From Green to Gold: Five Ways CFOs Can Benefit from Climate Risk Disclosure

Chief Financial Officers (CFOs) are facing mounting pressure from various stakeholders to address climate change. Activists demand that companies commit to shrinking their carbon footprints, investors expect companies to both operate sustainably and maintain strong profitability, and regulators, including the U.S. Securities and Exchange Commission (SEC), are preparing to require companies to make detailed disclosures about climate risks.

Faced with these pressures, finance executives often lack the tools they need. Currently, there is no globally recognized, detailed framework for measuring climate risk that spans industries, markets, and jurisdictions. Instead, CFOs must choose among multiple systems that use different calculation methods and data definitions. According to accountants and sustainability measurement experts, the result is that they often only gain a rough understanding of climate risk.

A panel of the U.S. Commodity Futures Trading Commission (CFTC) noted: "The absence of standards and the differences between standards may create obstacles for climate risk management. It is extremely difficult for a single institution to obtain all the data needed to build a detailed dataset."

Nevertheless, CFOs can still gain useful insights into the impacts of climate change through a range of strategies, from scenario planning and identifying the company's most severe vulnerabilities, to relying on high-integrity data and separating estimates from facts. Accountants and sustainability measurement experts say these insights can reveal ways for CFOs to reduce risk, eliminate waste, and lower capital costs through "green financing." With a clearer understanding of a company's environmental, social, and governance (ESG) performance, CFOs can also improve capital allocation by identifying merger and acquisition opportunities or business lines that may struggle to transition to low-carbon operations and are suitable for divestiture.

Robert Hirth, co-vice chairman of the Sustainability Accounting Standards Board (SASB), said: "More and more people are seeing opportunities on the ESG side—creating new products, developing new materials, finding new ways to bring products to market." He added: "Demand for this kind of reporting is definitely growing." Hirth predicts that lenders and insurers will eventually routinely request ESG performance data from finance executives.

Accountants and sustainability measurement experts point out that CFOs may discover significant vulnerabilities when assessing the impacts of climate change. For example, Fannie Mae and Freddie Mac, two government-sponsored enterprises, guaranteed $6.88 trillion in mortgage debt in 2019 without incorporating flood risk into their guarantee fees. Additionally, the CFTC's Subcommittee on Climate-Related Market Risk stated in a September report that the asset value of global fossil fuel companies could decline by $250 billion to $1.2 trillion during the transition to alternative energy.

Meanwhile, CFOs who identify and mitigate climate risks, or help drive the clean energy transition, can lower their company's cost of capital. A striking example is Tesla, whose stock price has risen more than sevenfold since the beginning of 2020. Smaller companies focused on battery technology, solar, or wind power have also seen remarkable gains. In the less prominent municipal bond market, most counties pay lower underwriting fees and bond yields than those more vulnerable to climate change.

At the same time, sustainable business lending is growing. JPMorgan Chase and Bank of America recently committed $2.5 trillion and $1.5 trillion, respectively, to low-carbon business and sustainability over the next decade.

CFOs who delay "going green" may soon receive a push from U.S. regulators. SEC Chairman Gary Gensler aims to require companies to disclose their responses to climate change risks, including details of metrics such as greenhouse gas emissions. Treasury Secretary Janet Yellen supported the SEC's disclosure push in April and said the Treasury would consider promoting the Biden administration's greenhouse gas reduction goals through taxation, international cooperation, and economic policy. Additionally, the Federal Reserve announced in January the creation of a supervisory climate committee to "develop appropriate plans to ensure that supervised institutions are resilient to climate-related financial risks."

High hurdles

CFOs face several challenges when responding to regulatory pressure and attempting to translate climate change data into actionable metrics for strategic planning such as capital allocation and risk management. According to Rebecca Self, Sustainable Finance Director at carbon finance consultancy South Pole, finance executives need to shift to longer time horizons when considering climate change impacts, thinking in terms of the next decade or decades rather than focusing on quarterly or year-end reports. Self, an accountant who previously served as CFO of HSBC Holdings' sustainable finance unit, said CFOs also need to remember that when extending forecast periods, they must accommodate greater imprecision and uncertainty. She said: "Accountants are used to dealing with very strict audit requirements, compliance requirements—very precise reporting. Turning that toward climate change and long-term scenarios like the Paris Agreement is really challenging."

Furthermore, finance executives should recognize that vulnerabilities arising from climate change often vary much more within a company than risks such as credit, interest rate, or exchange rate risks. For example, a petrochemical plant near the Louisiana coast faces greater risk than a corporate headquarters located on higher ground. Self said in an interview: "Physical climate risk can be very granular, down to the building type and building structure." CFOs need to delve into "very detailed things," including whether a building has ground-level steps.

Measuring climate risk also requires considering complex indirect costs imposed on stakeholders such as suppliers, employees, and neighboring communities. Hirth said during a webinar hosted last month by the American Institute of CPAs (AICPA): "As public companies begin reporting on ESG, they also face more pressure to report on their supply chains." Investors and customers will ask CFOs "how their supply chains help them achieve their net-zero goals."

When choosing methods to measure a company's climate impact, finance executives must select from a jumble of inconsistent frameworks that vary in scope and depth of detail. Hirth referred to the multitude of systems as the "alphabet soup of ESG reporting." Some companies use up to four different frameworks simultaneously. A recent study by the International Federation of Accountants (IFAC) showed that companies in the U.S. and Germany most often follow the system created by the Global Reporting Initiative (GRI), while their counterparts in the UK and France tend to favor the UN Sustainable Development Goals.

