Climate Advisers recently submitted a comment letter to the International Sustainability Standards Board (ISSB) in response to its efforts to establish a global baseline of climate-related financial disclosures. Disclosures on climate-related financial risks are key to providing investors and markets with the information needed to make decisions on the financial risks driven by both the physical impacts of climate change and the transition risks associated with government action, consumer preferences, technological disruptions, and reputational damage.
Estimates say that climate change could cost the global economy $23 trillion by 2050. Providing investors with data on which businesses pose greater financial risks in relation to these growing problems is urgently needed. Particularly important in this discussion is the role that deforestation plays in financial risks for investors and the global economy because deforestation emissions are released over time and are magnified by the associated reduction in global carbon storage capacity through carbon sinks.
Deforestation is a leading driver of the biodiversity crisis and accounts for 10 percent of global climate warming emissions. Recent analysis shows that carbon loss from tropical deforestation has doubled in the last two decades, intensifying climate impacts and their costs on the economy. These emissions are largely driven by the agriculture expansion and other economic activities that harvest commodities like beef, palm oil, timber, soy, and other products.
These are serious global problems that the ISSB is trying to address to support investors and corporations in addressing the need for better and more consistent information on climate related financial risks.
In the United States alone, financial risks from deforestation could affect a diverse variety of sectors that are collectively responsible for nearly 40 percent of the country’s GDP. The U.S. imports over $618 billion worth of tropical commodities dependent on healthy natural environments that are threatened by deforestation. Against this backdrop, U.S. investors and many economic sectors rely on preventing further deforestation to reduce financial risks and economic harm, and can benefit from the consistent standards like those being developed by the ISSB.
The ISSB’s efforts to set a baseline for providing quality and comprehensive data on the climate-related financial risks will enable investors to make more informed decisions. Climate Advisers’ comment to the ISSB commended three components of its initial Climate-Related Disclosure Exposure Draft that establish a strong foundation for developing their baseline for disclosures:
- Incorporating the Task Force on Climate-Related Financial Disclosures (TCFD) framework as a structure for the qualitative disclosure of issuers’ analysis and governance of climate risks and, as appropriate, opportunities.
- Comprehensive emissions coverage, including the ISSB requirement for the disclosure of Scope 3 emissions.
- Including industry-specific disclosures through the Sustainability Accounting Standards Board (SASB) framework.
To further ensure the ISSB’s baseline disclosure standards are effectively meeting the needs of investors Climate Advisers recommends that additional amendments be made.
1. Deforestation and Land Use Change Should Become A Required Assessment Category Within SASB Industry Disclosures
Regulations that do not explicitly mandate industry-specific disclosures around climate-related financial risks from deforestation and land-use change for high-risk industries would be incomplete and ineffective in protecting investors. Although a small handful of SASB industry disclosure guides recommend including metrics around deforestation and land use change, the scale of sectors exposed to tropical commodity supply chain risk is much larger than those required to report on these exposures through SASB. Exposed sectors include food and beverage processing and production, automobile manufacturing, textiles, chemicals, pharmaceuticals, retail, food service, personal care products, print publishing, forestry, construction, energy and biofuels, and finance. In order to better protect investors from climate-related risks from deforestation, the SASB and the ISSB should:
Include ‘carbon sinks’ or ‘deforestation and land use change’ as a horizontal reporting category under the environmental industry disclosures, alongside GHG emissions, air quality, energy management, water and wastewater management, waste and hazardous materials management, and ecological impacts. Although many of the current environmental, social, and governance categories are relevant to climate-related financial risks from deforestation, they overlook the magnitude of the impact of destroying or degrading carbon sinks for years to come and eroding a crucial component of current plans to limit global temperature rise.
For example, GHG emissions are relevant for the year in which deforestation takes place but eliminating carbon sinks has a long-term impact because the land is no longer able to store carbon. Emissions from deforestation and land use change are also released slowly through the soil over multiple years, rather than in one year. Furthermore, including this category would mean that every industry would be required to assess exposure to climate-related risks from deforestation and land degradation or the destruction of carbon sinks.
Use the CDP Forests questionnaire as a guide when recommending metrics for climate-related risks from deforestation and land use change. CDP Forests clearly defines high deforestation risk commodities and countries and provides a menu of key performance indicators that companies with tropical commodity supply chains, financiers with high deforestation risk investments, and forestry asset managers could use to provide shareholders with standardized and comparable disclosures. CDP definitions around countries and commodities at high risk of being linked to deforestation would serve as a helpful guide for assessing materiality in a company’s supply chain or a financial institution’s investments.
2. Materiality Should Not Be Left Up To The Reporting Entity Alone
According to the draft disclosures, “the responsibility for making materiality judgements and determinations rests with the reporting entity for all requirements” and “an entity shall disclose information related to a specific requirement when it concludes that the information is material to the users of the information in assessing the enterprise value of the entity.” However, Climate Advisers believes that companies, financial institutions, and asset managers with high climate-related financial risks from deforestation and tropical commodities, as defined by CDP Forests, should be considered per se material, rather than the decision being left up to the reporting unit. Deforestation and land use change are both appropriate and needed because they are inherently material due to the outsized impact that they have on climate change both through the current year emissions and the destruction of carbon sinks.
