The need for carbon risk disclosure
The committee received substantial evidence about potential carbon
risks. The committee accepts the analysis that the physical risks of climate
change, along with the challenge of transition to a lower carbon world, present
material risks to Australian businesses. The committee also notes the evidence
that rapid changes in price arising from unexpected negative events (including
events or trends associated climate change) can result in volatility which
under some circumstances can present risks to financial stability.
This should not be taken to mean that the committee believes that all or
even most of the specific risks presented to it by submitters will necessarily
eventuate. This is inherent in the nature of risk. Likewise, caution ought to
be exercised in assessing the scale and financial significance of these risks.
The committee accepts that the most accurate pricing of these impacts is likely
to be provided by the market in an environment characterised by disclosure of
The committee considers that there are different ways that businesses
can effectively respond to carbon risks, and does not consider this report to
be an appropriate vehicle for dictating which particular methods should be
adopted. Instead, the focus of this committee is on the a priori need
for businesses to have strategies for managing carbon risk, that are informed
by proper analysis (and disclosure of) the risks facing them.
This chapter sets out the rationale for corporate disclosure, and some
of the key forms of carbon risk facing Australian businesses.
Investors need to be fully informed about the circumstances of a company
in order to make optimal decisions about where to invest. Investment
opportunities can be assessed only if all the relevant information is
available. As one submission puts it, 'Disclosure is the oil in the engine of
the financial system'.
Investors may have reasons other than profit maximisation for wanting
information. For example, the ethical, environmental or distributional
consequences of the actions of a company they are thinking of investing in may
be material to them, regardless of financial returns.
Governments may also require information for policy or administrative
reasons. For example, they may need information about carbon emissions in order
to manage them or to demonstrate that they are meeting international targets.
This report considers only the financial risk associated with carbon,
and only incidentally considers the values involved in amelioration of carbon
Firms have an incentive to disclose some information in order to attract
Further, a lot of information is available from other sources.
However, there is an asymmetry in the relationship between the firm and
potential investors. A firm has access to all of its operating information,
whereas in the absence of disclosure investors do not know what information is
available, and will incur costs in obtaining information that they seek.
There is also an agency problem. Investors generally do not play a
direct role in the management of a firm. The interests of the managers of the
firm do not necessarily coincide with those of the investors.
In particular, the time horizons of investors and directors may be quite
For example, many bonus payments for managers and directors are based on
short-term performance measures.
Adequate information is also critical in supporting financial stability.
At the macroeconomic level, financial stability exists when 'financial intermediaries,
markets and market infrastructure facilitate the smooth flow of funds between
savers and investors and, by doing so, help promote growth in economic
activity'. Safeguarding financial stability involves reducing vulnerabilities
in the economy, and these vulnerabilities are often associated with how
financial market participants price and manage risk.
Risk is measured by the likelihood that an event will happen, weighted
by the consequences of its happening. Thus the risk posed by an extremely unlikely
but catastrophic event may be the same as that posed by a more probable but
less disastrous event.
Market participants cannot price risk accurately without full
information disclosure. For example, estimates of the value of an asset can be
weighted by the risk of loss or damage to that asset. This requires
transparency as to risk. Transparency takes the form of corporate disclosures
Financial stability may be threatened when events which were
unanticipated or the risk of which was underestimated impact upon the economy,
causing sudden, sharp price adjustments.
Because of the asymmetry and agency problems, governments have often
mandated disclosure of relevant information including financial statements. The
objective is to ensure that investors are able to compare the returns available
to them, and to see if a firm is managed well. By ensuring that individual
investors are informed, disclosure rules assist in the efficient allocation of
capital throughout the economy, as well as supporting financial stability by
minimising potential for rapid, destabilising price adjustments.
In addition, various bodies with interest in, or responsibility for,
corporate performance also require some levels of disclosure. For example,
stock exchanges and professional organisations may have such rules.
In deciding whether and how to mandate disclosure, governments—and other
bodies with the power to demand disclosure—have to decide what information
should be disclosed, in what level of detail, and over what time horizon.
To be useful in decision making, information disclosed by companies must
be 'consistent, reliable, comparable and clear'.
In recent years there has been a trend towards making disclosure more
uniform, and aligning Australian financial disclosure with overseas norms,
through the work of the Australian Accounting Standards Board and the adoption
in 2005 of the International Financial Reporting Standards.
There is some evidence that higher levels of disclosure are associated
with better individual corporate performance, although it is difficult to
separate the effects of disclosure from actual performance, and to allow for
selection bias where voluntary disclosure is involved.
CPA Australia acknowledges these difficulties in reporting its own study, which
also showed very positive effects from 'solid ESG practices', that is, sound
practices for reporting on environmental, social and governance performance.
One result of improved disclosure appears to be a focusing of attention
which leads to different ways of seeing things and thence to innovation and by
that means to better corporate performance.
What is carbon risk?
Carbon risk is a shorthand term for risks to a company from climate
change. It does not refer simply to the immediate effects of climate change
itself, but also to the financial effects of regulatory change or changes in
The Prudential Regulation Authority of the Bank of England has developed
a categorisation of climate change risks which has been adopted in several of
the submissions to this inquiry. It comprises:
physical risks, including first-order risks of assets being
destroyed by cyclones or agricultural land being rendered useless by prolonged
drought, and second-order risks such as disruption to supply chains;
transition risks, which could arise from the transition to a low
carbon economy, for example the risk that it may not be possible to develop
coal reserves if carbon pricing renders them uncompetitive with other sources
of power; and
liability risks, where people who suffer damage from climate
change seek redress from those they believe are responsible.
