TCFD and climate risk for leaders – an illustration of early engagement and impact

The UK Government is planning to set in law the world’s most ambitious climate change target, cutting emissions by 78% by 2035 compared to 1990 levels¹. Most sectors will likely be affected by the Government’s ambition to transition into a net-zero or below economy in the next 15 years. We explore what companies are doing now to respond and what risk managers can do to strengthen their position including proactivity around the Taskforce for TCFD reporting.’ With ‘strengthen their position including proactivity around Task Force on Climate-related Financial Disclosures (TCFD) reporting.

From April 2022, more than 1,300 of the largest UK-registered companies and financial institutions will be legally required to disclose climate-related financial information in line with recommendations from the Task Force on Climate-Related Financial Disclosures. This will include many of the UK's biggest traded companies, banks and insurers, as well as private companies with more than 500 employees and £500 million in turnover.

• What is TCFD?
• The value of analytics – an illustration
• Key benefits for the risk manager
• Your next steps

What is TCFD reporting?

Many UK companies have been producing corporate social responsibility or specific sustainability reports for many years. But TCFD goes way beyond this sort of reporting and makes climate risks and resilience integral to financial reporting and projections. In short, it recognises climate as a financial risk that should be assessed, quantified and managed.

All of the above means that risk managers, empowered by analytics, have an opportunity to play a central role in the strategic planning of their organisation’s plans to address climate change.

TCFD and analytics: An opportunity for risk managers

Risk managers can take advantage of state-of-the-art analytics and engineering to place their respective organisations in a position of strength in discussions with insurance markets, creating resilience in the context of risk financing against catastrophe risks.

TCFD requires organisations to have a view on the physical impact of climate change as well as the risks and opportunities associated with transitioning into a net-zero or below net-zero economy. With TCFD approaching, a proactive risk manager would be very well-positioned to demonstrate their achievements to financial investors in building longer-term physical climate change resilience, and their capabilities in testing future risk profiles of the organisation.

Figure 1 below illustrates how risk managers are already proactively using analytics in their day-to-day risk management to evaluate the financial costs of their climate change impact. The key difference with TCFD reporting is that for its climate change impact assessment, a more forward-looking perspective of the organisation’s strategy and associated financial risks and opportunities is required. This means that choosing strategically relevant time horizons and climate change scenarios to measure the impact associated with the transition into a net-zero world, and possible ‘fall-out’ of the resulting physical risks, is essential.

TCFD is here to stay. The UK Government has set out the expectation that all listed companies and large asset owners need to disclose their financial risks owing to climate change in line with the TCFD recommendations by 2022². The Financial Conduct Authority (FCA) has introduced a new listing rule which requires commercial companies with a UK premium listing to include a ‘comply or explain’ statement. This rule applies for accounting periods beginning on or after 1 January 2021³. Mandatory TCFD-aligned disclosures across major segments of the UK economy need to be completed by 2025, with a significant portion of requirements to be introduced by 2023.

Catastrophe and climate risk models already widely used in the risk management domain can be utilised to form a view on how to most efficiently finance the changing physical risk profile of an organisation. These can also be used for future planning by calibrating these ‘current climate’ baseline catastrophe risk models to the expected impact of climate change for given scenarios and time horizons.

The value of analytics - an illustration

By drawing from experiences and key lessons learnt in working closely with corporate risk managers, below is an illustration of a physical climate change impact assessment journey.

• A global energy company is planning to diversify its business model by investing and operating new renewal energy business units, which are focusing on solar and wind power.
• Given the global nature of this physical asset portfolio which now is being changed to transition into a net-zero world, the portfolio would be exposed to a range of physical climate hazards such as acute weather risks (flood, wind and wildfire) and also chronic hazards (such as drought/heat-stress and sea level rise).
• In the wake of the global COVID-19 crisis, all budgets including risk financing, are now being closely reviewed and heavily scrutinised by the CFO.
• In parallel the board is tasking the sustainability director of this energy company to assess the financial impact of climate as part of their TCFD-driven disclosure and to satisfy financial investor pressure to have ‘a view’ on climate.

