Climate Risks, Cost of Capital and Company Valuation
What Corporate Directors Need to Know About Climate Risks
Corporate risk taking and monitoring remains a top priority for board of directors, investors and other stakeholders. Risk management systems are considered by investors in proxy voting, in executive compensation and company valuation. With the advancement of technology, risk management frameworks are changing rapidly; they range from relatively well understood traditional business risks, to newer cyber risks and political risk, to least understood and grossly underestimated climate risks.
Climate risks are considered the most consequential challenges for business in the next few decades. As the UK Central Bank Governor Mark Carney argued October 8th 2019 in Tokyo at the TCFD Summit (1), climate change threatens global financial stability both short-term and long-term; short term through clear and immediate impact of physical risks on existing business models, and long-term through risks embedded in transformation of global economy to a low-carbon economy.
Poor understanding and complexity of climate-related risks, coupled with fragmented reporting and lack of reliable measurements, has caused a significant underestimation of financial impact of climate risks on business. Not surprisingly, investors and landers are leading the effort to quantify climate-related risks in their decisions about the allocation of capital to enterprises with the highest potential to produce attractive and sustainable future returns.
About 130 banks with combined assets of $43 trillion dollars, have made commitment so far to the goals of the 2015 Paris Agreement to mitigate climate risks through financial systems. . Such commitments, made not as a political statement but as a risk management strategy, put pressure on corporations to factor in climate risks into their operations and strategic planning. Concrete and measurable actions follow. After the September 2019 Climate Week in NYC, 66 countries, 102 cities, 93 corporates, 12 investors and 10 regions say they will be carbon neutral by 2050 - these are tall and consequential business goals.
Some businesses act on climate goals. Such as Unilever, which goes 100% renewable now with its entire operations -- including factories, offices, data centers and warehouses worldwide being run on 100% renewable energy, ahead of its initial 2020 target date commitment. The consumer goods conglomerate has set a goal of being carbon neutral by 2030. Google and Amazon have just made (October 2019) the most ambitious commitments to renewable energy and carbon neutrality goals. These three recent examples represent companies that are seen by investors as well equipped to deliver attractive and sustainable future returns by tackling climate change risks and opportunities.
Most US businesses, however, do not fully understand and therefore underestimate the impact of climate risks on both their current operations and long-term viability of a company. Investors, both asset owners and lenders, take a notice and adjust their strategies respectively, utilizing such risk-mitigation techniques as increasing cost of capital, reducing exposure, or divesting some assets. Some corporate boards were caught by surprise with such nvestors actions.
Three climate risk categories of importance to directors are discussed below.
Physical risks - related to climate-related catastrophic events
Liability risks - related to company’ governance of climate-related environmental and social factors
Transformational risks - related to company's ability to perform in the future under various climate scenarios
Physical risks relate to catastrophic events such as floods, fires, hurricanes etc. These risks include physical assets risks and business disruption risks. Catastrophic events are expected to be more frequent and severe, which existing business models grossly underestimate. This is of great concern to financial markets, where the insurability of assets is becoming a pressing material issue, impacting not only insurance companies but -- more importantly -- stability of entire sectors.
Material impact of physical risks can be assessed using traditional business accounting tools. Over the last decade it has been well documented that the cost of doing business under climate change conditions has been increasing steadily. Such increases are clear and material in certain sectors, despite productivity gains related to digitalization. The cost of “doing-business-as-usual” is expected to continue to increase across the industries, with some sectors being affected faster than others (energy, utilities, agriculture, tourism, finance, real estate, FMCG)
Liability Risks reflect how a company is perceived and evaluated by customers, investors, communities and other stakeholders with regard to climate-related events, strategies and a pace of transition to a low-carbon economy. Liability risks impact directly the cost of capital and the brand value of a company.
Materiality assessment of liability risks is more complex than assessment of physical risks, as liability risks impact primary, secondary and tricially business outcomes. These are the risks that investors aim to factor in to predict mid-term and long-term company’ performance. To that end, investors demand more transparency in corporate reporting. As a result, the measurements of liability risks are evolving from companies’ voluntary “free style” disclosures (sustainability reports) to standardized measurements and platforms (ESG (2), CDP(2) TCFD(3)). These measurements impact cost of business. As of Dec 2017, Moodies’ incorporated ESG scores to evaluate company ratings, which directly translates into cost of capital: the better the ESG score, the lower the cost of capital.