The CFTC subcommittee noted that because so many systems are used, climate data, measurement techniques, and risk analysis methods vary widely. The subcommittee said: "Significant gaps across sectors and asset classes hinder not only climate risk management but also operational and investment analysis that relies on data-driven processes. Information is not comparable, leading to measurement discrepancies." The Bank for International Settlements (BIS) believes existing measurement systems are particularly unsuitable for banks. BIS said in recent research: "Existing analyses typically do not translate changes in climate-related variables into changes in banks' credit, market, liquidity, or operational risk exposures or losses on bank balance sheets." Arnaud Picut, head of global risk practice at financial software provider Finastra, said the accounting profession has not yet translated climate change data into numbers that accurately measure all financial risks, "and the broader potential financial risks have been treated only marginally—or not at all."

Building consensus

Hirth said industry and government standard-setters aim to establish a unified ESG disclosure system, but reaching consensus may take time. "The next few years could be somewhat difficult because we're trying to move from all these different frameworks to agreement." IFAC, while pointing out inconsistencies in reporting methods, said most companies fail to obtain high-quality independent assurance on their sustainability reports, threatening market stability. IFAC stated: "Low-quality assurance is becoming an emerging investor protection and financial stability risk," adding that only 51% of 1,400 global companies provided assurance on their ESG reports, many relying on consultants rather than professional accountants.

When assessing climate change risks, CFOs need to capture several types of data beyond their enterprise resource planning systems. Finance executives need to determine what data to capture and how to define it. Even for greenhouse gas emissions, organizations follow different definitions. Wes Bricker, vice chair and assurance leader at PwC, said in an interview: "Some companies have entered into supply agreements with contractual commitments to report greenhouse gas emissions." Bricker, who served as SEC chief accountant from 2015 to 2019, asked: "What if I have multiple clients using different definitions?"

Accountants and sustainability measurement experts say that by overcoming these challenges, CFOs can make progress toward reliably translating climate change data into treatments for goodwill, intangible assets, inventory valuations, and other topics under GAAP and IFRS. Kelly Hereid, director of catastrophe research and development at Liberty Mutual, said: "At the end of the day, these are the metrics that drive capital management and profitability. If you can understand the extent to which climate change will alter your risk appetite, then you can really start making decisions accordingly."

Accountants and sustainability measurement experts say CFOs can take several steps to turn the obligation to report climate change risks into an opportunity to gain insights that improve the business.

1. Prioritize credible, accessible data

Bricker said finance executives should first focus on data that can be captured and confirmed as credible. For example, CFOs can determine their company's greenhouse gas emissions through a combination of verifiable data and estimates, clearly distinguishing between the two as with any financial reporting. Bricker said: "Start with what is known, identify the unknowns, and create estimates that clearly label what is known and what is estimated." Finance executives should also clearly define the several types of data used to assess climate risk and ensure definitions are used consistently both inside and outside the company. Bricker said: "CFOs can have a truly positive impact on curbing climate change costs by helping internal users and external stakeholders focus on what matters." They are "increasingly communicating with external stakeholders so they understand the business report, what it conveys, and where disclosures are located."

2. Set short-term milestones while pursuing long-term goals

Accountants and sustainability measurement experts say CFOs can ensure measurable progress in reducing their company's carbon footprint by defining multiple near-term milestones within a long-term planning horizon. A series of short-term goals can reassure employees, investors, and other stakeholders that the company is on track, or help them decide when to adjust to meet targets. Bricker said: "I see CFOs focusing on long-term planning horizons and setting near-term milestones—additional measurement and accountability—to understand whether they are on track."

3. Use scenario planning to frame long-term uncertainty

Through scenario planning, finance executives can pursue their carbon emission goals within a range of high and low potential costs and opportunities over the coming decades. Self said this analysis "does not pretend to be a perfect vision or forecast of the future. It's about running different scenarios, asking 'what if' questions of a long-term nature, thereby helping to inform today's decisions."

4. Prioritize vulnerabilities and focus on the biggest risks

Accountants and sustainability measurement experts say CFOs can limit the cost and time of analysis by focusing on identifying the company's largest physical climate risks—whether drought, flood, heat, or storms—and prioritizing across locations and business lines. Self said such analysis, using geospatial and other data, may reveal that a few locations carry higher risk, consistent with the Pareto principle, where the majority of risk is concentrated in about 20% of the portfolio. Hereid said during a Liberty Mutual panel discussion this month that companies "should focus on where losses actually occur" and "where we have the highest scientific certainty." For example, estimates of storm surge flood risk are relatively reliable through 2030 and may justify relocating warehousing or other operations to higher ground. Self said by identifying the biggest risks early, CFOs can avoid unnecessary research and confidently say "'I need to do a deeper investigation at this particular location.'" Without prioritization, "you could go on almost forever, getting into very fine detail."

5. Focus on specific metrics

Among U.S. companies publishing ESG disclosures studied by IFAC, 31% report based on the framework recommended by the Task Force on Climate-related Financial Disclosures (TCFD). The TCFD, created by the Financial Stability Board at the request of the G20, describes 11 categories of disclosure across four areas: governance, strategy, risk management, and metrics and targets. The TCFD provides only a framework, not in-depth details on how to measure climate risk. Bricker recommends CFOs follow the SASB standards, which describe sustainability disclosures for 77 industries across 11 sectors. According to IFAC, 48% of U.S. companies use SASB. Hirth said CFOs should embrace rather than resist the rising trend of ESG disclosure. "At the end of the day, you have to tell your story to attract investors and satisfy your individual stakeholders," he said. Finance executives should view sustainability disclosure "as a way, not a cost, to focus on the things that make you a better company—reducing risk, making you more attractive to customers, more attractive to employees, and giving you a better supply chain."