Net Zero Journey and Climate Risks: key guide for SMEs
Posted on: July 12th 2022 · read
SMEs are under growing pressure from boards, investors, capital providers, employees and customers, all calling for stronger commitments to the climate, greater transparency, and more data to support decarbonization and Net Zero claims. The issuance of scope 3 emissions reductions targets by global organisations is expected to cascade and impact a significant number of SMEs across the UK economy. Based on our research we note SMEs do not generally feel equipped to evaluate, quantify and report on climate change.
According to Net Zero for businesses “Progress, not perfection, is key to achieving ambitious climate goals. In 2021, there was a 334% increase in Net Zero commitments among Fortune Global 500 companies – but what gets overlooked is the 60% of companies that still have not set targets for 2030. ”
The UK government has issued ambitious plans to reduce its greenhouse gas emissions to become a Net Zero economy by 2050. To support this ambition, the UK will become the first country in the world to make Task Force on Climate-related Financial Disclosures (TCFD) aligned disclosures fully mandatory across the economy by 2025, going beyond the ‘comply or explain’ approach.
Government Net Zero progress to date
A report by the UK Climate Change Committee (CCC) has warned that there are still significant gaps in the UK government’s Net Zero policy, including sustainable land use and the energy efficiency of buildings. Detailed plans and strategies are still required for waste management, agriculture and achieving full decarbonisation of electricity generation by 2035, the CCC said.
The report includes a number of recommendations to the Department for Business, Energy & Industrial Strategy (“BEIS”) and we have included below the recommendations which are of importance to SMEs:
Across all sectors, for planned regulations and incentives such as carbon pricing, ensure thorough consultation with the private sector throughout the policy development process. Signals of intent should be given well in advance so that the private sector by default moves in step with the UK transition to Net Zero (timing ongoing)
Develop a strategy for engaging with small and medium-sized enterprises (SMES) on decarbonisation, particularly high-emission, low-engagement businesses. Introduce a package of measures within this, including a one-stop-shop for SMEs to get decarbonisation advice with a carbon foot-printing tool, develop a strengthened low-carbon advisor / auditor role for SMEs and develop an effective financing strategy to support SME decarbonisation (timing 2023)
Do not delay in taking steps to legislate for listed UK companies and financial institutions to publish transition plans from 2023. Publish plans for a clear transition plan standard, based on a transparent consultative process with experts, practitioners and private sector actors, and building on lessons learnt from the Task Force on Climate-Related Financial Disclosures (TCFD) (timing 2022)
Building on the Voluntary Carbon Markets Initiative (VCMI) consultation in summer 2022, the Government should develop concrete proposals for standardising and regulating the claims corporates can make relating to offsets, for ensuring the quality and additionality of offsets on the market, and for directing carbon offsets to the highest quality and impact projects (timing H1 2023)
TCFD nutshell overview (4 pillars 11 recommended disclosures)
Governance: How are the board and executive team managing climate-related risks and opportunities?
Strategy: What is the impact of climate-related risks and opportunities, and how resilient is the company’s strategy under different scenarios—for example, an increase in global average temperature of 1.5 or 2 degrees Celsius by 2050.
Risk management: What is the process to identify and manage climate risks, and how does it integrate into the overall risk management process?
Metrics and targets: What is the company’s greenhouse gas (GHG) footprint across scopes 1, 2, and 3? What are its climate targets, and what are the metrics to assess and manage climate-related risks and opportunities?
By 2050, it is expected that organisations must produce close to Net Zero emissions and will neutralise any residual emissions not possible to eliminate by permanently removing an equivalent volume of Co2 using carbon capture technology.
This document contains considerations SMEs should take into account in their Net Zero journey and assessment of climate change on their operations and value chains. In addition, we have included critical queries that can be asked internally to help elevate climate change as a board level issue.
SMEs will be required to have a complete understanding of their carbon footprint, will be pressured to start producing climate change risk impact assessments and to start developing and testing their strategy against transition risks (such as assets being stranded due to the energy transition) and physical risks (assets losing value due to climate-related events like flooding or fires).
What is Net Zero? Or Net Zero explained?
The internationally recognised Science Based Targets Initiative (SBTi) defines corporate Net Zero as:
- Reducing scope 1, 2 and 3 emissions to zero or to a residual level that is consistent with reaching Net Zero emissions at the global or sector level eligible 1.5 degrees aligned pathways.
- Neutralising any residual emissions at the Net Zero target year and any greenhouse gas (GHG) emissions released into atmosphere thereafter.
SMEs should prioritise decarbonisation over and above offsetting their journey to Net Zero.
How do I even start my Net Zero journey?
- Explain internally that TCFD is not a checklist exercise. It is a risk assessment strategic framework to help evaluate the impact of climate change.
- Start to plan how you will approach the measurement of your carbon footprint.
- Set Net Zero targets including a long term SBTi target (targets should be in line with limiting temperature rise to 1.5 degrees).
- Make a commitment to Net Zero by neutralising residual emissions.
- Awareness training to be implemented across all aspects of the organisation.
What queries could we ask the board and/or internally that can facilitate and sharpen the strategy and identify knowledge gaps?
