In line with its decision to commit to the Paris Agreement of limiting global warming to 1.5°C, New Zealand is working towards implementing a mandatory climate-related financial disclosure regime for certain financial institutions. Aiming to go into effect this year, NZ may be the first in the world to legislate such a climate-related financial disclosure regime.
A small Pacific nation
The IPCC special report on the impacts of global warming of 1.5°C has made it clear: Unless we limit global temperatures to 1.5°C above pre-industrial levels, the impacts on natural and human systems in some nations in the Pacific could be disastrous.
As a Pacific Island nation, connected to its Pacific whanau (family) by culture, history, and politics, Aotearoa New Zealand (NZ) takes seriously its responsibility to ensure prosperity and environmental protection in the region. Consequently, NZ has committed itself to honouring the Paris Agreement by developing and implementing clear and stable climate change policies that contribute to the limiting of warming to 1.5°C. In a show of this commitment, NZ became a world leader by taking the step to enshrine a target of net zero emissions by 2050 in legislation. To meet this commitment, one of the climate policy initiatives NZ has decided to implement is a mandatory climate-related financial disclosure regime for certain financial institutions.
Despite being a small Pacific nation, NZ could be the first country in the world to embed a mandatory climate-related financial disclosure regime into legislation. This seems a bold step for such a small country, but there is a strong rationale behind this decision. NZ is seeking to limit destabilisation of its economy through identification and mitigation of climate related risk, and to seize the new market opportunities that are anticipated to emerge as the country transitions to a low carbon economy.
Seeking a smooth transition
To achieve the 1.5°C commitment, in 2019, NZ set a target for reducing net emissions of greenhouse gases (other than biogenic methane) to zero by 2050. In setting this target, NZ was aware of the associated financial risks, such as disruption to supply chains, the stranding of assets, and poor decision-making in regard to capital allocation required to achieve the necessary level of economic decarbonisation. It was fully aware that the transition to net zero must be managed well to maintain the country’s financial stability.
A recommendation of the Task Force on Climate Related Financial Disclosures (TCFD) is that disclosure of information about the risks and opportunities climate change presents to corporations will help to smooth the transition to a more sustainable, low-carbon economy. Therefore, the NZ government, accepting this recommendation, proposed the introduction of a climate-related financial disclosure regime. The intention was to introduce a process for making information about the financial risks of climate change to a business or entity publicly known. Importantly, the intention is to make the risks known to investors, and to provide information to the market as to how the reporting entity will address the risk, thereby, managing that risk.
Implementing a new climate change regime
NZ climate policy finds its roots in the country’s first dedicated piece of climate change legislation, the Climate Change Response Act 2002 (Climate Response Act). The Climate Response Act established the framework for an emissions trading scheme. Since the inception of this Act, climate policy in NZ has continued to develop. A major step was taken in 2019 with the passing of the Climate Change Response (Zero Carbon) Amendment Act 2019 (Zero Carbon Act). Importantly, the Zero Carbon Act introduced the 1.5°C limit as a purpose against which future climate policy would be measured. The Zero Carbon Act also introduced a number of other significant policies into regulation, however, its most important contribution was the introduction of the target of net zero carbon emissions by 2050.
With three pillars
There are three essential pillars of an effective climate policy regime: a carbon pricing mechanism, an emissions reduction target, and a mandatory disclosure regime. Having established an emissions trading scheme and set in place a net zero target, the last step for NZ was to introduce a mandatory disclosure regime. However, the NZ government decided not to include this in the Zero Carbon Act, in part due to political nervousness from having already introduced policy that promised to have significant impacts on the national economy. There was concern that introducing the third pillar too quickly would be overly disruptive to an already ‘climate policy saturated’ market, and that it would introduce an unnecessary level of instability.
Nevertheless, three years on from the last round of significant climate policy reform, the proposal for the mandatory regime was sent out for public consultation. Despite some financial institutions saying that they preferred to retain voluntary reporting and the status quo, the majority of the sector’s participants advocated for the imposition of a mandatory, regulated, disclosure regime. It was subsequently introduced to Parliament in April 2021.
The Bill, as currently drafted, proposes three key actions: the implementation of the mandatory reporting framework, the creation of new climate accounting standards, and the development of an assurance mechanism. The aim is to weave climate-related disclosure into the established legislative instruments and reporting framework, which already requires financial institutions to report annually on financial and non-financial matters.
The current regulator of the financial markets, the Financial Market Authority, will oversee and monitor the regulation. Similarly, the current government entity responsible for producing accounting, audit, and assurance standards, the External Reporting Board (XRB), will produce the reporting standards and related guidance materials. The accounting standards will align with the recommendations of the TCFD, as these recommendations are considered at this time to represent international best practice.
