We take a look at the risks posed by climate change and how global climate change investment requires a strategic rethink on part of the businesses.
As the Earth warms up, heat is being increasingly felt in the corporate boardrooms alike. In the summer of 2021, one of America’s top energy corporations, Exxon Mobil, was forced to appoint to its 12-member board three nominees from a small activist hedge fund called Engine No.1; the appointments seen by many as no less than usurpation. Investor concerns on environmental, social, and corporate governance (ESG) issues have been behind the unprecedented support these appointments garnered, including that from BlackRock, one of world’s largest investment management corporations. Blackrock on its part has committed to have a net zero portfolio by 2030.
Investors and Policymakers: Synched on the Climate Tune
Rating agencies and investors have been exerting pressure on companies by including climate risks in ratings methodologies and demanding them to engage in low-carbon transition or put forth net zero emissions plans and climate change investments. On the other hand, corporations the world over are increasingly recognising climate change as a megatrend and taking note of the attendant risks and implications on investment needs. The world’s largest asset owners, like pension funds, are indirectly but equally exposed to climate-change induced risks – they own assets across industries and asset classes. The Investment Association, the UK’s trade group for asset managers, plans to issue warnings for companies that fail to report climate-related financial disclosures. The Net Zero Asset Managers Initiative brings together 128 fund managers with $43 trillion under their care in a pledge to make investment decisions that support the goal of net-zero emissions by 2050 or sooner. However, so far, they have not been successful. As pressure builds up across the financial industry, ramifications of such announcements on the overall political economy could be significant.
In March 2021, the Securities and Exchange Commission (SEC), released its long-awaited climate disclosure rules for corporations in the United States. Broadly, the guidelines cover areas of governance, strategy, risk management, and metrics and targets. The UK, New Zealand, and Japan already have similar guidelines for businesses to follow. As customers’ demands shift towards green products, and investors demand a more active role of businesses in preventing a climate crisis, businesses themselves are looking beyond compliance and incorporating climate change mitigation as part of the corporate strategy. Adopting scientific knowledge and climate justice frameworks, like the findings of the Intergovernmental Panel on Climate Change (IPCC), methodologies from the Science Based Targets Initiative (SBTi) and the Just Transition Principles are at the centre of laying-out science-based, outcome-oriented decarbonisation pathways that are specific and measurable.
Net-Zero and Risks for Businesses
Most of the public discourse is heard around nations and corporations adopting net-zero targets, with focus on assessing and measuring emissions, followed by abatement. The taxonomy around metrics and targets lends to ease of governance and avoiding greenwashing. Businesses are increasingly being required to comply with regulations on establishing a baseline and integrating measures around carbon in their business reporting. On one hand, uniformity in assessment, measurement, and reporting standards (reporting scope 1, 2, and 3 emissions, greenhouse gases measured, definition of net zero) is required, and on the other, enterprise tools to collect and analyse data are key to integrating carbon into accounting practices.
As more businesses are grappling with establishing their baseline of carbon emissions across scope 1 and 2, and especially scope 3 emissions, the problem takes a complex shape when it comes to the areas of risk management and strategy formulation. Broadly, the risks posed to businesses are a combination of physical (disruption of business operations and damage due to extreme weather events and incremental changes over a period), transitional (meeting stringent regulations, adopting new technologies, and impact on assets and liabilities, changing supply chain dynamics) and, strategic (shifts in business models, emerging business scenarios).
Climate Change as Risk: Imminent and Non-diversifiable
Uncertainty around the extent and time of physical risks more than proportionately increases cost both for existing as well as new projects, thereby lowering returns for businesses. Businesses that have core assets in areas under high level of threat perception from climate events or else are dependent on resources from such areas particularly need to have contingency plans. As per a 2021 survey conducted by Deloitte, nearly 30% of executives said that their organisations were already feeling the operational impacts of climate-related disasters and more than a quarter were facing a scarcity of resources due to climate change. Possibility of physical damage or disruption to business operations is increasing the cost of insurance while an added layer of redundancy to minimise physical displacement and impact to operations directly increases capital layout and operational costs. For instance, flooding of coal mines, droughts in regions generating hydro-electric power, shut-in of energy generation units due to extreme weather events like hurricanes, snow blizzards, low wind speeds, etc. could repeatedly impact business continuity. There is no surprise that capital markets acknowledge climate change as a systemic risk and, therefore, non-diversifiable.
