On March 24, 2021, the Department for Business, Energy and Industrial Strategy (BEIS) published a consultation document seeking views on proposals to mandate climate-related financial disclosures by publicly quoted companies, large private companies and limited liability partnerships (LLPs).
The proposals build on the expectation set out in the Government’s 2019 Green Finance Strategy, that all listed companies and large asset owners should disclose in line with the Task Force on Climate-related Financial Disclosure (TCFD) recommendations by 2022. They have been developed in co-operation with the HM Treasury-led TCFD joint taskforce, which has considered an approach to economy-wide mandatory climate-related financial disclosure, as set out in the Roadmap and Interim Report published in November 2020, and the proposals should contribute towards the UK’s intention to become the first G20 country to make TCFD-aligned disclosures mandatory across the economy.
Responses to the consultation are requested by May 5, 2021. If confirmed, the necessary regulations will come into force on April 6, 2022, and will be applicable for accounting periods starting on or after that date.
Climate change as a financial risk
The consultation paper notes that climate change poses risks to companies, financial institutions and individuals, with both physical and transition risks potentially having material impacts on the value of companies and their assets. Physical risks are described as those arising from the climatic impact of higher average temperatures (such as the increased frequency and severity of extreme weather events), whilst transition risks are described as those arising from the changes in technology, markets, policy, regulation and consumer sentiment which will result from the UK’s transition to a low-carbon economy.
Disclosure as a mechanism for change
One of the aims of the Government’s Green Finance Strategy is to ‘green’ the UK’s financial system with disclosure an important means of achieving this, i.e. how organisations will manage the material financial risks and opportunities arising from climate change should improve transparency and encourage more informed pricing and capital allocation.
Over time, it is felt that increased (and better) disclosure of material climate-related financial information will influence behaviours of companies and their stakeholders. By becoming better able to compare companies’ exposures to climate-related risks and opportunities, investors will be better equipped to incorporate these risks into their investment and business decisions and other stakeholders will have greater information to help them with relevant decisions.
The Government also considers it essential for appropriate behaviours to be embedded into organisational culture so that climate change is considered at all levels of an organisation and for this behavioural change process to be applied across all economically significant companies and LLPs. It sees the TCFD recommendations as useful in promoting this organisational change.
TCFD recommendations as framework
The TCFD recommendations are considered to be one of the most effective frameworks for companies to analyse, understand and ultimately disclose climate-related financial information against. As a result, it is proposed to use the TCFD’s four-pillar framework of Governance, Strategy, Risk Management and Metrics and Targets as the basis of the new disclosure requirements, with adjustments made where necessary to make the requirements consistent with UK company law. This is in line with a recent change to the Listing Rules made by the Financial Conduct Authority (FCA). For financial years beginning on or after January 1, 2021, commercial companies with a premium listing are required to ‘comply or explain’ against the TCFD’s four pillars and 11 recommended disclosures.
Alignment with other actions by Government departments and regulators
The proposals in this consultation paper are in line with a number of other steps being taken by the Government and other regulators.
As well as the action taken by the FCA referred to above, BEIS published a further consultation document, Restoring Trust in Audit and Corporate Governance, earlier in March 2021. That consultation (the Audit and Governance Consultation) includes a proposal for extending the definition of Public Interest Entities (PIEs) to include large companies within certain size limits, including large UK private companies and large UK AIM companies so that they would become subject to the more stringent corporate reporting and audit requirements that apply to PIEs. The Audit and Governance Consultation also proposes the introduction of a mandatory resilience statement to be prepared by PIE directors. This would address business resilience over the short-, medium- and long-term and views are sought in the Audit and Governance Consultation on whether the impact of climate change on the company’s business model and financial planning should be specifically addressed in the resilience statement, including in the long-term section. This would mean that the resilience statement could be used as a vehicle for disclosures consistent with the TCFD recommendations in the future. BEIS notes that while the timing of those reforms proposed in the Audit and Governance Consultation and implementation of the proposals set out in this consultation paper may differ, it believes that the approach to climate-related financial disclosures should be consistent with that envisaged by the wider reform programme.
