On 31 March the ISSB[1] launched their consultation on a comprehensive global baseline for sustainability disclosures (in general) and climate related disclosures (in particular) in line with announcements made at COP26[2]. It is important because this will be the global standard for ESG reporting that local jurisdictions will adopt to one extent or another. They have a handy snapshot of the consultation, which closes on 29 July.

Think IFRS[3] financial reporting standards but for sustainability. And it clearly follows on from the FSB’s[4] 2017 TCFD disclosure standards (that’s Taskforce for Climate-related Financial Disclosures for those still grappling with the unsustainable explosion in acronyms) that various jurisdictions are already well on their way to adopting – most recently the SEC[5] in their announcement a few weeks ago on US ESG disclosure requirements (see Better Late Than Never for more on that).

You can see the hallmarks of the TCFD in the ISSB proposal – it is based on the same four pillars of Governance, Strategy, Risk Management and Metrics & Targets.  

The announcement got us thinking about the types of ESG measurements that are gathered – often these are split into two – the ‘double materiality’ described in the EU’s EFRAG report in Feb 2021. There they distinguish between ’impact materiality’ which we’ve divided into ‘good’ and ‘bad’ below versus ‘financial materiality’ which we’ve labelled ‘ugly’:

• The Good: the extent to which economic activities of an organisation are aligned to sustainability-related goals. How ‘taxonomy-aligned’ an enterprise is in EU Taxonomy Regulation terms. Think, are you building wind turbines?
• The Bad: how much damage is the organisation doing to the environment? For example what are their scope 1, 2 & 3 CO₂ emissions? What is the carbon footprint of the wind turbine factory? 
• The Ugly: how susceptible is an organisation to climate-related (or sustainability in general) risks? Is your wind turbine factory built in a flood plain?

The various disclosure standards being defined around the world seek to measure these different aspects of ESG. The ISSB standards talk about “risks and opportunities” which are broadly the last 2 against the first. Though the risks do seem to be the main focus and provide the majority of the examples in the consultation paper. 

We think that these types of disclosures will contribute to how a company, or an asset, is valued in the future – considerations around climate-related risks will affect enterprise value. That is separate to the good (or harm) they may also be doing to the environment (or society more generally). A neat way to think about it which we’ve heard recently is “value versus values”. What impacts valuations versus the inherent purpose of an organisation.

In A Measured Approach we suggested that we might see in the not-too-distant future the introduction of EVA (ESG Valuation Adjustment). It has also been referred to as CCVA (Climate Change Valuation Adjustment) in a quite detailed technical paper published last year (Kenyon & Berrahoui, May 2021). That paper describes some of the technical challenges and possible solutions around putting such a framework in place. Here we just want to flag some of the broader questions around the topic – it does seem to be a subject people are talking about (e.g. see recent Risk.net article [paywall]).

Appreciating EVA or CCVA is a component of derivatives valuation specifically, we think the point can still be made more broadly. Ultimately this comes down to a more principled debate:

1. Are we seeking to properly measure and surface in pricing & valuations climate-related risks that hitherto have not been recognised? Or,
2. Are we trying to find a structure that recognises and rewards ‘good behaviour’ in the context of climate change?

Reward the good or punish the bad? Perhaps the answer is somewhere between the two, but certainly better data and measurement will be key regardless. ‘Punish the bad’ is probably too stark – it is more about encouraging the bad to be better... investment in measures that will reduce emissions and mitigate ‘the ugly’.

The Kenyon / Berrahoui paper suggests that current CVA[6] & FVA[7] measures are very focused on the near term (say out to 10 years) and that the most immediate climate risks may already be factored into those ratings. However as you look further out the existing CVA measures are just extrapolating out the 10-year view, but that does not take into account the broader long-term climate-change risks.

There is a debate around the extent to which existing credit risk models already capture some elements of ESG – this is visible in how credit rating agencies are becoming more explicit in how ESG impacts their ratings. And we are likely to see banks starting to do the same as ESG scorecards etc are woven into credit forms.

This comes back to the fundamental question of whether we are trying to measure mispriced risk. Essentially saying that current CVA & FVA measures, and the reserves made for the derivatives booked as a result, do not sufficiently take account of climate risk. That there are longer-term threats to the income streams of the counterparties faced (and therefore greater chances of default) than credit analysts have yet taken account of.

In this sense EVA or CCVA becomes an extension of current CVA. The Kenyon / Berrahoui paper talks in much more detail about the kind of framework that could be put in place to aid this analysis. However the focus does seem to be on ‘punishing’ those who may be more susceptible to climate change risk, almost irrespective of whether they are “doing the right thing” for the environment themselves.

Better measurement also means more consistent and comparable measurement – ESMA recently released an assessment of 64,000 Credit Ratings Agency (CRA) press releases, concluding there was still a high level of divergence between their ESG disclosures. So even within a fairly narrow band of CRAs, disclosures were quite inconsistent... imagine how much worse this will become initially with a broader range of reporting entities. From a derivatives perspective the larger players are of course FIs, and we are still at an early stage in being able to measure the climate impact of their portfolios. 

The other reason for better measurement is to encourage good behaviour. This encouragement could take the form of lower ROE[8] expectations for financing for ‘greener’ products or services, or perhaps from a supervisory or prudential perspective in giving better capital treatment to such activities (and conversely applying haircuts to activities that actively do harm or have high emissions). The carrot and stick here could prove a powerful tool in the hands of regulators in years to come. 

However it is used, it is clear that measurement of climate risk, and ESG more generally, is set to have a greater and greater focus. There are still many unknowns as to how to measure ESG risks and impacts, but we think many are already coming to the view that more will need to be done. And there will be a fair amount of trial and error along the way as organisations better understand what they are dealing with.

1. ISSB - International Sustainability Standards Board
2. COP26 - 26th UN Climate Change Conference of the Parties
3. IFRS - International Financial Reporting Standards
4. FSB - Financial Stability Board
5. SEC - Securities and Exchange Commission
6. CVA - Credit valuation adjustment
7. FVA - Funding valuation adjustment
8. ROE - Return on Equity