Scenario analysis emerges as a key issue as the PRI seeks TCFD disclosure

The responsible investment network doubles down on climate reporting

The Principles for Responsible Investment (PRI) recently announced that climate reporting is to be made mandatory in its annual signatory assessments beginning 2020.

Previously, the assessment included four opt-in indicators – based on the Task Force on Climate-related Financial Disclosures (TCFD) reporting framework – relating to governance, strategy, risk management and climate targets & metrics.

However, the indicators will remain non-assessed in 2020. “Beyond that, no decisions have been made,” says Edward Baker, Senior Policy Advisor at the PRI.

A possible approach being considered is the Bank of England’s recent review of banks’ climate readiness which identified three broad categories: responsible, responsive or strategic.

Market participants have welcomed the decision, with one calling it a “powerful incentive” for disclosure, particularly in view of the PRI’s “almost mainstream” status.

Peter Lööw, Head of Responsible Investments at Sweden’s Alecta, told RI: “The PRI is a natural actor to highlight different investor practices when it comes to TCFD-reporting, providing a platform for exchange and learning between investors, and to contribute to standardisation of parts of the methodology and metrics.”

Getting investors to lead on climate disclosure could have powerful knock-on effects on their portfolio companies, and thus through the entire economy. Investors would be incentivised to engage with investee companies to improve their climate performance; for corporates, class-leading disclosures would be rewarded with a lower cost of capital and improved share prices, so goes the thinking.

As Lööw explains it, assessing the climate performance of investments requires “all the strategies and future plans of portfolio companies” which investors may not necessarily have.

“This is really where the conversation should start but we now have a better basis for that conversation.”

Lööw is largely complimentary about how the climate change indicators have been incorporated into the assessment, commending the use of “pre-defined, multiple choice questions” which he says lends itself to analysis of trends and patterns, in addition to simplifying the reporting process.

However, he singles out the comment boxes for qualitative responses as “too limited to allow for in-depth explanations”.

“We believe this is an appropriate approach at this stage but bearing in mind that it will also limit any chance to assess the quality of actions or methods that investors have applied.”

Other signatories hold the opposite view, criticising some questions as being “maybe like overkill”.

One investor said: “A lot of the time the questions make full sense and come from interesting angles but sometimes you have to wonder, are all of them really material?”“The assessment is not easy to complete, let’s not kid ourselves. To give an idea, our PRI report draft, exported in a Word document, is 231 pages long. Once you factor in validation by several teams, you can imagine the amount of work this represents.” [The PRI has just launched a consultation on annual assessments.]

The comments come after the PRI have already updated the indicators to incorporate signatory feedback from the pilot year. Efforts were taken to streamline the questions and increase the practicality of the accompanying guidance, as well as re-balancing the emphasis on physical and transition risks from climate change. The first iteration was deemed too heavily tilted toward the latter.

According to the PRI, one of the areas signatories had the toughest time with was scenario analysis, a component of the risk management indicator soon to become mandatory in 2020.

Scenario analysis, a key plank of the TCFD recommendations, involves testing the resilience of a portfolio across a number of plausible climate scenarios. At minimum, the TCFD recommends using a 2°C warmer scenario, although others are available.

One issue is the lack of consensus over what constitutes a viable scenario. Assuming different population growth rates or policy responses will result in completely distinct models with different implications for an organisation, even when based on the same climate trajectory, for example 2°C.

Currently, the only scenarios that come close to being accepted as a ‘market standard’ are from the International Energy Agency (IEA). These are used for forward planning by a range of systemically-important institutions including policymakers, utilities, corporates and banks. However, the scenarios have been criticised for being too fossil fuel friendly by underestimating the growth of renewables and carbon emission cuts.

The IEA and the fossil fuel industry also enjoy close links. It is public knowledge that IEA scenarios have been authored by employees of oil companies on secondment. In turn, oil majors, such as BP, cite IEA scenarios to justify the continued extraction and production of oil.

Russ Bowdrey, an executive at Aviva involved in TCFD reporting, told RI: “The independence of the IEA from oil majors is laughable when Shell has permanent secondees at the IEA. The IEA is not going to make projections that predict the fall of the industry that keeps them in the money.”

These criticisms were raised after the PRI recently endorsed a scenario analysis tool – Paris Agreement Capital Transition Assessment (PACTA) – based on IEA data.

While the PRI assessment does allow the use of other scenarios, PACTA is the first freely available, off-the-peg tool and is anticipated to be a popular option once reporting is made mandatory, particularly among investors with limited resources.

In response to these concerns, the PRI has told RI it is “reviewing options with regards to engaging with the IEA”.

Jakob Thomä, the Managing Director of 2 Degrees Investing Initiative (2dii) – which developed PACTA – has himself voiced criticism of IEA scenarios in the past, however he told RI that using data from a well-recognised provider was necessary to “build trust” and drive adoption of the tool, which was the first of its kind upon release.

According to 2 dii: “Alternative scenarios to the IEA don´t currently cover all sectors or do not provide the same regional granularity, which is in particular beneficial for regional sectors such as the power sectors where the contribution to the decarbonisation significantly differs between regions.”

The widespread usage of the PACTA tool or the underlying IEA data has another distinct benefit: comparability, a core underpinning of climate reporting according to the TCFD recommendations.

Per the PRI: “Without credible comparability of climate related disclosures … it is difficult for financial system users and beneficiaries to trust the information they receive.”

However, across the board comparability risks reducing the relevance of scenario analysis for individual investors, thus limiting their ability to implement conclusions and improve portfolio resilience.Alecta, for example, has concluded that the PACTA tool is unsuitable to assess its portfolio due to the fund’s very limited exposure to energy intensive industries. This is because the tool only uses exposure to energy intensive industries to determine climate resilience and not the entirety of an investor’s holdings.

Mandating the use of a central scenario could also result in certain investments being treated favourably over others based on factors such as location.

2dii’s Thomä says: “Take an example of two Swiss funds of similar size, one is overweight in emerging markets and the other in developed markets. Even if both had the same percentage in renewables, the latter would be market leading purely because of the markets they are investing in, so it’s pretty clear that comparability may not be necessarily be the way forward.”

In this example, the EM investor would have to reinvest in more developed markets to reduce climate risk, potentially taking capital from where it is needed most.

The challenges around scenario analysis reveal the delicate balancing act facing the PRI: ensuring a rigorous reporting framework, while retaining enough flexibility so as to be material and actionable. Ultimately, success of the TCFD recommendations isn’t in market adoption but market action.