The evolution of regulatory frameworks for climate resilience: Disclosure powers change

Our industry is engaged in an important dialogue to improve sustainability through ESG transparency and industry collaboration. This article is a contribution to this larger conversation and does not necessarily reflect GRESB’s position.

Climate change has sparked a significant shift in how financial risks are managed. Shortly after the 2017 publication of the TCFD Disclosure Framework, businesses found themselves navigating new mandates to disclose climate-related data and incorporate climate challenges into financial risk assessment and management. No small task, especially for real asset businesses lacking expertise in climate resilience and sustainability.

Disclosures underwent yet another transition in 2023 when the TCFD formally disbanded, handing responsibility over to the International Sustainability Standards Board (ISSB). Under its guidance, the framework evolved into a fresh set of financial accounting standards known as IFRS S2.

It should be noted that IFRS S1 and S2 share a common objective: to encourage businesses to identify and disclose sustainability and climate risks within their operations. While IFRS S2 concentrates on climate-related issues, it applies the same approach to consider and disclose information related to environmental, social, and governance (ESG) issues.

Understanding this transition from TCFD to IFRS S2 is crucial as we navigate the evolving landscape of climate-related regulations. This shift marks a significant stride towards reinforcing climate resilience within real assets.

A primary objective among the many initiatives surrounding our response to climate risk is to transition from voluntary to mandatory disclosures. This far-reaching transformation has global implications for multiple industries. It impacts businesses striving to create value. It impacts their investors. It impacts regulators and those setting industry standards. All parties are engaged in a synchronized race to adapt to climate change, and this collective endeavor is progressing at a remarkable speed.

Fundamentally, we must significantly reinvent our financial and legal systems to address climate risk. Financial risk management has evolved naturally over centuries, but today’s breakneck change is markedly different. We have roughly six years of climate risk experience and have less than 30 years to transition our financial and regulatory infrastructure to achieve net-zero carbon.

The unpredictable nature of physical climate change adds another layer of complexity. Physical climate change is “baked in,” meaning that our actions now are unlikely to reduce physical risks until after 2050, and each year the severity and consequences of physical climate events worsens.

Historically, we have proved unreliable in predicting these events and are prone to underestimate their impacts. Managing this risk is like playing a game of snakes and ladders, but with a twist. Real asset investors must construct their own ladders to escape the multiplying invisible snakes that emerge with increasing size each year. Strategic planning and adaptability are paramount for success.

A lingering question remains: Will the relentless pace of climate change outstrip our capacity to mitigate its impact or adapt to its shifting landscape? Only time will tell.

Every day, we witness the unwavering dedication and tireless efforts of individuals who’ve embarked on remarkable initiatives. They’ve implemented policies and practices that significantly reduce carbon, or have transformed investment decision-making to align with insights from science-based climate data. Their commitment offers hope. The act of mandating climate disclosures also validates the early action taken by these leaders, which was both forward-thinking and necessary to navigate through the climate crisis.

At the crossroads of these efforts, effective regulation becomes the cornerstone for transformative climate action. Combined with peer pressure, we could find ourselves on an exponential curve of positive change. However, it’s imperative that these measures transcend mere public display and bring about genuine change.

Legislation holds some of the solutions, employing both incentives and deterrents. The “carrot” offers a constructive framework to help businesses effectively promote the green aspects of their financial products, as exemplified by the Sustainable Finance Disclosure Regulation (SFDR). Meanwhile, “sticks” include anti-greenwashing regulations and setting of GHG emissions targets.

The UK’s early adoption of the TCFD was hailed as a significant milestone in climate action, but the introduction of IFRS S2 triggered some confusion. Should companies disclose against TCFD if it no longer exists? Will we transition to IFRS S2, and when? The resounding answers are Yes, Very Likely, and January 2024. Over time, we hope that the IFRS S2 will outgrow its infancy challenges – and it is widely accepted that the UK will soon adopt IFRS S2. TCFD remains a valuable and valid framework and is now a stepping stone rather than an end goal for making climate disclosures.