Transitional risks reflect the ability of an enterprise to perform during transformation of businesses, from high-carbon/ fossil-fuel intensive conditions to green and clean enterprises. Transitional risks are mid-term and strategic in nature. Although markets recognize that such risks can be critical if not existential (as in the case of California’s utility PG&E), transitional risks are not well understood either by business or by capital markets. As it has been in the case of coal enterprises, which, since 2010 lost 90% of their value. Transitional risks include product portfolio risks (agriculture, FMCG products), financial risks (increased cost of capital, stranded assets) to risks related to the brand value (consumer and investor activism). Transitional risks, which may overlap with a liability risks, are complex in nature, they have a multidimensional impact on businesses and the business ecosystem over a longer period of time.
Materiality assessment of transitional risks are at early stages of development. The information regarding such risks published in company reports, has been fragmented, inconsistent and difficult to quantify. In order to better assess and factor in these risks, investors are deploying new risk assessment methodologies.
The concepts of stranded assets (4) almost unknown only a decade ago, is getting full acceptance of financial and investment community. Banks have started to use stranded assets approach to re-evaluate landing practices in production of coal in Europe and North America, palm oil in Indonesia and Ecuador, soy&beef in Brazil, or lumber in Amazon basin. As a direct result, banks have increased cost of landing throughout supply chains where revenues were exposed to stranded assets; in some cases banks have stopped landing and asset owners divested enterprises with exposure to stranded assets from their portfolios.
Standardization in sustainability reporting, though still mostly voluntarily, is progressing with an increased momentum: CDP (Carbon Disclosure Project), one of the oldest and most data-rich platforms offers investors data for comparative analysis of companies’ transition to low-carbon scenarios. TCFD (The Climate Related Financial Disclosure) developed by the FSB (Financial Stability Board) is a direct response to investors demands for transparency in reporting. As of the writing of this article, approximately 800 companies and 340 investors with $34trillion in assets under management globally, are supporting TCFD reporting.
Predictive analytics of future performance utilizing ML (machine learning) and AI (Artificial Intelligence) incorporates complex climate scenarios and its impact on capital markets to predict company’ future performance. These new modeling tools are rapidly evolving. They are in high demand by investors, insurance and financial sectors. Entellingence is one of such platform.
There is a pressing need for individual companies to understand and estimate climate risks to build viable plans for the future. Corporate Board, if they have not done so yet, need to address climate risks and opportunities soon to engage investors in a conversation about value creation.
What Questions should Directors Address re. Climate Related Risks:
In the company's existing risk management framework, how are the climate risks incorporated?
Does the company have a clear understanding of climate related risks? Opportunities?
Does the company have a formal process of incorporating climate risk analysis?
Where are accountabilities for climate risks assessment and mitigation?
Do we have a risk mitigation plan for catastrophic events? For the core business, for supply chains? Domestic and International?
What are the estimates of catastrophic events on cost of business?
How catastrophic events may impact financial performance short term, mid-term and long-term
Do we have scenario planning re. assets insurability? Short-term? Mid-term?
What is the company's ESG score in Bloomberg, MSCI, Refinitive and other platforms?
What is company’s Moody’’s credit rating? To what extend does it depend on ESG score? Do we understand how the ESG score impact company’s credit rating?
What kind of sustainability reporting the company is committed to? What are the plans? Challenges? Resource allocation? What is company’ standing in social media regarding environmental and social issues? What are potential liabilities?
How compliant is the company with environmental reporting? Does the company report to CDP? What are the scores?
What is the profile of company’s investors with regard to their perception on climate risks?
Are company’ revenues exposed to any stranded assets? If so, what portion of revenues?
How investors view company strategic plans with regard to risk management? Specifically climate risk management?
What factors impact proxy voting?
Explanation of Terms and Abbreviations
TCFD (The Climate Related Financial Disclosure) https://www.fsb-tcfd.org/ is a voluntary reporting platform based on principle of transparency, developed by the Financial Stability Board (2015). It aims at quantifying transition risks of enterprises. As of October 10th, 2019, 792 organizations globally with the capitalization of $9 trillion supported the TCFD
ESG - Environmental, Social and Governance factors, that traditionally have not been a part of financial analysis. In the US, ESG factors are voluntarily disclosed by companies in their sustainability reporting. Investors are increasingly using ESG ratings to predict value and earning potential of companies. https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp
CDP - Carbon Disclosure Project (www.cdp.net) is a 15-years old global platform, that compiles data on management and governance of natural resources from individual companies, supply chains and cities re transition to a low carbon economy. CDP data is being used by investors in modeling performance under various climate scenarios.
Stranded Assets are assets that have suffered from un-unticipated or premature right-downs, devaluations or conversions to liabilities; ex: coal, land or craps developed by illegal deforestation,
Entelligent https://www.entelligent.com/ is a platform utilizing predictive analitis to design climate-science based solution for low carbon impact investing.