Governing Climate Materiality Assessments

Material Climate Risk and Opportunity Assessment

The board's stewardship role in preserving and delivering value for shareholders innately means addressing climate as a key financial risk facing businesses. Fundamental to a board’s ability to make informed decisions on climate risk and opportunities is assessing what is material to the business. This article explores the significance of this guidance in the US context , delves into industry-specific examples, examines leading practices, and outlines key questions for boards.

“The board should ensure that management assesses the short-, medium- and long-term materiality of climate-related risks and opportunities for the company on an ongoing basis. The board should further ensure that the organization’s actions and responses to climate are proportionate to the materiality of climate to the company.”

Principle 4, How to Set Up Effective Climate Governance on Corporate Boards
World Economic Forum

The Evolving  US Context

In recent years, there has been a significant  shift in the regulatory landscape propelling the United States toward  decarbonization.  This momentum began in 2021, when the US rejoined the Paris Agreement, and continued with the Inflation Reduction Act of 2022, the largest investment in clean energy and climate action in history. More recently, legislation has focused on climate-related disclosure with California’s climate laws in 2023 and, most recently, the SEC climate ruling in 2024. This regulation plays a pivotal role in shaping how and the urgency with which companies perceive and address climate-related risks and opportunities.

However, the climate-related disclosure regulations at the US federal and state level and European regulation vary in scope, detail, and timelines, which creates challenges for management teams and board oversight if companies active in multiple jurisdictions. With regard to materiality and the requirements for assessment of climate-related risks and opportunities, there are notable differences.

1. The SEC and California climate rules are guided by financial or investor materiality while the EU Corporate Sustainability Reporting Directive (CSRD),   relevant for public and private US businesses with material operations in Europe, is guided by both financial and impact materiality and extends across an array of environmental, social, and governance (ESG) topics.
2. While both the SEC climate rule and California’s rule will accept a qualitative assessment of material climate-related financial risks and do not require disclosure of opportunities, CSRD is far more rigorous, requiring companies to financially quantify the impacts of both climate-related risks and opportunities and to conduct a double materiality assessment.
3. Finally, the CSRD requires certain climate-related disclosures irrespective of materiality, such as a company’s processes, including its use of scenario analysis, to identify and assess climate-related impacts, risks, and opportunities.
4. While not discussed here, it is worth noting that with regard to greenhouse gas  emissions reporting, the SEC requires scope 1 and 2 if material; California (via CCDAA) requires scope 1, 2, and 3 regardless of materiality; and CSRD requires scope 1, 2, and 3 unless there is a detailed explanation as to why climate is not material.

While challenging, the role of the board to oversee and be accountable for the assessment, management, and integration of material climate risks and opportunities is even more important given the inconsistencies in regulation. Boards must be vigilant to ensure regulatory requirements do not become a distraction and stall forward progress on the capacity of the organization to assessment climate risk and build climate-resilient businesses.

Value of Materiality Assessments: Industry-Specific Examples

Examples from various industries highlight the value of the insights gained through conducting a climate risk and opportunity assessment for both physical and transition risks.

Physical risk assessment

A physical risk assessment by an aerospace company identified that one of its greatest risks is from rising temperatures. Expected increases in heat can cause buckling of railroad tracks, which could in turn critically damage the company’s finished product, which is transported by rail. To mitigate the risk, the company evaluated alternative means of transport and routes.

A global alcoholic beverage producer and distributor identified rising temperatures and drought as a  significant risk to their ability to meet organic growth targets. Specifically, they faced a reduced clean water supply and lower agave yields in Mexico. To address these issues, the company made significant investments to diversify sources of water and expand agave planting in more optimal growing regions.

In both cases, the companies identified significant risks to the business that were not otherwise on their radar. They financially quantified the impact of these risks and compared that analysis to other top risks. Armed with this information, and considering their risk tolerance, they took actions proportionate to the materiality of the risks to avoid and reduce risk exposure. Given the materiality of these risks, these were strategic, board-level conversations to determine the appropriate risk mitigation plan.

Transition risk assessment

Consider the mining industry, and how even within the same industry there can be sufficient upside for some and significant downside for others in the transition to a low-carbon economy. An iron ore miner may lose value driven by a likely reduction in demand for steel stemming from an increase in the lifetime of steel infrastructure as well as an increase in the availability of scrap steel. On the other hand, a copper miner may experience growth during the transition as the expansion  of electricity networks, renewables, and other electric technologies necessary to decarbonize energy systems use more copper as a raw material.

