Episode 23: The four pillars of the TCFD - risk management

The third in our series discussing the guidance produced by the Taskforce on Climate-related Financial Disclosures, we examine the pillar of risk management and the issues we see for businesses working to understand, manage and disclose their climate risks. The size and scale of the challenge can be daunting but, as raised and discussed, “Organisations can’t stand still while the world changes around them. Leaders need to understand that you can take decisions today that will help steer you on a pathway and enable short-term risks to be managed.”

If you have time please follow the link to John Evans 'Climate Risk Barriers' survey. It should take no longer than 5 minutes to complete.

Featuring: Sally Cook, Head of Strategy, Energetics and John Evans, director of JE Advisory and former Head of Enterprise Risk Advisory, Commonwealth Bank Australia

Our host: Joel Hextall, Regional Manager – Western Australia, Energetics

Note: The information and commentary in this podcast is of a general nature only and does not take into account the objectives, financial situation or needs of any particular individual or business. Listeners should not rely upon the content in this podcast without first seeking advice from a professional.

Transcript

Speaker 1: 0:04

Welcome to the energetics exchange podcast conversations with energy and climate experts. Please note that the information and commentary in this podcast is of a general nature only, and does not take into account the objectives, financial situation, or needs of any particular individual or business business should not rely on the content in this podcast without first seeking advice from a professional

Speaker 2: 0:30

Welcome listeners to the next installment of the podcast series prepared by energetics today's topic is on the task force on climate related financial disclosure, the risk management pillar. My name is Joel Hextall I'm Western and regional manager. And before I introduce my guests, I'd just like to provide an acknowledgement of country today. We're recording this podcast across three locations in the spirit of reconciliation. Energetics acknowledges the traditional custodians of country throughout Australia and their connections to land sea and community. We pay our respect to their elders past and present and extend that respect to all Aboriginal and Torres Strait Islander peoples as mentioned in the introduction today's podcast is on the risk management pillar of the task force on climate related financial disclosure, some brief history and facts from the March, 2021 overview report provided by the TCFD climate change is a financial risk due to the rise in natural catastrophes and chronic environmental shifts and the transition to a low carbon economy. It consists of four key pillars. They are governance strategy, risk management and metrics and targets of these four pillars. There are 11 recommended disclosures that provide investors and stakeholders with climate related decision, useful information. In previous podcasts, we have covered governance and strategy in the future. We'll have a podcast specific to metrics and targets for today. We draw our attention to the risk management pillar. The objective of the risk management pillar is to disclose how the organization identifies assesses and manages climate related risks. The three key points to be addressed to fulfill the objective are describe the organizational process for identifying and assessing climate related risks. Describe the organizational process for managing climate risks. And importantly, describe how the above are integrated into the overall risk management of the organization. Unlike the strategy and metrics and targets pillars, materiality should not be a consideration for risk management as disclosure should be made, regardless of the materiality. Joining me today is John Evans formerly the head of enterprise risk advisory at the Commonwealth bank of Australia and now director of J E advisory. John is an expert in risk management for the financial sector specializing in climate risk and a regular contributor to the climate risk projects that energetics deliver. We are also joined by energetics his very own head of strategy. Sally cook, Sally, may I start with yourself? What is risk? And most specifically, what is climate related risk?

Speaker 3: 3:02

Um, in its simplest form risk is an uncertain future events. So in general, climate related risks are commonly grouped in three areas. The first are physical risks, which occur due to the change in the earth system and include things like increasing in temperature, extreme rainfall events, second transition risks. So things like policy and market changes, which occur during the transition to a low carbon economy or reputational risks, which you could see for example, through the stakeholder investor or customer pressure and the liability risks, which arise from the stakeholder litigation and regulatory enforcement, but even despite all of those risks, there are many climate related opportunities which needs to be considered as well. Um, like your ability to differentiate your product or service in the market, potentially move into new markets, build reputational capital and enhance business value in a low carbon economy.

Speaker 2: 3:55

Practical point of view, how I risked traditionally identified, assessed and managed.

