Net Zero, Transition Risk and Sustainability Disclosures

Have you been hearing more companies committing to Net Zero? What is Net Zero? How could Net Zero impact our portfolios?

The Paris Agreement, which Pembroke publicly supports [1], calls for countries to limit global warming to well below 2⁰ C  and preferably less than 1.5⁰ C compared to preindustrial levels. To achieve this objective, it is estimated that global CO₂ emissions must be reduced by 45% from 2010 levels by 2030, and then to “Net Zero” by 2050. [2]  In 2021, energy-related global CO₂ emissions were estimated not to have fallen, but rather to have reached their highest level ever, 36.3 billion tonnes. [3]

As the gap between the current level of global emissions and the 2030 target grows wider, the risk grows of what the Principles for Responsible Investment (PRI) call the “Inevitable Policy Response”. Such a response refers to the risk of accelerated government policies, including carbon pricing to disincentivize carbon-intensive industries and incentivize alternatives, and constitutes one of the many “transition risks” faced by companies.

To understand our portfolio exposure to decarbonization and transition risk, Pembroke collects estimated and reported CO₂ emissions data for its holdings. This data is provided by third-party vendors and thus can be subject to error. As an analyst, it is frustrating to collect a company’s CO₂ emissions data from two third-party sources and the company itself, only to end up with three different numbers.

Many companies do not report emissions. That is one reason Pembroke conducted a survey late last year asking all of its companies if and when they would begin reporting climate risks and opportunities according to the Task Force on Climate-Related Financial Disclosures (TFCD) framework (See Pembroke Perspectives Q1 2022).

The TCFD framework sets out four thematic reporting areas: Governance, Strategy, Risk Management, and Metrics and Targets—each with recommended disclosures. If companies disclose emissions and sustainability data in a common framework, investors will be able to compare third-party-reported information with company-reported information, reconcile differences, and  more confidently draw conclusions about the potential impacts of climate risks and opportunities on the value of their investment portfolios.

The harmonization of global climate reporting should receive a major boost as the International Sustainability Standards Board (ISSB) finalizes its IFRS Sustainability Disclosure Standards. The ISSB was announced at COP26 in Glasgow in November 2021. It operates as one of the two standard-setting boards, along with the IASB (International Accounting Standards Board), for International Financial Reporting Standards (IFRS) under the IFRS Institute. In April, the IFRS Foundation announced the establishment of the Montreal centre of the ISSB, which is expected to play a major role in the board’s North American activities.

In July, Pembroke participated in a roundtable discussion organized by the Financial Reporting and Assurance Standards (FRAS) Canada and the PRI. The discussion was part of an outreach to gather input from investors, preparers and service providers about the ISSB exposure drafts. The roundtable group addressed some of the concerns investors have about sustainability-related financial disclosures.

The harmonization of sustainability-related financial disclosures should create the framework for publicly traded companies and issuers of debt to provide consistent, decision-useful information about their CO₂ emissions, and climate-related risks and opportunities. Investors should be able to use that information to draw conclusions about the exposure of companies to transition risk and their level of preparation, resilience and flexibility in the face of a rapidly changing policy environment.

Pembroke expects carbon pricing instruments, whether in the form of carbon taxes or emissions trading systems, to be an increasingly important policy tool. According to the World Bank’s State and Trends of Carbon Pricing 2022, there are 68 carbon pricing instruments operating globally. [4] According to this report, carbon prices must rise further to meet the Paris Agreement goals and there are cross-border adjustment mechanisms and harmonization efforts under way, as well as calls for an international carbon pricing floor.

In conclusion, Public Net Zero commitments by countries and companies, the harmonization of sustainability disclosure standards, and the possible convergence of global carbon pricing will increase the transparency of possible or implied carbon-related expenses or liabilities. This information may have significant implications for the enterprise value of some companies. As long-term investors focused on growth and innovation, Pembroke is working to understand the risks and opportunities posed by Net Zero and the associated decarbonization of the global economy.

 

[1] https://private.pml.ca/2021-q3-why-pembroke-supports-paris-agreement/

[2] https://www.un.org/en/climatechange/net-zero-coalition

[3] https://www.iea.org/news/global-co2-emissions-rebounded-to-their-highest-level-in-history-in-2021

[4] The World Bank. 2022. “State and Trends of Carbon Pricing 2022” (May), World Bank, Washington, DC. Doi: 10.1596/978-1-4648-1895-0. License: Creative Commons Attribution CC BY 3.0 IGO

 

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