CLIMATE-RELATED DISCLOSURES – NEXT STEPS

Introduction

In October 2021, New Zealand enacted legislation in the form of The Financial Sector (Climate-related Disclosures and Other Matters) Amendment Act 2021 – which amended the Financial Reporting Act 2013 and the Financial Markets Conduct Act 2013 (FMC Act).  The legislation introduced a mandatory reporting regime under a new Part 7A of the FMC Act for certain ‘climate reporting entities’ (CREs) to prepare climate statements in accordance with the climate-related disclosure framework to be issued by the External Reporting Board (XRB).

This regime will require CREs to disclose climate-related risks and opportunities affecting their businesses.  Although New Zealand claims to be the first to pass such legislation, many other OECD countries have taken or are taking similar steps.

The roots of the new reporting regime can be traced back to the work of the work (in 2017) of the international Task Force on Climate-related Financial Disclosures (TCFD).  In particular, that climate change is seen as an economic risk that is likely to impact business’ performance and prospects materially – because it encompasses physical risks (weather events and changes in land uses) as well as so-called transition risks such as governmental and market responses to the threat of climate change.

The new regime comes into force in October 2022 – although its first two, core, obligations (preparing climate statements and keeping records) are expected to start to apply from April 2024.  This is because CREs will have an obligation to release climate statements (and the undertake the record-keeping obligations in respect of those statements) in relation to financial years that begin the date that the XRB releases its final climate standards (NZ CS 1) – which is expected to be at the end of this year.  (Note that the requirement to obtain an assurance engagement in relation to climate statements which are required to disclose greenhouse gas emissions is not expected to kick in until 2 or 3 years later).

What is a CRE?

The new regime will apply to CREs – which are FMC reporting entities that are considered to have a higher level of public accountability than other FMC reporting entities.  It is estimated that around 200 large financial institutions will be captured, including:

• listed issuers (equity or debt)- with a market cap exceeding $60 million;
• large registered banks, licensed insurers, credit unions and building societies – with total assets exceeding $1 billion (for licensed insurers – where premium income > $250 million); and
• large managed investment schemes – with total assets exceeding $1 billion.

It is expected that some markets (such as insurers and other financial institutions) will see voluntary compliance even if participants are not sufficiently large. 

Compliance framework

The key requirements for CREs will comprise:

• preparing climate statements that comply with the new disclosure framework;
• keeping proper records (that will enable them to prepare climate statements);
• obtaining an assurance engagement in relation to the climate statements – to the extent that those statements are required to disclose greenhouse gas emissions; and
• lodgement of climate statements on the Financial Service Providers Register within 4 months after balance date.

Assurance engagements

Assurance engagements are aimed at independently verifying a CRE’s greenhouse gas emissions (where this is disclosed in a climate statement).

Those CREs that make disclosures of their greenhouse gas emissions have a breathing period, following the start of their obligation to prepare climate statements, for disclosing greenhouse gas emissions (and having that disclosure confirmed through an assurance engagement).  The reasons for this are:

• this is new territory and the professional services market needs time to build capacity to provide this expertise; and
• the most appropriate framework for assurance practitioners is still unknown – whilst the role is like that of an auditor (verifying the accuracy of what is disclosed) the newness of the subject matter means that it is yet to be determined whether such assurance engagements should be undertaken by the accounting profession or there is scope for the other professionals and, if so, the applicable framework (to make sure that their work is equally credible).

No longer comply or explain

Changes have also been made to the ‘comply or explain’ approach under the new regime.  Initially, it seemed that CREs could be exempted – if they determined that they were not materially affected by climate change.  However, the regime as enacted will require all CREs to comply – and to the extent that a CRE has determined that it is not materially affected by climate change, its disclosures (and forward-looking analysis) would note that not many (any?) material risks/opportunities exist.  As a result, the climate statements may state that minimal (or no) changes are expected for the CRE’s governance, risk management, strategy and targets.

On balance, I think this approach is likely to generate better, more comparable levels of disclosure than that seen in the NZX’s initial dabbling in this area (in the corporate governance disclosures required of listed issuers).

The work of the External Reporting Board (XRB)

The XRB started consultation, at the end of last year, on NZ CS 1.  The consultation material describes the XRB’s proposed approach to how NZ CS 1 will mandate standards in respect of a CRE’s governance and risk management frameworks. 

The XRB will seek to align NZ CS 1 with the recommendations of the TCFD.  As a result, the climate standards are expected to be forward-looking and succinct.  And they will seek to be at high-level disclosure and not be overly prescriptive.  This is a pointer to disclosure of the potential impact of the physical risks (and transition risks) of climate change on the CRE.  To date, the most obvious departure from the TCFD recommendations appears to be the inclusion of future as well as current investors as the primary audience for the climate statements.

It is also apparent that the current focus of the disclosures will be inward (i.e. the impact of climate change on a CRE’s business).  However, the market leaders (in Europe) are also looking at outward impacts (the label ‘double materiality’ has been used) – to look not only at the impact of climate change on the CRE’s business, but also the impact of the CRE’s business in contributing to, or mitigating, the effects of climate change (such as through its greenhouse gas emissions or investment and other decisions).

Amongst other things, this will see disclosures on:

• Governance:  Focusing on the level of oversight and monitoring by Boards (and senior management) on climate-related risks and opportunities.  CREs must disclose how the Board accesses expertise, performance metrics for climate-related policies, holds the business accountable on climate-related targets, and processes for making decisions on climate-related issues.  There is a proposal for a description of whether/how climate-related performance metrics are incorporated into remuneration policies.
• Risk Management:  The focus is on how climate-related risks are identified, assessed and managed, and how those processes are integrated into risk management processes.  CREs must disclose the tools and methods used and timelines applied to describe the processes for identifying and assessing climate risk.  Also likely to be required is disclosure of how the CRE determines the significance of climate-related risks – when compared to other business risks.  The objective being to provide a picture of the CRE’s overall risk profile – and the robustness/integrity of its risk management processes.

The role of the FMA

The FMA appear to seek to facilitate a process of capacity-building (aka learning by doing).   This seems to contemplate a period of some year in which it set expectations and support the market (both CREs and the public) to respond to compliance issues and enquiries – and only move to providing guidance at a later date.

Logic would suggest that there will be a few hurdles to overcome before the FMA can move to its more traditional role of supervision and enforcement.  Chief amongst these will likely be the big question of whether/how CREs can access to market data and models from which to build forward-looking scenarios.  This will depend on whether CRE will be required to build capacity internally or there will be access to centralised databases.

As a result, whilst the FMA will have a significant range of enforcement actions available to it under the CRD regime, and climate statements will be subject to the fair dealing rules in the FMC Act, as well as prohibitions on false, misleading and unsubstantiated statements, its work is likely to be focused on education and capacity-building for some time to come.

Getting ready

Realistically, CREs should be using the lead-time to prepare.

The draft sections of NZ CS 1 released by the XRB provide the opportunity to begin preparation ahead of the final standards being published.  And CREs should be building the systems to prepare climate statements in accordance with the expected standards.

Longer term, CREs will need to think about uplifting their governance and risk management processes, adapting strategies and aligning targets and measurement to meet their exposure to climate change risk.   This means looking at risk management processes and questioning if they are sufficiently robust to measure the risk of exposure to climate change and the effectiveness of any mitigation strategies used.