The NZ government has decided to adopt a mandatory, as opposed to a voluntary, disclosure framework. Voluntary mechanisms for reporting the impacts of climate change were already being applied within some sectors; however, the government did not believe voluntary reporting alone would deliver the timely improvements required to maintain a stable financial system. The expectation is that a mandatory regime, which will produce consistent and comparable disclosure of information across the financial sector, will enable an urgent but positive climate response from the financial markets. It is envisaged that it will enable financial institutions to better measure and consider climate related risk, and in doing so, allow markets to operate more efficiently through well-targeted investment.
An encompassing regime
Not all financial institutions will be captured under the new disclosure regime. The intention is, for now, to limit mandatory disclosure to only a portion of the entities already captured under existing financial market legislation; in particular, those with a significant share (99 percent) of the market’s capitalisation. This includes large listed issuers, large registered banks, and licensed insurers and managers of registered investment schemes. Of these entities, it will only be those which meet the specified size thresholds in dollar value which are required to report, the aim being, to limit the impact on smaller financial institutions of having to meet disproportionate disclosure costs for limited gain to the market.
All reporting entities captured by the legislation will be required to incorporate climate statements, which report on the material impacts of climate change, into their annual reports. Initially, to provide flexibility for entities for which climate change is not a material risk, the Bill proposed that a mandatory ‘comply or explain’ model for disclosure be adopted. The ‘comply or explain’ model sought to ensure reporting entities would consider the material impact of climate change. If, however, it determined the impact to be immaterial, the entity would provide an explanation as to why disclosure was not necessary. This may now be dropped from the Bill. In response to feedback, the ability to explain away compliance is likely to be removed. In addition, a failure to comply with the requirement for disclosure could result in significant penalties, depending on the nature of the breach concerned. For example, the draft legislation demands that knowingly failing to comply with the climate standard could result in a sentence of five years in prison or a fine of up to New Zealand dollar (NZD) 500,000 for an individual. For an entity, the fine could be up to NZD 2.5 million.
Having now passed through the Select Committee, the Bill is currently working its way through the final approval process. It is expected to receive Royal Assent and come into force in late 2021. It will send NZ into a swift transition.
Implementation of the mandatory climate-related financial disclosure regime and the new climate accounting standards will be a formidable task. However, NZ is not alone here. Across the globe, countries are at various stages of working through the steps they will need to undertake to operationalise similar TCFD-aligned frameworks. With mandatory disclosure regimes still in their infancy, countries will need to ensure they have sufficient flexibility in their frameworks to adjust to lessons learned as the framework matures. That flexibility will also be necessary to ensure the regimes align globally.
In NZ, there are a number of concerns about how prepared corporations will be to manage the new regime and the transition it will force. For example, for those institutions required to make disclosure, compliance and reporting costs will rise, particularly in the early years as capacity and skills are built. Without the initial expertise and skill base, there is a concern that an inferior quality of reporting may result in an inaccurate picture of climate-related risk. There is also concern about the market impact on corporations if their ‘weaknesses’ are exposed. No doubt, the first years of the disclosure regime will present a steep learning curve to corporations. Government has offered some relief, like delaying the introduction of assurance measures for three years after the regime’s introduction to allow time for corporations to adjust and learn.
Regardless of the perceived drawbacks of a disclosure regime, government and the institutions themselves agreed that these steps need to be taken, and quickly, to meet the targets that NZ has set itself.
A good time to lead
When it enshrined the purpose of limiting global temperatures to 1.5°C in 2019 and the target of net zero emission by 2050 in legislation, NZ was the first country in the world to do so. If the NZ mandatory disclosure regime comes into law by the end of this year, it will again be the first country in the world to enshrine a mandatory climate-related financial risk disclosure regime of this scale in legislation.
While there are certainly risks in being a first mover on mandatory climate disclosure, including grappling with the challenges of a new accounting style and publicly acknowledging potentially negative climate risk, NZ sees a clear market advantage if its financial sector has early access to high quality, comparable, and reliable information on climate risks. If it can transition early and smoothly to net zero emissions, it may also avoid the serious implications of a market failure from failing to respond in time to climate change.
At a micro-level, each financial institution required to report is expected to benefit from the identification and mitigation of their climate related risk. They should be able to identify weaknesses in supply chains and to identify assets which have the potential to become stranded. At the macro-level, consistent and comparable reporting across the financial market should allow for the efficient allocation of investment by making risks apparent; a change which will lead to the appropriate pricing of climate change risks and assets, and greater prospects of financial stability.
It is anticipated that new market opportunities will emerge for technology development. This includes the burgeoning climate services sector rapidly developing in NZ that will be available to provide advice and guidance as similar regimes develop internationally.
The introduction of mandatory climate-related financial disclosure regimes internationally, although slow to start, is likely to gain pace, rapidly. We will see other countries like the UK and China, and political and economic unions like the EU, implement similar regimes over the next couple of years. There will be challenges involved in coordinating approaches; it will be necessary to ensure that accounting standards and assurance mechanisms align, and that requirements are consistent to avoid market fragmentation. Financial markets will demand that jurisdictions implement, align, and coordinate mandatory disclosure regimes globally. Like the rising Pacific Ocean, this is all but a certainty.