Research has concluded that the financial risks of deforestation are particularly acute with respect to seven commodity products – cattle, palm oil, soy, timber, natural rubber, cacao, and coffee. A CDP analysis of 187 companies potentially affected by climate and deforestation commodity risk found that nearly 25 percent of those companies’ revenue depended on four commodities linked to deforestation: cattle, soy, timber, and palm oil. If the probability of deforestation is particularly high in certain countries, such as Indonesia or Brazil, assuming the continuation of practices that are today leading to deforestation, a potential 25 percent reduction in revenue is of significant magnitude to be understood as “material.” Thus, companies importing significant quantities of cattle, soy, timber, or palm oil, and/or with extensive supply relationships in Indonesia, Brazil, and other countries with high tropical deforestation risk, would likely need to disclose information, both quantitative and qualitative, concerning the risks of deforestation; regulatory risks that might lead to asset stranding; and supply chain parameters, since this information can portend future financial risks of significant magnitude.
However, if companies are responsible for conducting internal materiality analysis to classify climate-related financial risks as ‘material’ or ‘immaterial,’ it’s possible that different companies with similar risks profiles may come to different conclusions. Without more extensive guidance around materiality, especially for industry-specific disclosures that may be relevant to all actors within an industry, the ISSB guidance risks creating an uneven playing field among competitors. Since the CDP Forests questionnaire has already established clear definitions for determining materiality of exposure, relevant country and commodity dependencies should automatically trigger a mandatory disclosure to protect investors against concentrated climate-related financial risks from deforestation and land use change.
3. Incorporate A Double Materiality Perspective
The Exposure Draft focuses on the specific aspect of financial (or outside-in) materiality in S1. This differs from the mainstream understanding of materiality, which could potentially compromise the credibility of the ISSB as a standard-setter for sustainability disclosure. Furthermore, any sustainability issue which is classified as primarily material from an inside-out (impact) perspective can quickly become financially material to firms and investors. For example, research has shown that the recent development of disclosure regulations and standards influenced the capital market’s prioritization and assessment of firms’ ESG issues.
It is therefore important to acknowledge the impact that standards have on the perception of investors in determining which ESG issues are material and therefore can contribute to market-based incentives for environmental and social behavior. As double materiality-based approaches are increasingly implemented internationally, the capital market’s consideration of both climate risks and impacts is likely to further intensify. Considering the dynamic nature of the materiality concept and coherence with other international regulations, we strongly recommend the ISSB to go beyond a financial materiality approach and incorporate the inside-out perspective in the materiality definition.
4. Incorporate the role that ecosystem services play in mitigating or exacerbating climate-related financial risks
The ISSB should require companies to identify and disclose their natural resource dependencies because the collapse of natural ecosystems, in turn, significantly exacerbates climate-related financial risks. The emerging framework of the Task Force on Nature-related Financial Disclosures (TNFD) measures nature-related financial risks, including those that exacerbate climate-related financial risks, and it also aligns closely with the TCFD in its coverage of strategy, governance, risk management, metrics, and targets when assessing the potential impact of nature-related financial risks.
Climate-related financial disclosures would be incomplete without considering the nature-related financial risks with significant climate impact or that have a multiplying impact on climate-related financial risks. For example, if rising deforestation rates result in a tipping point being surpassed in the Amazon rainforest, scientists estimate that the majority of the ecosystem would gradually collapse and turn into a Savannah-like environment, releasing up to 90 billion metric tons CO2,equivalent to seven years of global emissions, as the forest dies off. The impact to agricultural supply chains would be substantial as a result of reduced rainfall for irrigation and rising temperatures.
Changes in natural environments, including through deforestation and loss or degradation of natural ecosystem services, are increasing climate-related financially material risks to companies and economies, but they are not currently being incorporated into financial reporting or qualitative disclosures in any systematic way. To address this gap, senior executives from financial institutions, corporations, and accounting firms have cooperated in the development of the TNFD, whose framework is supported by the G7 Finance Ministers and the G20 Sustainable Finance Roadmap process. It is explicitly being modeled to align with the TCFD, using the governance, strategy, risk management, metrics and targets framework, and structured to align with the ISSB as a global baseline, with additional disclosure as needed to report on material nature-related risks. Although it is an emerging framework and is still in the process of incorporating valuable stakeholder feedback, the ISSB should evaluate it carefully as it develops its final rule, since the financial impacts of nature based risks are exacerbated by, and interrelated with, those of climate change.
Investors need access to quality data to make informed decisions that avoid unnecessary financial risks related to nature loss and climate change. Establishing an ISSB baseline for reporting that incorporates the above recommendations will ensure that investors are prepared to address these risks and support stable markets and economies over the coming decades.