Speaker 3: 3:59

It's fair to say that risk management processes are fairly well embedded in most large companies. Um, a lot of companies adopt the three lines of defense model. So they look at risk from an operational level of the business, a responsibility for the oversight level of the business. So for example, the executives and CEO, and then the board and independent audit function, which is independent reporting to the board and its committees under that operating framework, risks are rated for their potential impact, according to their consequence and likelihood. Um, and they can be assessed as inherent, which is without considering controls, which are things that the company might do to reduce the consequence or the likelihood of the risk, uh, or they could be rated as a residual risk, which is after controls organizations might also identify treatment actions for controls, where they don't exist, or where they're ineffective, those risks, their ratings controls and treatments will commonly be documented in a risk register, which is used as the basis for internal and external reporting,

Speaker 2: 4:54

Climate risks, new and unique risks, or do they potentially exacerbate known risks and require additional control measures when reviewed from a climate change perspective?

Speaker 3: 5:04

That's a really good question. They can be both some examples of new risks that organizations might not have considered, uh, uh, emerging markets changes in technology disruption to their existing markets, or they can be, um, risks where, uh, the existing risk they've identified as changed or, um, exacerbated. So for example, um, potentially an increase in health and safety risks associated with increasing heat days. Um, but it's also interesting to think about climate related risks as being quite dynamic. So if you look at the historical observation on the last 10 years of, uh, Australian climate policy, in particular, you can reflect on how dynamic it's been, uh, and think about how dynamic it will be in the future for us to get to net zero. So these risks are ongoing, um, and we also need to consider them a current problem, not necessarily just a future problem, uh, particularly for physical risks. We're finding more and more now that some of those risks that are starting to impact in the shorter term. And they're not just a, long-term considered

Speaker 2: 6:05

A question for yourself, John, during your career in the finance sector, I can imagine the term risk has been used a lot, do climate related risks affect financial institutions. And if so, how?

Speaker 4: 6:15

Yeah, thanks Charlie. Various forms of climate related risks that science already mentioned, the physical and transitional risks they'll impact on every organization across the economy. In some way, financial institutions provide services to large sections of the economy and the population. So they have therefore subjected to aggregate impacts of climate risk on all of those counter parties. So for example, banks lend to a broad range of businesses and industries that will be impacted by climate related to risk of different ways. Similarly, insurers provide insurance coverage to a range of businesses and individuals. So the transition to a low carbon economy and the physical risks to the assets that are either insured or financed will have a material impact on the future financial results of financial institutions. But there's another aspect that's perhaps well, less appreciated by those outside the finance sector. And that is that these institutions need to borrow money or raise capital to continue to operate and grow their businesses. Their response to their climate related risks will be a key factor in the providers of these funds, deciding whether they're willing to fund them in the future. If they decide that they'd rather invest elsewhere while the costs of these funds will increase reducing the banks or the insurers profitability, or even challenging their viability going forward. So this is pretty serious stuff and a major strategic risks for financial institutions. And remember, of course neither financial or non-financial companies are able to control the changes in the physical climate and the structural changes to the global economy as it transitions to low carbon, what they can do or what they need to do is to structure their businesses. So as to make it more resilient to these changes, therefore limiting the likelihood and size of any damage to them and maximizing the opportunities as these changes occur.

Speaker 2: 7:59

So you mentioned a few of the challenges and barriers that financial institutions face there, but what would you suggest are the key challenges that organizations face in identifying, assessing and managing climate related risks?

