The Trillion-Dollar Problem No Company Can Afford to Ignore: Why CFOs Must Take Their Spots on the Front Lines of Climate Risk Assessment
Risk management is nothing new to CFOs. As stewards of the Company’s financial health, these executives have long been responsible for managing, assessing, and mitigating different types of risk—including financial, operational, and geo-political threats—and for using risk analytics and risk assessments to inform strategy and capital allocation decisions across the organization.
Now more than ever, CFOs need to add climate risk to their list of potential threats to the Company’s strategy, operations and financials. As awareness of climate-related impacts to businesses and the economy have grown, institutional investors have become increasingly interested in the impacts of climate on their investment portfolios.
Institutional investors, such as BlackRock, have started taking voting action against individual directors at high-emitting companies in an effort to hold them accountable for a company’s failure to disclose climate risk. Furthermore, the SEC’s recent proposal requiring certain climate-related disclosures, including financial risks and climate-related financial metrics in a Company’s financial statements, underscores the growing importance across various stakeholder groups.
Climate risk is another dimension of risk planning.
In order for CFOs to ultimately report on the impacts of—let’s say, “Event A” or “Event B” or “Transition Activity D”, on financial statement line-items, he or she must first assess and categorize the severity and likelihood of these events.
Climate risks can be classified in two broad categories: physical and transition risks.
- Physical Risks refer to the harm and risks associated with short- or long-term weather events. Physical risks can be acute: short-term extreme weather events such as wildfires, hurricanes, floods, tornadoes, and heatwaves. Or they can be chronic: longer-term phenomena such as sustained higher temperature, changes in precipitation patterns, drought, decreased arability of farmland, sea-level rise, ocean acidification, and decreased availability of fresh water.
- Transition Risks refer to stresses arising from the shifts in regulatory policy, consumer demand, business sentiment, or technologies associated with the transition to a low-carbon economy. Companies must assume a need to adapt to mitigate climate change as certain regulatory, technological, and economic shifts will likely occur—and have already begun to occur—as part of this macro-economic shift.
Classifying physical and transition risks is an important exercise for all industries. A Tech CFO, for example, may rely on a single (or limited number) of manufacturers for critical hardware component—and would benefit from identifying key manufacturers located in high-risk regions. Natural disasters in high-risk regions would make it more costly to obtain production materials and harder to deliver products to customers (think, typhoons in the Philippines, wildfires in California, or tornadoes in Texas).
Both types of risk—and the tolls they exact—continue to grow. Here are just a few stats to put the problem in perspective:
- In 2021, the U.S. experienced 20 separate climate-related disasters, each one exceeding $1 billion-dollars in damages.[i] This is second only to 2020 when 22 different billion-dollar climate-related disasters struck across the U.S.[ii],[iii]
- In a recent CDP report, 215 of the biggest global companies measured by market capitalization reported approximately U.S. $1 trillion at risk from climate-related impacts, with more than half of these risks expected to materialize within 5 years.[iv]
- In a recent survey of C-suite executives, two-thirds of executives expressed concern about climate change, with 97% of companies expressing already experiencing negative impacts from climate change.[v]
CFOs must drive the agenda on climate risk assessments.
A climate risk assessment is the starting point for identifying and understanding the potential business-critical risks your company may face from climate-related issues. Utilizing an external climate risk expert who can efficiently laser in on the specific risks for your company, and use industry-related data as a proxy, will save significant time and resources. It allows CFOs to integrate these risks into the company’s financial control process, financial planning and reporting, while including strategy, judgements, and assumptions in the reporting, similar to other financial statement disclosure processes.
The SEC’s proposed enhancement of climate-related disclosures gives CFOs guidance for these efforts. The proposal outlines specific requirements for audited financial statements including disclosure on three broad categories of climate-related financial statement metrics: Financial Impact Metrics, Expenditure Metrics, and Financial Estimates and Assumptions.
SEC Financial Statement Metrics – Proposed
|Financial Impact Metrics||Companies would be required to disclose financial impact on a specific line item if the sum of the absolute values of all the impacts on the line item is greater than one percent of the total line item (for the relevant fiscal year).|
|Expenditure Metrics||Companies would be required to disclose the positive and negative impacts associated with climate-related events, transition activities, and climate risks. Expenditure metrics would require separate aggregate amounts of (i) expenditures expensed and (ii) capitalized costs incurred (for the relevant fiscal year).|
|Financial Estimates and Assumptions||Disclose whether the estimates and assumptions used to produce the financial statements were impacted by: |
– Exposures to risks and uncertainties associated with severe weather events and other natural conditions (physical risks)
– A potential transition to a lower carbon economy or any climate-related targets (transition risks and targets)
In addition, the SEC proposed rules require companies to disclose scope 1-2 emissions, and scope 3 if material or if included in GHG reduction targets. Scope 1 emissions include direct emissions from brick-and-mortar stores, factories, office buildings, and/or company vehicles. Scope 2 emissions include purchased energy produced off-site for electricity, heating, or cooling. Scope 3 emissions include emissions from all other activities such as business travel, employee commuting, vendors in your supply chain, waste disposal, and more. Without bright-line guidance on scope 3 emissions reporting, the materiality determination may be challenging for companies not accustomed to assessing carbon emissions across its value chain. As such, we recommend starting the carbon inventory process early as you will likely need to calculate or estimate scope 3 emissions in order to make the materiality determination. Incorporating your carbon inventory into the climate risk assessment process will help bolster the assessment and inform financial reporting later down the line.
There really isn’t a moment to spare.
Climate-related disasters are increasing in frequency and regularly impacting regions they have never impacted before. New reporting expectations and requirements are coming from every direction. It’s no longer a question of if your company will be impacted by climate-related risk; it’s a matter of when.
While climate risk reporting may seem like a daunting task, it is an essential process. A climate risk assessment is the first step to incorporating climate risk into your financial reporting. And the good news is, there are a number of tools available to support CFOs in this process and help your company get up to speed fast. Clermont Partners can point you in the right direction and provide the assistance you need at every step. Reach out to learn more about climate risk disclosure and how to weave it into your financial narrative and investor relations strategy. And give your company and your investors the confidence of knowing you are giving climate risk the attention it deserves.
[i] See NOAA, National Center for Environmental Information, Billion Dollar Weather and Climate Disasters: Summary Stats (3rd Quarter release 2021), available at https://www.ncdc.noaa.gov/billions/summary-stats/US/2020.
[ii] See NOAA, National Center for Environmental Information, Billion Dollar Weather and Climate Disasters: Summary Stats (3rd Quarter release 2021), available at https://www.ncdc.noaa.gov/billions/summary-stats/US/2020.
[iii] See NOAA, U.S. saw its 4thwarmest year on record, fueled by a record-warm December (Jan. 10, 2022), available at https://www.noaa.gov/news/us-saw-its-4th-warmest-year-on-record-fueled-by-record-warm-december.Back To Blog