- How aligned is our business strategy to Net Zero?
- How clear are we on the climate-related risks and their impact on our business?
- What are the signposts to watch for that indicate which climate scenario is most likely?
- How are we delivering on decarbonization compared to our peers and customer expectations?
- How fast should our transition be, and how should we prioritize?
- How are we creating value from our low-carbon credentials with our customers?
- What are our shareholders’ concerns on climate, and are we addressing them?
- How does our performance management system encourage decarbonization?
How to successfully start a climate risk assessment:
Do you understand the different types of climate risk that can affect your organisation? i.e What is climate risk? Do we need to engage an external party to provide awareness training?
The Prudential Regulation Authority defines three types of financial risk from climate change: physical risk, transition risk and liability risk.
Physical risks from climate change arise from a number of factors, and relate to specific weather events, such as heatwaves, floods, wildfires and storms, and longer-term shifts in the climate – such as changes in rainfall, extreme weather variability, sea level rise, and rising average temperatures.
“Some examples of physical risks crystallising include increasing frequency, severity or volatility of extreme weather events impacting property and casualty insurance,” the PRA explains in its Supervisory Statement on enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. “And increasing frequency and severity of flooding leading to physical damage to the value of financial assets or collateral held by banks, such as household and commercial property.”
Transition risks can arise from the process of adjustment towards a low-carbon economy.
A range of factors influence this adjustment, including climate-related developments in policy and regulation, the emergence of disruptive technology or business models, shifting sentiment and societal preferences, or evolving evidence, frameworks and legal interpretations.
“Examples include tightening energy efficiency standards for domestic and commercial buildings impacting the risk in banks’ buy-to-let lending portfolios,” the PRA explains. “Or rapid technological change, such as the development of electric vehicles or renewable energy technology, affecting the value of financial assets in the automotive and energy sector.”
Liability risks arise from parties who have suffered loss or damage from physical or transition risk factors and seek to recover losses from those they hold responsible.
For example, the physical risk of flooding affecting the value of property assets can lead to increased credit risks, particularly for banks, or to underwriting risks for liability insurers, if it results in legal claims to recover financial losses from this physical damage.
There is a transition risk that companies in the wider economy who fail to mitigate, adapt, or disclose the financial risks from climate change will be exposed to climate-related litigation.
This could impact their market value or lead to higher claims for insurers that provide liability cover to those companies.
“The legal risks from climate-related liabilities can be of particular importance to insurance firms, given these risks can be transferred through liability protection, such as directors’ and officers’ and professional indemnity insurance,” the PRA says.
Do you understand the TCFD challenges that you may encounter?
Beyond the fundamental questions of strategy and governance included in the TCFD, several challenges remain that should be considered by SMEs when developing their Net Zero journeys. These include:
Short-term data vs long-term impact: climate forecasting is not perfect and it is based on future events. There is a lack of historic data to model the impact of climate change over the long-term and to quantify its potential financial impact over a range of different scenarios.
Should we create our own scenarios or use something off-the-shelf?
The official TCFD advice on this point isn’t particularly strong – they note that companies can use publicly available scenarios, develop their own, or a combination of both. If anything, the TCFD guidance appears to lean towards companies developing their own scenarios, especially for heavy emitters that need to stress test specific business risks.
Climate change beyond borders: identifying and measuring physical risks is extremely complex. SMEs with complex global supply chains will need to take location-specific risk into consideration.
Understanding your supply chain approach to climate change
It is critical for SMEs to start the process of understanding their suppliers climate change practices and how they manage the related risks and opportunities today (e.g. is there a sustainability risk framework).
Implementing a standardised climate change impact assessment questionnaire that can be shared with your suppliers can help identify risks. This could be an effective solution to record and assess your suppliers’ climate standing, as well as comparing it to other suppliers.
Adopting a risk-based approach
The approach towards the review and subsequent monitoring of climate related risks should be commensurate with the level of risk they pose. To achieve this, SMEs should have a process in place to screen all risks identified and assign a score to each risk depending on their magnitude and likelihood.
These assessments can help SMEs make hard choices sooner rather than later and identify the signposts that will inform future decisions.
Final considerations (challenges ahead)
Recent CDP data found that only one in 20 listed companies have strong targets to reduce emissions, water use and deforestation impact, and around 50% of greenhouse gas emissions reported aren’t covered by science-based targets to align with keeping climate change to 1.5°C. The following are final considerations SMEs should consider:
- Do we have the right financial and operational set up?
- How will we inspire people to trust that we will deliver our climate ambition?
- How will we measure our total value chain emissions?
- How can we communicate progress internal and externally?
- How will we set the right targets?
- How will we know if we are making progress, and if we are on track?
- Encourage discussion at Board level, and get the right teams involved.
- Look at what you’re already saying and consider what’s missing.
- Set out a plan to work up to full disclosure – this doesn’t all have to be in-year
- Avoid boilerplate disclosure. Stay strategic and material, and remember – less is more.
- Talk to the specialists, not the people who think they are specialists. Listen to the narrative and thought leadership from sector leaders.
- Listen to what your peers are doing and talk to them.
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If there are any topics raised in this article that you would like to talk to us more about, please do get in touch