Meanwhile, the EU is adopting a measured approach, crafting an “ecosystem” of climate-related legislation anchored by the EU Taxonomy as its core framework. This taxonomy serves as a guiding star, defining essential terms and specific alignment requirements across diverse climate and sustainability-related matters. Its implementation is delegated to individual legislations tailored to specific criteria, including industry, location, and use-case scenarios.

The Corporate Sustainability Reporting Directive (CSRD) now determines which businesses should disclose climate-related information, pointing them to the European Sustainability Reporting Standard E1 (ESRS E1) to understand what disclosure information is considered “climate-related.” ESRS E1 mirrors the TCFD but avoids direct reference to the framework, thus avoiding the technical dilemma faced by the UK, which, for the time being, still does reference TCFD.

Although parallels can be drawn between IFRS S2 and ESRS E1, they aren’t carbon copies. The grand vision is for global businesses, regardless of their jurisdiction, to confidently rely on IFRS S2 as the gold standard for both internal accounting practices and external disclosures. Its beauty lies in its adaptability, as it aims to align with regional legislative requirements, including those of ESRS E1. This harmonization even extends to the forthcoming climate-related disclosure mandates from the US SEC, which are poised for imminent release… or so we anticipate.

Now, if this all sounds a tad unwieldy and complex, don’t worry. It’s partly because this landscape is relatively new and inherently complex. To make climate disclosure more accessible and straightforward, the IFRS is also developing a Digital Sustainability Taxonomy.

This new taxonomy is designed to enable the structured storage of information in a digital format, aligning seamlessly with other digital frameworks like XBRL, a stalwart in accounting. Additionally, this taxonomy is set to harmonize with similar digital frameworks in development in the EU and UK (and likely US SEC too).

This strategic move promises to alleviate some of the complexities of disclosure, while enabling some degree of automation in climate-related financial accounting, assessment, and decision-making.

IFRS S2 relies on data submitted to GRESB as a trusted data source for calculating climate-related performance metrics.

Moreover, with the incorporation of the Digital Sustainability Taxonomy, data derived from GRESB submissions opens the possibility for it to be integrated into financial accounting software. This facilitates automated tracking and disclosure of year-on-year performance against financial KPIs for sustainability and climate resilience.

Aligning financial accounting systems with this specific taxonomy lays the groundwork for businesses to automate the calculation of quantitative metrics for disclosure, alongside relevant legislative frameworks. The evident advantages lie in the potential reduction of time, labor, and complexity associated with making such disclosures.

However, it’s crucial that some qualitative aspects of disclosure necessitate written statements, explanations, and discussions – a parallel to the current practices in financial reporting. Much of this qualitative data is embedded within your regulatory filing structures, accessible through publicly available and undisclosed documents.

It’s interesting to contemplate the potential applications of artificial intelligence (AI) in interpreting unstructured data. AI has the capacity to extract valuable insights, potentially identifying overlooked disclosure requirements or unlocking new capabilities to analyse how successfully climate-related policies have been implemented.

Corporate AI tools like Microsoft’s Copilot aim to “combine the power of language models with your business’s data” and “works alongside popular Microsoft 365 apps such as Word, Excel, PowerPoint, Outlook, Teams, and more.” Google Bard already links with their suite of web apps and Google Drive. Imagine AI sifting through your data and regulatory filings to locate information required by a Digital Sustainability Taxonomy. This could streamline your disclosure process, reduce human error, and ensure compliance with diverse regulatory standards in complex sustainability reporting. Automation and AI could elevate disclosure to the next level, offering deeper data insights.

The race against climate change is a challenge that’s still being written. Will its pace outstrip our ability to combat it or adapt to its consequences? It’s an open question. Nonetheless, we possess all the essential ingredients for success: positive motivations and strong drivers for action, the indomitable spirit of human ingenuity and dedication, AI to accomplish more with less, and regulations to guide our efforts. We have the frameworks to catalyze change on a global scale.

Our mission may seem insurmountable until we’ve succeeded, but our collective determination and adherence to both voluntary and mandatory disclosures hold the promise of a more sustainable future in real asset investments.