Speaker 4: 8:13

Yeah, as you say, Childers, there's a lot. Um, but I think I'd highlight three key challenges. I think the first one is just an appreciation of the breadth of the potential climate related impacts is it's quite immature. Um, and it's meaning that identification is not with not always comprehensive. So for many organizations that I guess I'm thinking of banks in particular where my experience lies, most parts of the balance sheet are going to be impacted by climate risk in one way or another. I think the second challenge is that climate risk is a major strategic risk. It it's something that that could cause the strategy to fail, to deliver its intended outcomes by some significant margin. Strategic risk itself is actually a relatively new category in many risk frameworks and strategic risk primarily comes from external sources that we're not able to control. So for example, regulatory change technology advancement, competitive landscape, or what our customers or society expects on wants from us. So strategic risk is in some cases, not that well understood. And in many cases as immature in the way it's being implemented and embedded into business processes. So climate risk is being built on a less than robust foundation. In the worst cases. This could lead to boards signing up on strategies that have no clearly articulated approach to some major challenges to the success of the strategy, particularly those less familiar challenges such as the impact of climate change. And I think the third major challenges that climate risk has impacts across most or all of the risk classes. It's not sort of mutually exclusive, but it's actually rarely, uh, explicitly and comprehensively included in the frameworks for those other risk classes. So for example, credit decisioning and portfolio management tools probably have insufficient explicit consideration of climate risk and wider ESG risks in them at the current time. Although I think that is getting significantly better now. And this is partly due to the fact that climate risk is just different in nature to the risks that most risk frameworks are used to considering. And I guess the key things there are the long-term nature of it. You know, these are longer timeframes than traditional business and strategic planning horizons would use. There's also the fact that climate change is, is a certain risk is it's going to happen. It is happening and it's certainly not irreversible. So it's not cyclical like lots of other risks that people are used to considering. There's also the aspect that, you know, the climate risk is dependent on specific characteristics of an exposure such as geography, location, topography, or, or build quality. And these are things that probably haven't previously been necessary to bring in to some of those other decision-making processes. And of course we face the large uncertainty in terms of both impact and timing of these risks, which is, uh, difficult to deal with and last, but by no means least there's no relevant history here. So making traditional risk modeling methods largely redundant. So in many cases, climate risk factors, aren't fully included in risk measurement models yet. And all climate risk relevant data are not yet being collected. So

Speaker 2: 11:14

Sure sounds challenging. If you could summarize, what are the most important actions for organizations when it comes to managing climate related risks?

Speaker 4: 11:23

Yeah. Fundamentally organizations need to embed the consideration of climate related risks into all of their business decisions. Now that kind of sounds easy, but it won't happen automatically. And it won't happen by osmosis will. Why is that? And I think it's because people don't really know how to take account of climate related factors, as we've already mentioned, appreciation understanding of the breadth of potential climate related impacts is immature. And the nature of the risk is very different, uh, with little or no experience to draw on. I think also corporate memory's a little bit short, um, often businesses forgotten or are unaware of the assumptions that underpin current methodologies. So they don't always recognize that those assumptions may be compromised by climate related factors. And so, you know, example, there might be assuming that the behaviors of the past will continue into the future. And on top of all of that uncertainty and complexity of climate related impacts can be let's face it a little bit overwhelming. So in order to help decision-makers the risk management frameworks need to provide the structure and tools for comprehensive consideration of all relevant climate related factors as it's designed to do for all other risk types currently, however, even for these existing risk types, the full integration of risk consideration into business decisions is quite immature. And I think, you know, that was evidenced in the finance industry, by the findings of the Royal commission. For example, I think two particular high priority actions for financial financial institutions really need to be number one, portfolio management decisions need to reflect the future climate related risks and opportunities, meaning taking less exposure to some traditional industries and sectors and more exposed to those sectors aligns the transition to a low carbon economy. And I think the other thing is around product pricing. And we hear a lot about the climate risk isn't being priced in by markets, product pricing needs to reflect the climate related risks over the terms of the products or loans that we're offering. So banks need to move away from lending and pricing on the basis of the risk that existed historically and take a much more forward-looking view to the risks that will be relevant to future potential losses. And they may also need to contemplate more risk-based pricing where they actually charge customers with high climate risk, more than they do for loans, which have low climate related risks.

Speaker 2: 13:42

Thank you, John, we'll come back to you shortly for some of your recommendations. However, Sally, as head of strategy at energetics, I can imagine our clients come to you for advice regarding how to manage climate related risks a lot. So how are climate risks affecting our clients strategy to not only mitigate risk, but potentially grow from the transition to a lower carbon economy

Speaker 3: 14:06

Trusting Joel? Well, when I'm salvation, there's a lot of the clients that we're working with go through the risk assessment and the, and the remaining elements of the TCFD and find that an it, Sarah economy is very beneficial to them in so many ways. Um, that could be from the more obvious things around new business opportunities. And some of the things that John mentioned in terms of being able to capture some of that green capital, that's starting to flow into the market from the banks, but also from less obvious things around being able to attract and retain talented staff within their businesses. And we also find that there's opportunity that exists both in an existing core business practice, but also in the decisions around growth and mergers and acquisitions that companies are making. And where we see essentially a new frontier here is how do we embed a better understanding of climate related risk and opportunity into those decisions and doing appropriate due diligence on those as well. That's picking up on a lot of good comments that John made as well, not just on the cost of capital and the, and the flip side of that, the availability of capital, but also, um, understanding your in PLISSIT assumptions and bringing in a greater consideration of climate related risks in areas where you might not have previous

Speaker 2: 15:18

It's comforting to know that it's not all doom and gloom that, um, where there are risks, there are also opportunities. Thank you for highlighting that. So back to your John, what are the biggest barriers to progress on managing climate related risks and the opportunities that may be presented?