It is difficult to definitively link any specific weather event to
carbon emissions. However there is a substantial and growing body of evidence
documenting observed changes in weather patterns attributable to anthropogenic
warming. They include increases in the number, duration and intensity of heat
waves, extreme high sea levels, strong cyclonic winds and an increase in the
number of extremely high rainfall events. These translate to health risks,
bushfires, and flooding by both rivers and the sea.
While quantification is difficult, the magnitude of the physical damage
that could result from global warming is vast. The effects are already being
The number of registered weather-related natural hazard loss
events has tripled since the 1980s and inflation-adjusted insurance losses from
these events have increased from an annual average of around US$10 billion in
the 1980s to around US$50 billion over the past decade.
The damage and loss are partly due simply to the destruction of assets.
However, the economic damage caused by disruption of global supply chains, such
as occurred when floods in Thailand destroyed factories producing electronic
components, can be at least as great.
The impact of physical events can wash through the financial system. For
example, losses that are claimed against insurance can lead insurance companies
to refuse insurance to properties in vulnerable areas. This can reduce the
value of properties, and if they are held as collateral it can lead to losses
by banks. 'Fire sales' of assets by either insurers or banks could lead to
further losses in either or both sectors.
In December 2015, nearly 200 governments agreed to take action to limit
the increase in the global average temperature to well below 2°C above
pre-industrial levels, and to try to limit it to 1.5°C—the 'Paris Agreement'.
The agreement came into force last year after it was ratified by the required
number of countries. Each country will decide on particular measures to achieve
the targets they have set themselves.
Transition risks include the risk that regulation intended to reduce
carbon emissions will reduce demand for a product. Companies could be affected
by regulation in Australia but they may be more exposed to risk from the
transitions away from fossil fuel taking place elsewhere.
There have been various calculations of what the impact of international
actions to meet the Paris targets might be. For example, two submissions
suggest that for the 2°C goal to be met, 80 per cent of proven fossil fuel reserves
would need to remain in the ground in order to limit emissions.
Should these constraints remain unresolved by technological
developments, companies may find themselves with assets whose value is impaired
by changing patterns of demand. This will affect not only the companies that
own the assets, but also companies and funds that own shares in them.
Transition risks also include indirect risks, such as the risk of
reputational damage, both at a national level and for individual businesses.
Consumers may avoid companies and brands which are seen as not behaving
In the extreme case, trade or other sanctions could be imposed where a
country is perceived as not bearing its share of the cost of emissions
reduction. The National Institute of Economic and Industry Research assesses
the risk of punitive measures against Australia as greater than 50 per cent.
In addition to physical and transition risk, further risks to companies
could arise where it is found that directors of companies or trusts financially
or otherwise affected by carbon risk could have, but did not, take steps to
reduce their exposure to that risk or, more importantly, did not disclose that
A legal opinion obtained by the Centre for Policy Development concludes:
...it is likely to be only a matter of time before we see
litigation against a director who has failed to perceive, disclose or take
steps in relation to a foreseeable climate-related risk that can be
demonstrated to have caused harm to a company...
As noted above, it is difficult to link specific events or actions to
specific climate-related events. However, it is conceivable though in no way
certain that, in the future, carbon extracting and using firms could be held
responsible for damage due to climate change.
The Financial Stability Board's Task Force on Climate-related Financial
Disclosures, in its Recommendations Report, includes a useful summary of
analyses of sectors and industries affected by climate related risks.
Australian exposure to carbon risk
The committee heard evidence that as a resource dependent economy,
Australia is arguably particularly highly exposed to carbon risk.
Coal is our second biggest export, after iron ore, and constitutes over
11 per cent of exports by value. Natural gas is our fifth biggest
Although there will be some level of continuing need for coking coal, both
thermal coal and natural gas are likely to see reductions in demand as the
Paris targets are implemented. A submission to this inquiry asserts that 'The
seaborne thermal coal market is in structural decline.' It estimates that up to
US$70 billion of investment planned for the next decade in fossil fuel is
unneeded, and assets could be stranded.
Agriculture is also exposed to climate risk. The World Economic Forum
has warned that global warming has put agricultural productivity in Australia
For example, modelling has suggested that an increase in average temperatures
of more than 2°C would see the majority of agriculture in the Murray-Darling
basin wiped out.
Over 5 per cent of Australia's exports—$16 billion a year—is accounted
for by 'Personal travel (excluding education) services', mostly tourism, making
it the sixth biggest export.
Domestic tourism is also an important contributor to GDP. Specific tourist
attractions like the Great Barrier Reef are endangered in the long term by
Tourism can be temporarily disrupted by cyclones and floods.
A large component of the nation's savings is held by superannuation
funds. One submission notes that 'the average Australian pension fund maintains
investments in the causes of climate change, leaving it exposed to carbon risk'.
The UK Prudential Regulation Authority has observed that for these entities, it
is not easy to deal with carbon risk by the usual methods of diversification
and hedging, because the risk is systemic.
Small investors—self-managed superannuation funds and individuals—may be
at greater risk because they do not have access even to those methods of
diversification. They may not be able to purchase, or have the skills to
analyse, the data that big investors use.
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