The risk manager of the energy company has always proactively used climate and catastrophe risk analytics to quantify and manage the impact of risk on their existing assets and consequent interruption of the organisation’s business and value chain. This has resulted in:

• A solid understanding of the company’s current risk profile as well as the exposed assets that are driving the key risk within the portfolio’s assets
• Valuable contribution to the climate change strategy recently announced by the CEO of this energy company.

The risk manager connects with the sustainability director who is responsible for its TCFD-driven disclosure. They then engage with risk advisory consultants and brokers, learning that the analytics already utilised for the risk financing natural catastrophe risks could be further built out for a physical climate change study.

• Based on this climate change impact assessment, a pro-active climate transition strategy can be devised which could include the measurement of financial impact on the company’s balance sheet based on physical and the transition related risks and opportunities.

• By measuring the changing risk profile associated with transition and resulting physical climate risk impact, an organisation could increase risk retention levels significantly before KPIs on the balance sheet would be affected in a material way.
• This process highlights that retention vehicles, such as captives, could be more of a feasible option to better manage the retained portion of the risk in the longer term, also in a more volatile insurance market environment in the wake of climate change.
• Observing the illustration of analysis in figure 2, some of the freed-up capital resulting from a change in risk management strategy could be utilised in the investment of targeted physical risk mitigation measures of exposed assets, which would reduce the portfolio cost of risk remaining on the balance sheet. This would therefore increase climate change resiliency.
• The risk manager, with the help of the broker’s analytical team, would then be in a position to engage with the CFO of the organisation and demonstrate together with the sustainability function, the risks and opportunities from transitioning into the new diversified business model.
• Using a similar figure to the one outlined in Figure 2 above, the risk manager then submits a business case to the CFO. This would show the potential cost savings that could be made over the coming years by retaining more risk as well as investment into targeted risk mitigation measures to build into the physical asset portfolio climate change resiliency.

If the go-ahead is given by the CFO, the risk manager can then engage with the markets in changing the current risk management and financing strategy for the new asset portfolio.

Any freed-up capital from the higher retention levels could be used to retrofit the design of key exposed assets against flood and earthquake risks, thereby also demonstrating proactive risk control to both the CFO and the insurance markets.

In turn the sustainability team, in close collaboration with the risk manager, could demonstrate as part of their TCFD-based disclosure to their financial investors, that the risks and opportunities associated with their transition strategy and associated physical risks into renewable assets are measured, and where possible mitigated, to build in resiliency in the wake of climate change.

Key benefits for the risk manager of utilising analytics in the context of climate

What are the key benefits of using analytics from a risk management perspective?

1. Obtain an in-depth analytically-underpinned understanding and quantification of the organisation’s climate risk profile.
2. Enables risk managers to play a strategic role in addressing climate change and its associated risks. It sits strategically alongside their respective sustainability functions that are often tasked by the board.
3. Provides a template for proactive climate risk management and can be closely aligned to TCFD requirements, risk managing and finance planning.
4. It can include new asset portfolios acquired during the time companies transition to a net-zero or below net-zero world.
5. Using the company’s overall risk tolerance as a tailored benchmark, it optimises risk financing by comparing the risk mitigation options of retaining or transferring your risk.
6. Creates an analytically empowered baseline for long term climate change resiliency, that can be used to satisfy financial investor requirements.

This illustration demonstrates that proactive risk management utilising analytics, can offer an organisation a position of strength when addressing climate change. It provides the opportunity for risk managers to play a key strategic role.

The climate risk strategy of the organisation can be underpinned and justified by analytics to internal senior stakeholders which can ultimately result in more proactive risk financing and climate change resiliency.

Your next steps

• Review your organisation's climate change strategy and engage with the sustainability functions, if you have not done so already.
• Engage with your risk consultants and/or brokers to analyse your organisation’s climate change risk profile to arrive at an analytically-underpinned climate change strategy.