Speaker 4: 15:33

I think that one is a very, very interesting question. And one by consultancy business ran a recent survey on to try and tease out the key drivers. The survey suggested 14 barriers to meaningful progress ranging from non-belief in global warming, technical issues, such as lack of relevant data and three to a lack of awareness and understanding of climate drivers. The results showed two factors coming out on top. So the first one was misalignment of long-term climate impacts and short-term management, tenure and incentives. The second one was skepticism over the usability of climate scenario analysis results for decision-making. I'd actually love to get some further input on this. So anyone who'd like to participate in the survey is the loop. And I think we've put the details of that in the podcast description. So please feel free to go there and give me your thoughts. I think the misalignment point highlights the fundamental issue of timeframes. So climate related risks extend longer than traditional business planning and risk assessment. Horizons, skepticism point really connects into the general issue of uncertainty. And now this is what I believe is perhaps the major issue for many organizations when it comes to acting on climate change. And this is because uncertainty is something that people aren't used to, you can't measure it. Um, you can really only investigate it via scenario analysis. And as we know, scenarios are full of assumptions that will need to change over time with circumstances. And they can also, uh, there's assumptions can very easily be challenged and, and no holes poked in them. We also see a really wide breadth of potential impacts when we look at these different scenarios, um, which will depend on the scenarios that are examined. And of course, that sort of broad set of bookends makes decision-making harder because we really don't know where in that spectrum you're going to land. So I think building confidence to act on the basis of uncertain outcomes and something that will need to rapidly improve if organizations aren't going to stand still, while the world changes around them, to help them do this. I think help. We need to help leaders understand that you can make decisions today that are going to help steer you on a assumed pathway and manage short-term risks. But you need to know when a further decision is going to be required. So at what point are those assumptions that you were working on beginning to become invalid or less likely to play out in the way that you previously thought? I think we also need to recognize that decisions we make today do impact future outcomes, especially if we're entering to long-term contracts. Um, and an example I'd like to give there is around home loan lending, where, you know, historically banks have made home loans for 30 years, um, on the assumption that behaviourally people will refinance those every four or five years. Well, that might not be the case. If there is no market for that refinance. And if we don't recognize this, then we're going to get severely burned when those loans are still on our books in 20 years, time and suffering physical risks from climate change. And lastly, I think we need to take appropriate and measured actions when new information on climate related risk exposures are assessed. So although lots of scenarios may have been explored so far action in response has been relatively slow. And I think that's primarily due to concerns around a number of, of aspects. Currently profitable business may have to be foregone and associated and associated relationships with customers might become damaged. You know, we've got an impact on staff and the conversations that are going to need to be able to have with customers. And also we don't know what the final state will look like. So, you know, people are reluctant clearly to make act, take action today that may turn out to be suboptimal in the longterm and maybe unnecessary in retrospect,

Speaker 2: 19:12

Thank you, John. Now you have been a wealth of knowledge experience and recommendations to summarize or highlight the three main points or recommendations that our listeners may consider when dealing with the risk management pillar of the TCFD, what would you say?

