The Climate (ESG) Risk Management & Net-Zero Wave: -The Non-Financial Corporate Perspective

Abstract:

With regulatory and disclosure guidance for sustainability, ESG, and climate change evolving rapidly for financial institutions, non-financial corporates walk a precarious path if they do not follow suit and begin the long journey that is risk analysis and development of subsequent external reporting. This article explores potential paths forward for these institutions and provides guidance around pivotal first steps.

The Climate (ESG) Risk Management & Net-Zero Wave:

The Non-Financial Corporate Perspective

Over the last few years, financial institutions around the world have experienced tremendous pressure from governments, regulators, and customers to significantly step up their overall sustainability and Environmental, Social, and Governance (ESG) activities with increased attention on the risk management side of things— and on climate risk in particular. The “E” in ESG, represented by physical and transition climate change risks, is probably the area causing the most headaches to banking executives. As bankers and investors are formalizing their ESG and climate risk processes, they are also cascading respective requirements and expectations down to their customers and investees.

To support the transition to a sustainable economy, authorities are now also turning their attention from financial institutions to non-financial corporates where they are introducing a variety of sustainability, ESG, and climate risk requirements and mandatory disclosures. At the same time, a number of corporates are already feeling the first negative impacts on their businesses from both the changing environmental and regulatory climate and/or the related mitigating actions of the leading governments and policy makers.

Sustainability, ESG, and Climate Risk Reporting

Following up the financial industry regulations and disclosure requirements, the leading global policymakers have introduced a number of reporting regimes also for non-financial corporates, some examples include:

• EU-wide Corporate Sustainability Reporting Directive (CSRD) hitting 50,000+ EU firms from 2024 onwards
• Mandatory climate-related financial disclosures by publicly quoted companies, large private companies and LLPs applicable to 1,300+ of the largest UK corporates as part of  the UK’s broader Sustainability Disclosure Requirements (SDR) framework
• Singapore’s SGX Sustainability Reporting Guide
• Global International Financial Reporting Standards’ (IFRS) Sustainability & Climate Disclosure Standards

 All in all, companies around the world will have to collect, analyze, process and disclose more sustainability and ESG data. In particular, there is a lot of attention paid to carbon and net-zero factors and application of the double materiality and forward-looking perspectives on reported information. Last but not least, all these activities have to be performed in a more standardized and auditable fashion:

• Carbon and GHG focus – it is no longer a nice-to-have to report on a company’s carbon and Green House Gas (GHG) emissions. It has become mainstream to calculate both direct (Scope 1) emissions and indirect (Scope 2 and 3), which cover the entire value chain of a company with both its upstream (e.g. sale, usage, and disposal of products) and downstream (e.g. supply chain) activities. To accommodate this, companies have to gather new information, establish new processes and assumptions, and perform new calculations according to an established carbon and GHG accounting framework such as the Greenhouse Gas Protocol. 
• Double Materiality – the classical Corporate Social Responsibility (CSR) approach of looking at a company’s impact on the environment around it has been around for more than a decade. What is new is the Double Materiality assessment closing the loop from the environment back to the company. Now, companies have to report on the ESG risks impacting their operations and activities, with particular attention towards climate risk.
• Forward looking perspective and strategy – a number of new reporting areas now include forward-looking elements, i.e. the coverage has expanded from the actual/historical data towards the what-if, future considerations such as providing a view on how the future emissions of the company are likely to evolve, how the deteriorating climate is going to impact the company, and what strategy the company is envisioning going forward to tackle this.
• Net Zero and Paris Alignment – some of the frameworks are pushing forward-looking requirements even a step further, asking companies to disclose their strategy for de-carbonization in order to reach a net-zero carbon footprint by 2050 (i.e. the Paris Alignment). According to a study performed by Standard Chartered Bank, for 52% of top corporates, net-zero transition will be the most expensive effort they have ever embarked on. In the same study, 61% of institutional investors stated they will not invest in companies that lack a net-zero Paris-aligned transition strategy. 
• Standardization – there is an increasing need for investors to look at reports of various companies and efficiently assess their sustainability and ESG exposures. Investors need to be able to compare apples with apples and pears with pears, which is vital for them to efficiently decide which company better suits their sustainability and ESG investment criteria, appetite, and strategy. To facilitate this, new reporting structures and formats are required that will make comparability and transparency of these reports easier compared to the earlier regimes.
• Auditability – a number of the the reporting frameworks, such as the CSRD, come with the requirement that all this new information has to be included in the Annual Management report, with a sign-off from the board and an external auditor as well. There are expectations that these climate disclosures are to be akin to SOX Controls for Internal Audit. Firms need to step up the auditability of their activities in this area, ensure the process for data collection, storing, processing, and reporting is governed accordingly, and the supporting infrastructure is sound, transparent and reliable. 

