Climate Disclosure and Risk for Asian Companies
Climate change is now prompting substantial structural adjustments to the businesses and society overall while governments tighten climate policies and regulations to cope with the shift of the economy away from fossil fuels. The business-as-usual scenario is no longer valid and has been recognized as risk-taking. Companies are also under pressure to disclose how climate change affects their operations and financial performance. Nonetheless, recent research states that over 70% of large to mid-cap companies do not disclose or are aware of climate risk in their annual financial reports 1, let alone internalize these risks and carry stress-test scenarios based on Task Force on Climate-Related Financial Disclosure 2 report.
AN URGENCY TO EDUCATE THE MARKET
Climate risk can span from short- to mid- to long-term horizon. The mispricing of climate risk and misperception of these risks only as a long-term risk can be fatal for companies, particularly in sectors of energy, utility, or materials. Therefore, it is urgent to motivate companies to acknowledge climate risk and provide transparent disclosures on the business value-at-risk, hence shifting to a resilient and financially sustainable business.
Hong et al. (2016) and Caldecott et al. (2014), strongly emphasise that both physical risk and transition risk, have a transparent material impact on company level.
Schroders Investment Management (2018) estimates that companies would have to spend at least 4% of their market value to ensure their asset against physical climate risks.
DEFINING CLIMATE RISK
- Physical risk: severe, unpredictable weather events as well as climate change, such as heatwaves, storms, floods, fire, droughts, sea-level rise.
- Transition risk: regulatory changes from high carbon to low carbon economy, associated with policy, liability, technological with in-depth market and social implications.
- Technological advancement of renewables and energy efficiency increase the risk to existing industries relying on fossil fuels.
- Social risk due to changes in consumer trends and behaviour.
METHODS TO MEASURE THE CLIMATE RISK
Current methods of measuring climate risk are based on companies carbon emission disclosure. Based on these numbers, companies such as Blackrock, S&P Indexes, MSCI, Moody’s etc construct their climate-carbon scorecards that are either in absolute or relative terms. The problem with these measures is that they use carbon footprint as a proxy for the real physical climate risk. The logic is very simple. The more companies pollute, the higher the CO2 concentration which in term leads to an increase in frequency and severity of climate events and extreme weather. Hence to mitigate this direct impact of companies on climate, they should be forced to limit their carbon emission (and equivalents). One way to achieve this is by creating national or regional carbon markets such as ETS or imposing higher carbon taxes. That means they will likely be faced with carbon prices that could reach $60-$120/tCO2 instead of current prices that are in single digits for most countries.
CLIMATE RISK DISCLOSURE IN EMERGING MARKETS
A recent study reveals that most of the emerging market companies fail to disclose enough data on climate risk by reporting to the CDP questionnaire. They score F due to the lack of understanding or awareness of climate risk. The results are even more concerning when comparing the top to bottom companies. Among emerging market companies, bottom companies have an inadequate climate disclosure when compared to the top companies 3.
Image: CDP rating for 136 US companies vs Top 50 and Bottom 50 MSCI Emerging Market Companies
CLIMATE RISK AND FINANCIAL PERFORMANCE
Climate risk and a firm’s financial performance are negatively correlated. The study reveals that companies with high climate risk have the lowest profitability ratios (P/E and P/B). The comparison is more obvious when using the P/B ratio. For bottom companies in the emerging market, the correlation is even three times stronger. This highlights the previous findings that bottom companies with low P/E face a significant climate risk, which they ignored, unpriced, and did not disclose. Concerning that there is a clear trade-off between climate risk and financial performance, it is beneficial for companies to acknowledge climate risk by marginally increasing climate risk data transparency 4.
Image: Climate risk correlation with firm profitability ratios