosed that they had conducted scenario analysis, a significant increase on 41% in 2021. The most common scenarios referenced were RCP 8.5 (a high-emissions future) and RCP 2.6 (a very low-risk future), indicating that companies are planning for what would be effectively worst-case and best-case scenarios.
Three-quarters (75%) of companies surveyed had performed risk analysis, with companies focusing almost equally on physical and transition risks. Nearly two-thirds (62%) of companies performed opportunity analysis, with “products and services” listed most frequently.
Companies in the energy sector are more likely to disclose their decarbonization strategies than companies in any other sector, reflecting the pivotal role of energy in the transition to a low-carbon economy. More than four-fifths of energy companies surveyed (81%) disclosed either a specific net-zero strategy, transition plan or decarbonization strategy, compared with an average across sectors of 61%.
Financial impact of disclosures is still in its infancy
While companies are improving the coverage and quantity of their climate disclosures, they are only making limited progress on integrating their climate reporting with their financial statements. This key finding may help to explain why disclosures do not appear to be accelerating the decarbonization process: Their financial relevance is not clear. The Barometer found that fewer than one-third (29%) of companies surveyed are referencing climate-related matters in their financial statements as both qualitative and quantitative aspects.
There are several reasons companies may be reluctant to reference climate-related matters in their financial statements. First, finance teams may not have the knowledge to understand where climate risks sit in the context of the statements. Second, there is a mismatch in time horizons since financial statements refer to a comparatively short time horizon while climate risk is relevant to a much longer timeframe. Finally, the uncertainty and variability involved with climate scenarios present challenges when it comes to including these scenarios in financial models. Regardless, disclosures offer a critical step forward, notes Dr. Matthew Bell, EY Global Climate Change and Sustainability Services Leader. “Boards and senior management teams should be using their disclosures to inform their stakeholders, particularly their investors, about how they are understanding and managing their risks in practice,” he explains.
How reporting can help accelerate decarbonization
Reporting is an important aid to the decarbonization process because it enables companies to be held accountable — by themselves and others. Nevertheless, it cannot bring about decarbonization all on its own. Decarbonization ultimately depends on companies taking concrete, real-world actions, which include:
- Setting meaningful targets and tracking progress against them
- Reassessing strategy on a regular basis, using scenario analysis to stress-test assumptions
- Collaborating with partners to achieve ambitious decarbonization targets
- Exploring opportunities to transform business portfolios while reducing emissions
In addition, there are three specific ways in which companies can use their corporate reporting to support their decarbonization strategies:
- Prioritize materiality: Rather than trying to focus on every standard and metric, concentrate on telling a sharp, integrated story about the financial risks and opportunities that climate change presents to the business.
- Benchmark disclosures against peers: Study the disclosures of customers, competitors and suppliers to understand how they are responding to the opportunities and risks presented by climate change.
- Prepare for the implementation of the ISSB’s new standards: Ensure that the company has the appropriate processes and governance to respond to the higher levels of scrutiny that will accompany international adoption of the ISSB’s global baseline of sustainability disclosures.
Decarbonization efforts need to gain traction
Today, companies’ climate disclosures are still not as comprehensive as investors, regulators and other stakeholders would like them to be. Neither do they appear to be accelerating the decarbonization process. In fact, global energy-related carbon dioxide emissions rose by 6% in 2021 to 36.3 billion tonnes, their highest-ever level, according to the International Energy Agency.1
If companies are to meet their ambitious net-zero targets, they need to close the major disconnect between the disclosures they are making under the TCFD framework and their own transformation journeys. Climate risk disclosure should not be a box-ticking exercise, but a robust basis for corporate transformation.
Courtesy EY. By Matthew Bell
Full report available here