Response to the Financial Conduct Authority’s Discussion Paper Regarding Green Finance
Tom Wilkinson
Abstract: This piece is a direct response to the Financial Conduct Authority’s Discussion Paper regarding Green Finance (DP18/8). At its core, the FCA’s Discussion Paper deals with transparency in regards to climate change. Financial institutions have an obligation to disclose the effects of climate change on their operations and profits. In addition, institutions should disclose steps they are taking to mitigate climate change. The FCA provided a form for response, accessible at the following link: https://www.fca.org.uk/dp18-08-response-form
- What, if any, difficulties do issuers face in determining materiality? We are also interested in exploring how investors consider materiality in this context.
The influence of climatic events on profit has varied over the past few decades, but this influence is likely to increase. Mark Carney’s 2018 speech focused on weather-related losses having increased significantly, implying that profits have been decreased as a result.[1]Climatic change is currently affecting, and will continue to affect, materiality.
Due to the effects of climate change, it is becoming harder to accurately predict the strength and frequency of extreme climatic events. For example, storms that would previously have been determined to be “once-in-100-year” events may become much more frequent, and in some cases more extreme. The predictability of these events varies, in part because climate models typically rely on data from the past. With extreme climate events becoming more common, existing models cannot keep up with new trends. This means that accounting for climatic events in any analysis of materiality will be difficult, and that financial models will need to be updated. If a firm were to find that certain climatic events (i.e. extreme storms) were regularly affecting profit, then it would be necessary for this firm to update its modelling to reflect this. If these events are having an indirect effect, it becomes more challenging but still necessary to predict and determine materiality accordingly.
For materiality to be accurately determined with regards to climate change, access to as much data as possible is critical. This data should be presented to investors in an effective and clear manner. Investors require a better understanding of the risks associated with climate change as the purpose of investment is, ultimately, to generate profit for the investor. Mandatory reporting standards may change in the future, as regulatory authorities develop more robust methods for understanding climate change and its effects on the financial world.
- Would greater comparability of disclosures help investors in their decision-making more generally? If so, what framework would be most useful?
Greater comparability of disclosure would help investors with their decision-making.
At the very least, it provides investors with more information regarding their choices; for the ethical minded investor, comparability makes it easier to determine how her capital is affecting the environment. The most useful framework at present is that designed by the Task Force on Climate-Related Financial Disclosures.[2]This framework is separated into four sections: governance, strategy, risk management, and metrics and targets. Within each section, there are recommended disclosures, which could be undertaken to allow for insight as to how firms are trying to address their own impact on climatic issues.
The comparability framework can be improved by implementation of a ‘rating system’, which would need to be developed by the TFCD or the FCA. This hypothetical rating system would rely on the disclosures each entity is making, and provide a grade for each section of framework. The average rating for each entity could then be taken and presented, making it easy to compare various institutions at a glance.
In practice, this would appear as:
| Institution A | Institution B | |
| Governance | A+ | B |
| Strategy | B- | B+ |
| Risk Management | C | A |
| Metrics and Targets | B+ | A- |
| Average Rating | B | B+ |
With this rating system, it becomes possible to see which institution is performing better and fulfilling its obligations. If these reports were required on a regular basis, it would subsequently become possible for regulatory institutions to determine which entities are consistently meeting their obligations, and which are not (opening the way for penalties, if need be). From the above example, Institution A and B are performing similarly within the framework, but it also shows that it is possible for both to improve. This current hypothetical model assumes each category is weighted to the same extent. For the purposes of regulation, it could be practical to alter this. Perhaps risk management would be more important than metrics and targets in some cases.
As the authority on the matter, it would be appropriate for the FCA to set a mandate for regular reporting, annually at a minimum. An annual, or more frequent, reporting requirement ensures information is updated on a regular basis. It also allows the FCA to track the progress of various firms on meeting their own targets. Annual reporting should not be seen as the permanent solution, but is a starting point. For higher-quality information, the FCA should instead enforce bi-annual or quarterly reporting.
It may also be prudent for the FCA to request backdated reports. This is unlikely to be feasible in all cases, but provides the opportunity for firms already tracking their own climate change contributions to demonstrate what actions they have already taken to minimise or mitigate their impacts.
[1]Mark Carney. “A Transition in Thinking and Action”, International Climate Risk Conference for Supervisors, 6 April 2018, De Nederlandsche Bank, Amsterdam. Address.
[2]Task Force for Climate Related Disclosures, “Recommendations of the Task Force on Climate-Related Financial Disclosures”, pg. 13 – 17.
