In December 2016, the Task Force on Climate-Related Financial Disclosures (TCFD) published Draft Recommendations purporting to set forth “widely adoptable recommendations on climate-related financial disclosures that are applicable to organizations across sectors and jurisdictions.” Appended to these Draft Recommendations is a Technical Supplement, explaining that the TCFD is calling for companies to analyze and disclose risks related to climate change using a “scenario” analysis. Whether the TCFD’s Draft Recommendations become, in fact, “widely adoptable” will depend in part on how the recommendations square with the current regulatory framework for public company disclosures and how ready companies and the SEC are to support the new methods of analysis and standards for disclosure advocated by the recommendations.
TCFD’s Anticipated Final Recommendations
The TCFD is a 32-member industry-led task force established by the Financial Stability Board (FSB), an international group that makes recommendations about the global financial system. The TCFD, which is chaired by Michael Bloomberg and consists of members from both financial and non-financial companies across a range of countries, is currently finalizing a report on climate-related financial disclosures that it will present to its parent organization, the Group of Twenty (G20), in July 2017. The G20, which is comprised of finance ministers and central bank governors from nineteen of the world’s largest economies, and the European Union, will be holding its annual summit in Hamburg, Germany in July. At the meeting, the TCFD will present to the G20 the final version of recommendations that it has been developing since the TCFD formed in December 2015.
The Technical Supplement and Scenario Analysis
A “Technical Supplement” to the TCFD’s Draft Recommendations includes an elaborate discussion of “The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities.” The premise of a scenario analysis is that it pushes decision makers to explore uncertainty regarding risks. As the Technical Supplement explains, scenario analysis is a “well-established method for developing strategic plans that are more flexible or robust to a range of future states.” However, the Technical Supplement also notes that “use of scenario analysis for assessing climate-related risks and opportunities and their potential implications . . . is relatively recent.” The Technical Supplement sets forth the following steps in developing a scenario analysis regarding climate change:
- Identify and define a range of potential climate change scenarios, including a 2°C scenario, and the physical risks and opportunities presented by each scenario.
- Evaluate the potential effects of these scenarios on the company’s strategic and financial position.
- Use the results of the foregoing analyses to identify options for managing the identified risks and opportunities through adjustments to strategic and financial plans.
The TCFD’s recommendations seek to have public companies disclose the details of their own scenario analyses in their public disclosures, including disclosures made pursuant to requirements of the Securities Exchange Act of 1934 (e.g., annual reports on Form 10-K). The Technical Supplement provides the following outline of a climate scenario analysis:
As described by the Technical Supplement, a “scenario” describes “a path of development leading to a particular outcome. Scenarios are not intended to represent a full description of the future, but rather to highlight central elements of a possible future and to draw attention to the key factors that will drive future developments.” According to the Technical Supplement, scenarios are hypothetical constructs, meaning they are not forecasts, predictions or sensitivity analyses. The Technical Supplement notes that each scenario chosen to assess climate-related risks should have the following characteristics:
- Plausible. The events in the scenario should be possible and the narrative credible (i.e., the descriptions of what happened, and why and how it happened, should be believable).
- Distinctive. Each scenario should focus on a different combination of the key factors. Scenarios should be clearly differentiated in structure and in message, not variations on a single theme.
- Consistent. Each scenario should have strong internal logic.
- Relevant. Each scenario, and the set of scenarios taken as a whole, should contribute specific insights into the future that relate to strategic and/or financial implications of climate-related risks and opportunities.
- Challenging. Scenarios should challenge conventional wisdom and simplistic assumptions about the future. When thinking about the major sources of uncertainty, scenarios should try to explore alternatives that will significantly alter the basis for business-as-usual assumptions.
Apart from these general guidelines, the Technical Supplement provides few specific details about how scenario analysis should be employed or, as explained below, how this scenario analysis relates to financial disclosures.
A New Concept for Public Disclosure
Although the TCFD acknowledges that “use of scenario analysis for assessing climate-related risks and opportunities and their potential implications . . . is relatively recent,” the TCFD fails to acknowledge that disclosure of scenario analysis in public financial disclosures is a new concept for companies. The TCFD cites to several articles that have been written about scenario analysis, one of which notes that “[s]cenario analysis has been used by the private sector for the last 25 years to manage risk and develop robust strategic plans in the face of an uncertain future,”1 but none of these articles relate specifically to public disclosure of financial risk. The TCFD does not explain how such an analysis fits into the current regulatory framework for public financial disclosures.
The TCFD’s climate scenario analysis differs from the types of analysis that companies typically employ to assess and disclose financial risks because climate scenario analysis is based on hypotheticals. This difference has caused at least one financial consulting firm, IHS Markit Ltd., to publish a report criticizing the TCFD Draft Recommendations as representing a “radical departure from established concepts” in disclosing financial risks. At present, most companies listed on a national securities exchange in the U.S. disclose only those climate-related risks that companies have determined to be material under the SEC’s Guidance Regarding Disclosure Related to Climate Change. Under this SEC Guidance, “material” is defined, as it is defined elsewhere in SEC guidance and regulations, as information providing “a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or, put another way, if the information would alter the total mix of available information.” Neither the SEC’s Guidance Regarding Disclosure Related to Climate Change nor any other SEC guidance documents include the concept of scenario analysis or require companies to choose and explain such hypotheticals when assessing potential financial risks.
Important Questions Remain
The TCFD’s Draft Recommendations promote scenario analysis as a novel method for assessing risk that would push companies to explore, and to explore publicly, uncertainty related to climate-related risks. The Draft Recommendations and the Technical Supplement avoid discussing how scenario analysis relates to the existing regulatory framework for public company disclosures. If the TCFD’s recommendations in their current form are finalized in July 2017, significant questions will arise for investors and companies to the extent that the recommendations get their attention. For example, would companies disclose only those scenarios and analyses for risks that they ultimately determine to be “material”? If so, would the current SEC definition of materiality apply?
For the time being, the companies and industries most implicated by the Draft Recommendations have avoided public engagement or debate with the TCFD.