BEIS also refers to ongoing consultations with a view to requiring Occupational Pension Schemes to make climate-related disclosures and the requirements on banks, building societies and insurance companies which are subject to a Supervisory Statement on climate-related financial risks, published in 2019, by the Bank of England’s Prudential Regulation Authority (PRA), with further guidance included in a “Dear CEO” Letter, issued by the PRA in July 2020. BEIS notes that the PRA is to assess the need for further measures in 2022, but believes that in both instances, its proposals will support the financial institutions in question.
In addition, BEIS is seeking views on how best to simplify the interaction of the proposed TCFD requirements with the Streamlined Energy and Carbon Reporting (SECR) framework which requires large UK companies and large LLPs to make disclosures on energy use and emissions in their annual reports, as well as ways in which the SECR obligations may be changed to make them more effective.
Companies and LLPs to be in scope of new reporting requirements
It is proposed that economically and/or environmentally significant companies should be within scope for the disclosure requirements and these are not just companies traded on a regulated market. As a result, it is intended that the following should be in scope:
- All UK companies that are currently required to produce a non-financial information statement, being UK companies that have more than 500 employees and have transferable securities admitted to trading on a UK-regulated market, or are banking companies or insurance companies (these are PIEs with more than 500 employees);
- UK-registered companies with securities admitted to trading on AIM with more than 500 employees;
- UK-registered companies which are not included in the categories above, which have more than 500 employees and a turnover1 of more than £500m; and
- LLPs which have more than 500 employees and a turnover of more than £500m.
Proposed mechanism for implementing the requirements and location of disclosures
The changes would be implemented through a Statutory Instrument, using powers under the Companies Act 2006 (CA 2006) and powers under the Limited Liability Partnerships Act 2000.
For companies, Sections 414A to D and Sections 414CA and CB CA 2006, which require certain companies to produce a non-financial information statement as part of their Strategic Report, would be amended so as to require the reporting of climate-related financial information in that non-financial information statement. As far as LLPs are concerned, only traded LLPs or banking LLPs are required to produce a Strategic Report, while large LLPs have to produce an Energy and Carbon Report under SECR, which forms part of their annual report2. As a result, BEIS is seeking views as to whether the Strategic Report or Energy and Carbon Report would be the more suitable place for the reporting of climate-related financial information by LLPs in scope.
Disclosure obligations proposed and required level of detail
As mentioned above, the regulations will require companies and LLPs in scope to disclose climate-related financial information in line with the four pillars of the TCFD recommendations, Governance, Strategy, Risk Management and Metrics and Targets relating to climate risks and opportunities. The regulations themselves will not require or prescribe the disclosure of climate-related financial information in line with the 11 more detailed TCFD recommendations, as the FCA’s Listing Rules now require. This is because BEIS believes that some of the recommendations are at a level of granularity that would be inconsistent with current legislative requirements in the Strategic Report, and it also provides a proportionate approach which recognises the greater resources and expertise that listed companies generally have access to, while still making a significant improvement to the reporting of the non-listed companies within scope.
It is proposed that the specific disclosures required will be as follows:
- Governance - A description of the governance arrangements in place to identify and manage risks and opportunities arising from climate change will be needed, together with information about who has operational responsibility for climate change (including the experience of that executive or committee) and, if the company has an audit committee, whether climate change is a matter considered by that audit committee.
- Strategy - A brief description of the company’s business model and strategy (to the extent that the company is not already required to report such information) will be required, as well as a description of how the company’s business model and strategy may change in response to effects relating to climate change, and the trends and factors that affect this change.
- Risk Management - A description of the principal risks and principal opportunities, including material financial risks and opportunities, relating to transition risk, physical risk and regulatory risk arising from climate change which may affect the business and a description of how the company manages those areas of risk and opportunity will be required. This will need to include a description of its business relationships, products and services which are likely to cause adverse impacts in those areas of risk, and a description of how it manages the principal risks. In addition, a description of the risk management policies pursued by the company in relation to climate change, any due diligence processes implemented by the company in pursuance of those policies and a description of the outcome of those policies will be required.
