The article takes a look at the risk to CFOs when constrained by a short-term performance focus, which can block a more strategic mindset that is needed to weather the financial perils and opportunities of climate change and the net-zero transition.
The escalation of climate risks and impacts has major implications for companies worldwide, placing their chief financial officers (CFOs) under rising pressure from regulators, investors and activists. Sustainability-related regulations and legislation are increasing around the world, with a focus on areas including greater transparency around climate risks and opportunities and transition plans. Meeting these standards is becoming more arduous.
In Europe, the Corporate Sustainability Reporting Directive (CSRD) came into effect in January 2023. The directive mandates companies to identify and quantify physical and transition risks, opportunities over the short, medium and long term, and detail their transition plans to a low-carbon business model and strategy.
In June 2023, the International Sustainability Standards Board (ISSB) issued its first global standards, IFRS S1 and S2, and has set climate reporting standards across G20 countries, including how climate risks and opportunities are integrated into financial planning. The UK’s Transition Plan Taskforce (TPT) set the global baseline for best practice transition plans, with the UK Financial Conduct Authority (FCA) now exploring how this guidance can support organisations disclosing transition plans under IFRS S2. The EU’s Corporate Sustainability Due Diligence Directive (CSDDD), closely linked to the CSRD, mandates 7000 companies to adopt and implement transition plans aimed at limiting global warming to 1.5°C in line with the Paris Agreement. Banks and insurers prudentially supervised in the European Union are, in addition, now required to demonstrate that they are managing their climate risks proactively.
CFOs will encounter a host of challenges with these reporting requirements. First, they must integrate non-financial measures to track progress on how their organisation is staying on top of climate risks. Then they need to consider the fact that climate risks affect all areas of the economy, impacting not just their businesses but also their suppliers and customers. Finally, and perhaps most uncomfortably for CFOs, the new reporting requirements demand assessments that cover projections over a medium to long-term timeframe. Articulating a strategy for long-term investment in mitigation and adaptation is challenged by the ever-present pressure to meet short-term financial and performance targets. Not to mention how to deliver the longer horizons covered using a robust, repeatable and auditable approach.
WTW analysis estimates global insured losses exceeded $100 billion for the fourth consecutive year and total economic losses are now beyond $350 billion. A study by the UK-based Energy Transitions Commission reveals that around $3 trillion a year of additional capital investment will be needed on average between now and 2050 to build a net-zero aligned global economy. This is the largest movement of capital in 100 years! Doing nothing is clearly not a smart choice.
What strategic action should CFOs take to match the sheer scale of the challenge ahead? Within the field of climate disclosure, we see a drive towards greater risk quantification. Taking a qualitative-only approach today may delay the process of gaining internal buy-in for key concepts, models and scenarios. Getting ahead now with transition risk quantification means that you can use a complex disclosure exercise like CSRD as a springboard for smarter strategic planning.
That is not to say quantification is a panacea, as there are common pitfalls. There is an increasing number of vendors that will provide seemingly cost-effective black box solutions, appearing to meet all a company’s disclosure needs. Whilst that might be sufficient for reporting requirements today, it is not necessarily future proof. We already see financial regulators increasingly requesting financial institutions to show their detailed workings on climate risk.
Securing internal consensus for the assumptions, scenarios and methodology behind climate risk analysis is critical if CFOs are going take the lead on driving a more strategic approach. As the world becomes more volatile, climate risk dynamics will become more complex. Clients with exposure across a range of geographies may find increasing value in analysis that can show regional differentiation.
For example, our own research and models around the transition show limited correlation between carbon intensity and transition risk. This may mean that a strategy initially focused on reducing greenhouse gas emissions will not necessarily improve the financial resilience of a business through the transition.
Climate risks are complex and inter-related, and for CFOs the climate challenge is yet another plate to spin. However, there is also a significant opportunity to play a leadership role in securing the future. Whether you are a CFO motivated by a strategic approach to climate change or simply responding to the possibility that your country is about to introduce a carbon tax, your business is probably already being materially impacted by climate change and the global net zero transition. It will affect your company’s future costs and revenues, your investment returns and your ability to access capital.
Securing the right adaptations to your business model and selecting the right financial strategy could be a source of enduring competitive advantage. A CFO that masters these challenges will successfully manage unprecedented levels of future market volatility for both their company, their career and the planet.