By conducting transition risk assessments, companies can identify risks and opportunities and take action to better position and protect the business, for example, by divesting from at-risk assets or investing in new business lines or growth strategies. This is fundamentally a question of business strategy, which requires engagement and oversight at the board level.

Leading Practices in Climate Risk Assessment

Board members and management of leading companies recognize the strategic value of a climate risk and opportunity assessment, regardless of disclosure requirements, to enable better risk management, improved resilience, and creation of business value over the long term. These companies are implementing the following leading practices:

1. Define Board Governance: As an aspect of business strategy, climate risks and opportunities should be owned by the full board. Board committee oversight and remits should be clearly mapped, ensuring there is clarity around responsibilities and how committees work together—it cannot be delegated fully to one committee. The board should have adequate understanding and knowledge to assess the potential impact of climate-related risks and should be kept up to date on relevant climate risks and opportunities on a quarterly basis.
2. Engage Stakeholders: Engage a diverse set of stakeholders to coalesce around the appropriate definition of “material” for the business. Gather multiple perspectives on risks and opportunities across risk, sustainability, finance, strategy, legal, business leaders, investors, and other external stakeholders throughout  the value chain.
3. Integrate into Enterprise Risk Management (ERM): Recognizing climate as a material financial risk and integrating it into ERM frameworks enables companies to identify, prioritize, and mitigate material risks effectively. Utilize impact scales that are relevant to your business and reflect your risk tolerance in order to understand what is material or consequential to the business. Communicate risks and opportunities in terms of financial impact and likelihood, and differentiate financial impact to the P&L versus the balance sheet.
4. Use Various Time Horizons and Scenarios: A climate risk assessment should cover short-, medium-, and long-term time horizons, and various global warming and best-to-worst-case scenarios should be considered.
5. Consider Physical Risk Across Assets and Supply Chain: A physical risk assessment should evaluate the physical climate risk exposures to a company’s portfolio of assets as well as its supply chain, and identify exposed locations and the assets most at risk.
6. Consider Transition Risk and Opportunities Across the Full Value Chain: A transition risk assessment should identify and prioritize a company’s exposure to transition risks and opportunities across the full value chain, aligned to the categories of policy and legal, technology, market, and reputational risk categories (in accordance with TCFD).
7. Quantify Material Risks Using Robust Data and Methods: Where risks are material, quantify the financial impact. If possible, model financial impacts to revenues, costs, asset values, cash flows, and equity valuation. Financial quantification puts dollar figures against exposures and also lays out options for mitigating risks, facilitating better, more informed strategic decisions. Understandably, many companies are reluctant to put a financial figure to climate risks. Applying a rigorous process with robust data sources and methods of quantification will reduce the level of uncertainty as much as possible and instil confidence in internal and external stakeholders.
8. Integrate Findings into Strategy, Financial Planning, Risk Management, and Disclosure in a consistent and coordinated way.

Questions for Boards to Consider

With climate governance responsibilities now mandated by SEC regulation, boards play a pivotal role in steering companies toward climate resilience and sustainable growth. Key questions boards should consider regarding climate risk and opportunity assessments include these:

• How does our company identify and assess material climate risks and opportunities across the value chain?
• Are strategic priorities aligned with long-term climate resilience and the transition to a low-carbon economy?
• Are incentives across the business aligned with effective assessment and management of climate risks and opportunities for the business (and not at odds with them)?
• What measures are in place to integrate climate considerations into decision-making processes and capital allocation strategies?
• Who is ultimately accountable for effective climate risk identification and management, and is there sufficient cross-functional engagement and alignment on approach and ambition?
• How is the board kept informed, and what steps are being taken to enhance board oversight and accountability in managing climate-related risks and opportunities?
• Are responsibilities across the board committees clearly defined, as well as a means of collaboration on climate risks and opportunities?
• Do we have adequate competencies among the board and senior management to manage climate risks?

US companies operate within an ecosystem where climate considerations intersect with regulatory mandates, investor and shareholder expectations, and evolving market dynamics. Assessment of the materiality and financial impact of climate risks and opportunities is not just a matter of compliance; it's a strategic imperative for mitigating risk and fostering sustainable growth and resilience in the business model. By embracing this view and implementing best practices, boards can feel confident that the organization’s actions and responses to climate are proportionate to the materiality of the risk to the company.

The World Economic Forum (WEF) has developed a set of 8 principles to enable directors to embed climate considerations into board decision-making and risk and opportunity oversight. This article is part of the 2024 series that adapts those principles for the US context. Click here to learn more about NACD resources for effective climate governance.