- Metrics & Targets - A description of the key performance indicators relevant to the entity’s exposure to climate change risk and opportunity, and the targets set by the business for those key performance indicators will be needed3.
BEIS notes that the current requirements relating to the Strategic Report only require disclosure of information that is material to a company. However, if required climate-related financial disclosures are not made, it proposes that the non-financial information statement must provide a clear and reasoned explanation for the omission. In this explanation the company or LLP would have to state why climate change is not expected to materially affect the company’s business model or strategy and provide a reasoned explanation of the basis on which it has come to this position.
Scenario analysis will also be encouraged but will not be required in a company’s or LLP’s annual report and accounts. BEIS recognises that this is one of the most challenging areas of the TCFD recommendations and while some companies are quickly developing capabilities in this area, there remains a significant skill and expertise gap for many companies. Where companies are already able to produce quantitative scenario analysis, they will be encouraged to continue to disclose their outputs to support the disclosures provided in the Strategic Report.
So far as alignment with SECR requirements is concerned, BEIS notes that the reporting exemptions under the SECR framework have caused issues for those such as corporate groups that are made up of both quoted and unquoted entities. In light of this, as part of the consultation process it seeks views on whether an amendment to the SECR regulations to align the SECR reporting requirements on quoted companies and large unquoted companies and LLPs would be beneficial.
Timing of new reporting requirements
The aim is for the necessary regulations to be made by the end of 2021. They would come into force on April 6, 2022, and be applicable for accounting periods starting on or after that date. As a result, companies in scope with a December 31 year end would need to comply for the first time when preparing their Strategic Report for the year ended December 21, 2023.
BEIS will review the case for expanding the scope of the regulations in 2023.
Guidance on application of the requirements
Non-binding Q&A are to be produced to support companies in their application of the new reporting requirements.
Enforcement of proposed duties
There are already general enforcement provisions in both the CA 2006 and the relevant LLP regulations which deal with a failure to prepare or file a relevant report. In addition, a director of a company or a member of an LLP is liable to compensate the company or LLP for any loss suffered as a result of any untrue or misleading statement in the Strategic Report or the Energy and Carbon Report if the director or member knew that the statement was untrue or misleading or was reckless whether it was untrue or misleading. Further, if the Secretary of State or the Financial Reporting Council believe that the reports do not comply with the requirements of the CA 2006, then they can apply to the court for an order requiring the preparation of revised accounts and/or reports. Since these existing provisions will apply to the new duties in connection with climate-related financial disclosures as the new duties will form part of the Strategic Report or the Energy and Carbon Report, BEIS is not proposing, at this stage, to introduce new monitoring or enforcement powers but is seeking views on this.
While listed companies are already having to ensure that their existing climate governance and risk processes comply with and can be mapped against the TCFD recommendations framework, and that there are no gaps in their environmental and climate reporting under, among other things, the CA 2006, the Listing Rules, the UK Corporate Governance Code and now the TCFD recommendations, large private companies and LLPs in particular are likely to be some way behind in having such policies and processes in place. There will be a number of challenges for them to overcome in ensuring compliance if the proposals are implemented as intended in the consultation paper, not least ensuring they have the necessary systems in place to be able to track climate change-related targets and progress in meeting them. Businesses should therefore carefully consider the applicability of this consultation to them, including analysing any relevant impacts and any gaps that may need addressing.
Those who are not prepared may risk challenges from the regulator, shareholders and other stakeholders. Failure to include climate-related disclosures in the Strategic Report (or the Energy and Carbon Report where applicable), or disclosures that are untrue or misleading could result in claims for compensation against the company and/or directors in their personal capacity, as well as sanctions from the regulator, shareholders or members and/or a requirement to prepare a revised report.
Across our Legal, Technology and Risk Consulting teams we have significant experience of supporting businesses with change programmes and sustainable finance initiatives and requirements. This includes supporting organisations with assessing impacts, conducting gap analyses, building programme plans to deliver the required changes and providing ongoing support across them, both from the perspective of resource and expertise to help carry them out and also supporting businesses with their governance, oversight and reporting processes as they progress these activities.