Enhancing Climate-Related Financial Risk Disclosure

This SIP builds on the observation that there is a system in place (or, at least, by and large) that would accommodate a significant change to capital allocation practices. What is required, is that climate risks are more salient to investors and managers, so that these risks are disclosed and market mechanisms can direct capital in ways that align with the PCT.

 

Actor(s)

There are two scenarios that could trigger this SIP. The first builds on existing rules and regulations and can be triggered by investors (including insurers) exercising their rights and demanding disclosure of (material) climate risks. The second process starts with the government (or a regulatory agency) changing the rules to make effective litigation more likely, and is then followed-up on either by public prosecutors or by the investors mentioned above.

 

Impulse (trigger)

In the first scenario (which builds on existing rules), a successfully argued case that imposes liability on a company (and possibly its directors) that does not sufficiently take account of climate risk, would serve as an effective trigger.

In a second scenario (which requires that the government introduce new rules that make successful litigation more likely), a successful case would be preceded by a change to the rules and/or to prosecution practices by the government (regulators).

 

Criticality

A secular trend towards ever-increasing physical climate risk should unfold as climate change takes hold. Provided that the legal system functions well, this also means that liability for non-disclosure becomes a more salient issue. It is, however, not clear whether the system is at a stage where these dynamics alone create a ‘critical’ state.

Movement towards such a critical stage is, however, gaining momentum. Investors increasingly demand that companies enhance their climate risk disclosures. Initiated by the G20 and the FSB, the Task Force on Climate-related Financial Disclosures (TCFD) has recently published its recommendations. In addition to creating widespread awareness around climate disclosures and establishing a ‘coalition of the willing’, the TCFD has come up with extensive technical guidelines for disclosure standards that would be largely consistent for all signatories and in all countries that are a party to it.

If governments act, for example by introducing rules that make it more likely that liability is established, it is likely that investors, in turn, will be (even) more perceptive to climate risk.

 

Feedback Dynamics

There are at least two mutually reinforcing (and individually self-reinforcing) feedback dynamics at play.

The first feedback dynamic is that of legal liability and managerial behaviour: Threat of litigation for causing, misreporting, or mismanaging climate-related risks seen as material -> company directors reduce emissions, and improve their reporting and management of climate risk -> corporate norms change -> legal norms (e.g. ‘reasonable director standard’) change -> threat of successful litigation increases, &c.

The second feedback dynamic builds on the improved reporting: More disclosure of climate risks -> investors confronted with climate risks, include this in their cost-benefit analysis -> interest rates for ‘dirty’ companies rise (so their costs rise), interests rates for ‘clean’ companies fall (so their costs fall) -> investment propositions of PCT-compliant businesses and business models improve relative to those of non-PCT-compliant business models -> more deployment of capital in line with PCT, &c {-> change of attitudes around PCT-consistent investment (and climate risks) -> investors require more disclosure of climate risk, companies are more willing to disclose in order to display their ‘clean’ credentials, &c}.

 

Timescale and scaleability

In the first scenario, attempts to trigger the feedback loop can start or intensify immediately by commencing litigation. However, there is no complete control on the timing of the trigger, because it requires litigation to be ‘successful’ – which is in the hands of the court.

In the second scenario, it would take a change in regulation to trigger the SIP (which could in principle happen soon but requires a cooperative government). Once that change has been made, however, successful litigation is more likely to occur.

In terms of scalability, there are many channels through which the trigger could be amplified. Through the use of legal precedent, a successful case could change the legal norm throughout a jurisdiction or, as is for example the case in the Commonwealth, for multiple jurisdictions that are formally bound by (or, less directly, that informally take guidance from) each other’s precedents.

But outside the legal system, the practice could spread too. For example, if a major jurisdiction makes the legal rules or norms around climate risk disclosure stricter, this may be reflected in the corporate governance standards that are part of the listing rules of that jurisdiction’s stock exchange(s). If foreign companies are listed on that stock exchange, they would be subject to these rules as well. Given that they are subject to these rules anyway, they may lobby for the adoption of such rules in their home country. Moreover, other stock exchanges might respond to the new rules by also adopting stricter climate risk standards (the opposite is also possible, albeit less plausible).

Finally, beyond institutionalised dynamics, it may be that a change to investor preferences/sensitivity to climate risks spreads around the world. This can be because the affected investor operates internationally (for large, internationally operating investors like Fidelity or BlackRock, a change in investment principles can have far-reaching implications), or because it prompts a change in the attitudes subscribed to by the asset management industry around the world (e.g. because asset managers meet, host conferences, create ‘PCT coalitions’, &c). Alternatively, once companies start to gain a competitive advantage in their funding because they deal well with climate risk, other companies might follow their lead.

 

Resistance

The salience of climate risk depends in part on the commitment of governments to the PCT; a weak commitment will lower transition and liability risks, which are amongst the more predictable climate risks (and may materialise sooner than physical risk).

Moreover, litigation and liability may not be a credible threat everywhere. First of all, for this mechanism to work there must be an effective legal regime in place. Second, some otherwise effective legal systems have weak incentives for the enforcement of subsets of liability rules. In the UK, for example, enforcement of regular corporate law directors’ duties through derivative actions presents formidable procedural hurdles and is not financially attractive. For countries where similar enforcement challenges exist, an introduction of alternative liability rules by the government (which are also enforceable, and in fact enforced, by the government) would help. After all, when liability does not pose a credible threat the tragedy of the horizon might return, because the financial system and the law no longer pull the long-term climate risks forward in time.

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License