Beyond greenwashing, towards global standards for business

Global warming is here and finance has to get up to speed. That's the central message of a new push to incorporate climate risk in disclosures, risk management and investment decisions across the financial industry. Technical challenges abound, but one of the biggest hurdles will be a shift in mindset: how to look forward and not at recent history.

"Past is not prologue for climate-related financial risk," said Mark Carney, former Bank of England governor, at an April event held by the London Business School's Wheeler Institute for Business and Development and the European Corporate Governance Institute. While many areas of climate disclosure are making speedy progress, the biggest gaps are in how to assess forward-looking guidance and strategic resilience. As United Nations Special Envoy for Climate Action and Finance, and the UK prime minister's COP26 finance advisor, Carney is leading a global push to design and put in place climate-related financial reporting standards for businesses, from the world's biggest banks to small and medium-sized enterprises.

Climate issues take place on a scale that does not show up in traditional risk reporting metrics, and historical data cannot account for the changes and transitions to come. Physical risk, political risk and the economic uncertainty related to the transition away from fossil fuels can no longer be viewed as external to the central task of assessing financial exposure. To manage appropriately, investors and regulators need new kinds of data that offer clear and comparable information about companies at all levels of the economy.

Ahead of November's United Nations Climate Change Conference (COP26), countries around the world are working to find common cause against carbon emissions, rising sea levels and increasing temperatures. The goal is to meet and potentially exceed the targets set in the 2015 Paris Agreement, when 196 parties pledged to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels.

Momentum stalled when the US in 2017 announced plans to withdraw from the accord and made good on that threat in 2020. President Joe Biden made rejoining the pact one of his top priorities, and hosted an April climate summit to jump start the initiative. Biden formally committed the US to cutting greenhouse gas emissions by 50% to 52%, relative to 2005 levels. His administration has called on the private sector to join the effort, saying governments cannot combat the climate crisis alone.

In finance, there is a growing consensus that climate factors need to be part of lending and investment decisions, but less agreement on how to put that into practice. Even proponents of green finance acknowledge that climate and sustainability factors have often been considered "nonfinancial", compared to more traditional, explicitly monetary metrics like interest rates and default risks. To bridge this gap, the Task Force on Climate Finance Disclosures (TCFD), an industry-led initiative backed by the Financial Stability Board, in 2017 released recommendations on climate-related disclosures and has since worked to encourage voluntary take-up of these standards.

Regulators also are addressing the issue. The European Union on April 21 proposed a new Corporate Sustainability Reporting Directive, to improve transparency and make it easier for investors to assess sustainability efforts at non-financial companies. This joins the EU's Sustainable Finance Disclosure Regulation for financial services companies and the bloc's new taxonomy for green investments. Similar efforts are underway in the UK, the US and around the world in a bid to make sure companies are providing enough usable information. There also are efforts underway to bring emerging markets into the discussion and make sure policies address their considerations appropriately.

The International Financial Reporting Standards Foundation is one of the non-governmental organizations tackling these issues from the industry side. In March, the group formed a working group to support the push for financial reporting that takes sustainable finance into account, and to promote convergence among the many proliferating standards of how to collect and report relevant information.

Lucrezia Reichlin, Professor of Economics at London Business School (LBS), ECGI chair, an IFRS Foundation trustee and steering committee chair for that group's sustainability reporting project, says the varied international efforts need to align enough to work together. If too many standards proliferate, they could undermine each other or create loopholes that allow companies to make their climate books look better than they really are.

"We need to have global, mandatory standards that can be auditable," Professor Reichlin said at the event. She pointed out that a large part of the world's current infrastructure may turn into "stranded assets" as governments actively change policy to mitigate climate risk. This creates a big risk and can pose a threat to economic growth, even as other measures offer new opportunities and positive momentum. Taken together, this creates enormous uncertainty.

Taxes and fees will be important policy levers but additional measures are needed. Said Professor Reichlin: "This is not enough, and we need other instruments. We need the involvement of the private sector and we need information." The coming risks mean the finance industry needs more disclosure and also new tools to tackle this uncertainty and prepare for a range of possible futures.

Carney said climate-change preparations are on the verge of a step change in how they impact the real economy, speaking at the LBS event. For example, the UK plans to implement a moratorium on non-electric vehicles by 2030, and governments around the world are working to strengthen carbon markets and set prices that discourage excessive emissions.

This creates risk as well as economic opportunity, and companies will need to assess how resilient they are. Greenhouse gas emissions, physical risk from storms, floods and droughts and even government regulation are all easier to measure than forward-looking exposure. Further, planning has to address not only what happens if governments and companies live up to their commitments, but also what might happen if they don't.

The lesson of the past three years of international work is that lenders and other capital providers have shown tremendous appetite for more disclosure, and there is a proven ability to supply much of it, according to Carney. But, he said, governments and other stakeholders have to do more: "The experience demonstrates the limits of a purely voluntary disclosure regime."

Financial disclosures have long reminded us that past performance is no guarantee of future returns, even as they use a bevy of backward-looking metrics to make their case to investors. To meet the challenges of the future, companies and regulators need to start looking ahead now. 

The virtual event Climate Standards and Enterprise Value was co-hosted by the Wheeler Institute for Business and Development at London Business School and the European Corporate Governance Institute. The event discussed the guiding principles of international sustainability standards based on enterprise value where Lucrezia Reichlin, Professor of Economics at the London Business School and ECGI chair, joined the former Governor of the Bank of England, Mark Carney, currently United Nations Special Envoy for Climate Action and Finance, and the UK prime minister's COP26 finance advisor. Elias Papaioannou, co-Academic Director of the Wheeler Institute and Professor of Economics at London Business School moderated the conversation.

Rebecca Christie is a non-resident fellow at Bruegel, a Brussels-based think tank.