Cost of Carbon and Transitioning
National and transnational policies are forcing businesses to pay a price for carbon either in the form of a carbon tax or else cap-and-trade mechanisms. With a higher cost of carbon, businesses would be required to transition to low-carbon alternates; some industries are being impacted more than others. Heavy industries and those that have a dependence on fossil fuels particularly face high cost of transition, like energy and utility companies that operate refineries and power plants. The oil and gas industry has a particularly arduous road ahead, while holding one of the largest shares of total emissions; the case of Exxon Mobil garnered attention more for its lack of action thus far. Due to high energy prices, there is a knock-on effect on other electricity-intensive industries such as fertiliser production, which is bearing the brunt of high energy costs and lower demand due to high cost of the end product. The impact on global food production and prices is direct and immediate.
Fig 1: The economic transformation: What would change in the net-zero transition by McKinsey & Co. Jan 2022
Economic measures like pricing carbon are meant to push businesses to transition to low-carbon alternatives. This transition for businesses requires rethinking of technology options and supply chain ecosystems, rendering existing investments redundant, and requiring fresh capital commitments, while demanding new skills even as jobs are lost. In fact, abrupt transition to alternatives could potentially cause large-scale asset-stranding. McKinsey’s study on net-zero transitions estimates that USD$2.1 trillion worth of assets could be stranded by 2050, a large majority in the form of coal-fired plants in countries such as China and India that are relatively new (less than 15 years old). Any sudden impairment of assets would lead to increased volatility in supply of goods and services, which is bound to make prices uncertain and therefore lead to a decline in market prices for financial assets. The study also estimates that climate change investments of approximately USD$9.2 trillion per year would be needed between 2021 and 2050 across sectors. With companies having to front-load costs of transition, upfront investments made in decarbonising may in fact have an adverse impact on company valuations in the short run, as seen in an analysis by Kearney. Then there are the likes of Danish energy company Orsted, that are already leading by example in making a just and profitable transition.
Decarbonising as an Exercise in Strategic Rethinking
When referring to carbon emissions reduction, most corporations refer to decarbonising operations to cut down scope 1 and scope 2 emissions. Scope 3 emissions – those generated in the upstream and downstream value chain – may remain intractable. Reducing scope 3 emissions need collaboration with customers, supply networks, and industry groups in a complex, multiyear change effort. Think auto manufacturers – replacing internal combustion engines with electricity-powered cars requires extensive Research and Development (R&D) effort, replacement of existing vehicle platforms with new ones, and yet all this change addresses only a part of the emissions. To reduce scope 3 emissions, which could account for a large majority of their total emissions, auto makers would also have to rethink their supply chains. Among other upstream dependencies, they would be required to switch to green steel. However, limited green steel supply could hamper the auto makers’ production capacity and in turn may require revamping of the procurement strategy. As some skills become redundant and there is a looming threat of loss of jobs, balancing relations with trade unions and retraining resources across the board will be a key imperative for corporations.
Some of these sweeping shifts will have ramifications not only for the individual corporations but bring about industry-wide changes, especially in resetting standards, examining policy implications, and realigning the business ecosystem. As they form their mid-to-long-term perspective around climate change and achieving their net-zero targets, corporations would need to think about combining sustainability goals with financial and market goals, transitioning business models and managing up-front costs of transition while structuring climate change investment decisions and still making good use of existing operations. As per a survey carried out by Bain & Co., more than 2,000 companies representing $27 trillion of market capitalisation have embraced internal carbon pricing. Once carbon is priced, companies consider it like any other cost in their decisions about capex, procurement, and R&D, and it guides portfolio decisions.
For organisations to stay relevant in this new reality, they need to surmount the challenges of adopting new technology, maintaining the economy, and bringing about alignment of intent among stakeholders. Evidently, change is required across the board – from how climate as a risk is identified and delineated to what Key Performance Indicators (KPIs) are drafted and measured, investments made, products sourced, built and sold, with the associated skills, incentives, and rewards. With customers demanding green products and investors wanting to see action beyond compliance, corporations will soon be left with no choice but to pivot swiftly to survive and thrive. The risks are real and significant and so is the opportunity. Within the boardrooms and deep within operations, new business models are needed, alongside innovative tools and processes, skills, metrics, and the leadership to bring about a shift in strategic thinking for a long-term climate aware future.