Speaker 4: 19:30

Yeah, I think fundamentally it's all about understanding the risks and factoring these into your decision-making to ensure the longterm sustainable future for your organization. And I think the three things that I would do first of all, was first of all, I would make climate risk of material risk type in its own rights in the risk management framework. I think this will help ensure transparency, governance, focus, and resourcing needed to develop and then bed climate related risk tools into all relevant elements of the business and its processes. And yeah, this may feel a little bit counter-intuitive when we're thinking about integrating climate risk into the existing risk management framework, which is what the TCFD actually asks us to do, but like many issues that need integrating, but also needed a strategic focus. This separation is probably needed at least in the short term to direct drive and oversee the integration, the embedding of climate risk into those wider frameworks. And I think we've seen this as an example of this in recent years has been financial crime, which is a, you know, an example of a compliance risk, but has been elevated to a risk type in its own. Right? I think the second thing is actually find out what the biggest barriers to progress are for your organization and focus on addressing these as a priority. I think that might mean developing education and training programs for employees to expand, um, understanding awareness and capability in the climate risk space. And I think the third thing is it's really important that we start taking incremental action steps. We can't afford any analysis paralysis here. Um, it's easy to be overwhelmed, but I think inaction is the worst thing you can do. So start collecting that missing data that allows improved understanding of the climate related risk exposures really focused on the risks to the organization from climate change rather than the risks to the climate from the organization, which I think is where a lot of disclosures have been focused so far. It's these risks to the organization, its business model are going to damage you. And then as I've mentioned before, I think pricing for the increased climate related risks and incentivizing customers to take climate risk mitigation actions that are going to protect both us and them.

Speaker 2: 21:31

Thank you, John, like John Sally youth, bring providing some excellent examples and insightful commentary today. What are your three recommendations for our listeners to consider?

Speaker 3: 21:40

We want them to three and I agree with Jones. I'm very good points. Um, building on the communication aspects that John highlighted, I think capacity building, following your risk assessment process. I think it's where these risks are often novel and often originate from an environment function and then need to be managed by a different function. There's a complexity in communicating and capacity building of people throughout the organization to understand how to interpret and manage climate related risks, which I think is not necessarily being widely addressed. I think considering your treatments carefully. So your new actions that you might take to address some of these risks, how do those policies processes need to change in practice? How does your existing practice need to change to take into account climate related risks and then consider in particular, I think again, drawing on some of the points that John made earlier around being open to other people's assessments. So you are exposed and vulnerable to the assessments that others will make on your business, which then feeds into the way that both of you, how you disclose to the market, but also in the way that you can frame your risks to get the most traction internally. So I think understanding your internal audience, what will drive them in the context of their stakeholder and external pressures will help you frame the risks and get more traction to address some of the barriers that John mentioned.

Speaker 2: 23:03

Thank you, Sally, that concludes the podcast. I hope our listeners have found it extremely insightful and informative my, I guess, key takeaways from this podcast and both from the research done prior the work we've done at energetics and from the responses from our guests, it highlights that although risks have always existed for organizations, investors, and stakeholders recognize the potential for climate-related risks, whether they be physical addition or liability risk, present new risks, or increase the severity or likelihood of existing risks over the coming decades. The task force on climate related financial disclosure, TCFD recommends disclosures in annual or sustainability reports that provide transparency to the magnitude that these risks have on the organization. I will leave you with a quote from John F. Kennedy, which I uncovered during my research for this podcast of which I feel is applicable to the need for organizations to start managing climate related risks. Today, there are risks and costs to action, but they are far less than the long range risks of comfortable inaction. That concludes our podcast on the risk management pillar of the TCFD. I'd like to thank John Evans, director of JE advisory and Sally cook energetics, head of strategy for an insightful exchange of their thoughts and experiences in this area. John mentioned a survey and his response earlier that's linked to that survey will be made available on the NZX website. Please do subscribe to the energetics podcast and keep an eye on an ear out for the next and final installment of our TCFD pillars, metrics and targets. Now for a quick overview of the task force on climate related financial disclosure in previous podcasts, we have covered governance and strategy in the future. We'll have a podcast specific to metrics and targets. However, for today we draw our attention to the risk management pillar in the March, 2021 overview report provided by the TCFD. There were a couple of highlights, essentially climate change is a financial risk due to the rise in natural catastrophes and chronic environmental shifts and the transition to a low carbon economy as mentioned before the four key pillars in the TCFD, a governance strategy, risk management and metrics and targets of these four pillars. There are 11 recommended disclosures that provide investors and stakeholders with climate related decision useful information. The objective of the risk management pillar is to disclose how the organization identifies assesses and manages climate related risks. Three key points to be addressed to fulfill that objective are describe the organizational process for identifying and assessing climate related risks. Describe the organizational process for managing climate related risks. And finally describe how the above, uh, integrated into the overall risk management structure of the organization.