The Urgent Need for Patient Capital: Using TCFD Scenarios to Identify Future Investment Priorities (Part 1)

A quarter-century has passed since the first climate treaty in Rio de Janeiro, and a year since the Paris Accord.

Yet commitments made at the country level have barely bent the curve of rising carbon dioxide emissions; they are still on track to rise at least through 2030.

Worse, no major industrial nations are meeting their newly adopted voluntary targets. The US under Trump has announced plans to withdraw from the Paris agreement altogether.

As such, two visions of the future remain on a collision course. One sees the world’s population growing by another 2bn over the next 30 years, with more people entering a burgeoning middle class that fuels rising energy demand and the draw on natural resources.

The other sees these trends as environmentally unsustainable and that a new course must be set to head off rising seas, epic droughts and ever more dangerous storms.

Institutional investors are caught in the middle of these competing visions. Do they continue to support the companies and economic delivery systems that effectively carry on ‘business as usual’? Or do they allocate more capital in new directions that may compromise the value of existing investment strategies and carbon-related assets?

This uneasy trade-off pits the risks of a rapid decarbonization of the global economy against a more deliberative approach that tips the scales increasingly toward unmanageable and possibly irreversible climatic responses.

Into this picture comes the Task Force on Climate-related Financial Disclosures (TCFD). In many ways, the TCFD is an extension of voluntary disclosure initiatives that have come before it, including the Global Reporting Initiative, Carbon Disclosure Project (now CDP), Principles for Responsible Investment, the Sustainable Accounting Standards Board, Climate Disclosure Standards Board, International Integrated Reporting Framework and G20/OECD Principles of Corporate Governance.

But one thing sets the TCFD apart: ‘scenario planning’.

Scenario planning is not new. Atmospheric scientists have used scenarios for more than a century to imagine how rising concentrations of carbon dioxide and other greenhouse gases might influence weather and climate patterns. Royal Dutch Shell adopted these tools in the energy sector in the late 1960s, as Middle Eastern countries nationalized their oil supplies forced the independent oil majors to rationalize investments in other regions with higher drilling and operating costs.The specter of ‘carbon stranded assets’ now is the latest extension of this energy scenario, as oil companies seek to tap more expensive and carbon-intensive reserves in oil sands, Arctic regions and deep underwater.

Scenarios are not meant to be predictors of the future. Rather, they are intended to present plausible alternative stories about how the future might unfold.

Or, as the TCFD explained in a recent primer, scenarios “should challenge conventional wisdom about the future. In a world of uncertainty, scenarios are intended to explore alternatives that may significantly alter the basis for ‘business-as-usual’ assumptions.” Link

To date, nearly 250 companies and financial institutions have publicly stated their support for its recommendations, including 150 firms that manage more than $80trn in assets .

Investors have also expressed their support for the TCFD 2°C scenario analysis in shareholder resolutions that received majority support at ExxonMobil, Occidental Petroleum and PPL in the 2017 proxy season. For a review of recent shareholder activity in the oil and gas sector, see Investor Climate Compass: Oil and Gas.

Yet this is hardly a time for the TCFD and its supporters to take a victory lap. Many companies continue to claim there is no clear correlation between climate factors and financial performance, especially when it comes to identifying material financial risks. To the extent such information is available, they argue such disclosure could reveal competitive information and impair future access to capital. At the same time, some companies maintain that policies to achieve a 2°C limit in warming are simply unattainable, rendering such a scenario futile. And at a more fundamental level, some companies believe that the disclosure framework for scenario planning is so broad and multi-faceted it risks over-disclosure that thwarts informed decision making; i.e., the forest gets lost in the trees. (For a critique of the TCFD, see IHS Markit’s Climate-Related Financial Risk and the Oil and Gas Sector).

It is this final point that may give investors the most pause. When one dives into the scenario process laid out by the TCFD, a decision-tree matrix quickly forms with increasing dimensions and layers of complexity. It begins with corporate disclosures in four broad categories: Governance, Risk Management, Strategy, and Metrics and Targets. Influencing these disclosures are: Market and Technology Shifts, Stakeholder Reputation, Policy and Legal Developments, and Physical Risks.

Then there is the selection of the scenarios themselves, including: Business as Usual, Newly Adopted Climate Policies, and the 2°C scenarios (of which the TCFD has identified at least six as possible reference points). Finally, within each of these scenarios, disclosures and explanations fall under: Parameters and Assumptions, Analytical Choices, and Business Impacts and Effects.

In these final three categories, Parameters and Assumptions tags 11 factors, including prices for key commodities and carbon emissions, growth in energy demand and energy efficiency, and the pace of technology and infrastructure development.

Analytical Choices tags seven factors, including time frames and climate models chosen for each scenario, and effects of physical risks and impacts through the value chain – from suppliers to customers. Business impacts tags eight more bottom-line impacts, including effects on production costs, revenues, earnings, capital allocation and future investments.Dutiful application of these procedures makes for a potentially exponential set of final disclosures and a seemingly endless supply of alternative conclusions, depending on which scenarios are selected and how each factor is applied and then related throughout the whole planning exercise.

If not careful, this labyrinth of scenario analysis could collapse under its own weight or be manipulated by companies that wish to produce their own self-serving results.

The second part of this analysis will look at ways to respond to the TCFD, suggesting that investors will need to develop their own ‘house view’ on scenarios.

Doug Cogan, formerly with MSCI, is the author of ‘The Greenhouse Gambit: Business and Investment Responses to Climate Change’. He now runs his own climate consulting firm. He is available via email.