Climate (ESG) Risk Management

In order to properly identify their exposures to physical risks (e.g. severe weather) and transition risks (e.g. elimination of gasoline-fueled automobiles in favor of electric vehicles), understand their interdependency, and assess potential future impacts, non-financial corporates have to ramp up their existing enterprise and operational risk management processes. Figure 1 shows a schematic of these relationships.

Mapping this unchartered territory requires new data, new skills, and very close cooperation with risk, business, and strategy teams to properly understand the sensitivities of a firm’s business model to physical and transition risks now and going forward 10, 20 ,30 years in the future.

As a result of this analysis, each firm needs to form up a transition plan for addressing transition risks and an adaptation plan to deal with physical risks going forward.

 Scenario Analysis & Climate Risk

A particular attention is paid to forward-looking metrics and calculations assessing the what-ifs, risks, and impact of alternative scenarios and strategies on a firm’s future performance. This causes a notable headache to non-financial institutions and their current business and financial planning processes as they have not been exposed that much to regulatory stress testing and scenario analysis activities like financial institutions have. TCFD has put together dedicated Guidance on Scenario Analysis for Non-Financial Companies, which helps firms to get started, but still this can be an entirely new domain for a number of them. However, there is a positive side— out of this exercise potential new climate opportunities could be identified and assessed by these firms.

Furthermore, scenario analysis is not just about climate risk. It is a well-established and powerful risk management and business planning tool that has been used by financial institutions for a long time. Due to the COVID-19 Pandemic, geo-political, energy, and inflation shocks , it is also becoming much more relevant for non-financial corporates so they can better asses the future implications of volatile and unstable environments in relation to their operations and revenues. Searching for an optimal transition strategy towards a Paris-aligned business model to reach net zero— while minimizing risk and maximizing returns— is a another perfect use case for forward-looking scenario analysis.

     “The Road to Net-Zero will be the greatest transformation of our times”

                                                The European Commission

Net-Zero Planning & Transition

There are a number of alternative business model roads that lead to reaching the Net-Zero Target by 2050 each with a different risk-return and cost profile. The challenge lies in finding the optimal Paris-aligned strategy and product mix that will lead to a firm’s net-zero carbon footprint (scope 1, 2, 3) by 2050— combined with the lowest risks and highest returns along the way under varying macro and climate scenarios.

Figure 2 below shows an example where a firm assesses the impact of the two most commonly applied climate scenarios on its expected future performance till 2050, starting with their existing business as usual (BAU) business model and strategy. In order to avoid a devastating hit on its performance under the Hot House World Scenario (where it faces most of the physical risks), the firm explores the impact of two alternative net-zero business transition strategies, which clearly deliver better performance under both scenarios— each offering a different balance along the way between short/long term risks, returns, and costs. In the end, the firm will choose the optimal strategy based on their strategic objectives, their risk appetite, and their view on future climate developments.

Parting Thoughts

Thinking about sustainability, climate risk, and net-zero strategy is no longer a nice-to-have for non-financial corporates. With the arriving wave of sustainability, ESG, and climate risk disclosures, corporates not only have to significantly boost their capabilities to produce newly required information and measures in audit-ready mode, but they must also scale up their risk management capabilities in order to identify climate change threats as well as mitigation and adaptation strategies going forward. The results better be good, because investors, auditors, and (increasingly so) customers are going to pay much more attention from now on.

On the bright side, as firms invest in new capabilities to address all of the above, they will become better at analyzing the impact of both the expected and unexpected. More importantly, they will be better positioned to make the right choices when navigating the volatile waters of these uncertain days— and of the days to come. Because whether it is a pandemic, geo-political, energy, inflation, or climate crisis, the key to tackling it is the same: to better understand it, to recognize its impact on the business, and to identify the best course of action going forward.