Climate risk impacts companies. ESG-aligned investors want methods to evaluate that risk, and ways for businesses to effectively manage it.
Modern scientific consensus points to the fact that our earth’s climate is changing. Global average temperatures have been increasing since the Industrial Revolution, a fact which has been linked to increased greenhouse gas (GHG) emissions.
An ongoing temperature analysis led by scientists at NASA’s Goddard Institute for Space Studies (GISS) has shown that the average global temperature on Earth has increased by at least 1.1° Celsius (1.9° Fahrenheit) since 1880.
Worryingly, the rate of global warming seems to be increasing. Most of the warming has occurred since 1975, at a rate of roughly 0.15 to 0.20°C per decade, and nine of the ten hottest years or record have occurred in the past decade.1
Although these figures may look small in isolation, the general trend is concerning and it’s worth noting that small shifts in the average temperature can disguise dramatic ones at the extremes.
As warming continues, the number of affected regions will grow in both number and size. Countries with lower GDP per capita levels will face a double threat in that these countries tend to reside in areas that are generally more exposed to the effects of climate change, whilst their residents may lack the funds and access to technology for adaption that wealthier first-world citizens may take for granted.
Scientists seem to be united on some of the physical effects that this global warming will induce, which include:
- Extreme weather events such as record-breaking heatwaves and flooding.
- Large-scale crop failures as the plants struggle to adjust to the rising temperatures.
- Polar caps melting, causing rising sea levels and threatening flooding of low-lying coastal areas.
- Ecosystem changes as animals shift their location to remain in their optimal environments.
- A raised likelihood of epidemics.
- Large scale oceanic changes such as the disruption of the North Atlantic current, in-turn impacting weather systems and altering precipitation patterns.
- More severe fires
In addition to the physical changes that will likely occur, almost all industries are threatened by the effects of climate change, either directly or indirectly. One 2019 study has shown that the U.S. alone could lose USD 520 billion across 22 sectors due to global temperature rise.2
The three types of climate risk faced by companies and investors
Companies, and the investors who finance them, experience three main types of climate-related risks.
1. Physical effects
These are related to the actual physical risks of climate change, as mentioned above. A business may have physical premises or operations located on the banks of a river, on a low-lying floodplain or close to a timber plantation for example, exposing it to water or fire damage. Another example could be the change in the availability of water due to shifting rainfall patterns.
2. Impacts incurred in the transition to a low-carbon, ‘green’ economy
With awareness of the global warming issue now almost ubiquitous, increasing numbers of organizations are reducing the amount of carbon involved in their business operations, whether it’s in their own manufacturing processes or in looking to source raw materials from ‘green’ suppliers.
As with any change, there is a transition cost as businesses pivot away from their prior products and practices, and towards new decarbonized ones, often resulting in what’s known as ‘stranded assets’ where due to the transition, certain business assets are no longer needed and lose their value to the organization.
Decommissioning existing tools and resources, and investing in new equipment, technology, and processes designed to reduce or eliminate carbon emissions and greenhouse gasses would be one such example of a transition cost.
3. Liabilities resulting from climate regulation
This risk is the financial one potentially incurred by organizations as they face fines and penalties for not complying with standardized industry, governing body, or government regulations, for example a country committing to be net zero by a certain date. The requirements being imposed by authorities is increasing both in number and severity as alarm grows around the global warming scenario.
Not only must businesses incur the costs of transitioning to cleaner and more sustainable operations and processes, but they face the increasing likelihood of damaging financial costs if they don’t.
ESG: accountability and transparency in managing climate risk
In an attempt to tackle climate change and sustainability challenges, governments and regulatory bodies are creating and enforcing legislation as a way to force industries and companies to reduce the environmental harm of their business practices.
Growing numbers of investors also want the businesses in which they invest to be sustainable and ethical. ESG is the acronym for Environmental, Social, and (Corporate) Governance, the three broad categories or areas of interest for these ‘socially responsible investors’.
ESG is a set of criteria required to be incorporated in financial evaluation, and lending or investing decisions by financial institutions. ESG criteria are guided by standards and frameworks which may be local or global, in an attempt to create consistency in evaluation, and to better understand risk.
Examples of these standards and frameworks include the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and the Task Force on Climate-Related Financial Disclosures (TCFD), amongst others.
These standards and frameworks list climate and other related indicators that should be measured, tracked, and reported on so as to understand the measures in place to manage climate change, as well as the emissions contributing to it.
ESG metrics are commonly thought of and referred to as non-financial in nature. This may, however, be changing as value and risk become increasingly associated to these metrics. Industry experts foresee ESG data needing to be managed similarly to financial data, and in-line with acceptable accounting practices. For example, double materiality is a recently introduced concept which now needs to be considered.
An extension of the key accounting concept of materiality of financial information (i.e. information that should be disclosed if ‘a reasonable person would consider it important’), double materiality refers to how it is not just climate-related impacts and risks to an organization which may be material, but that the effects and influence of the organization’s activities on the climate may be material as well.
There are multiple ESG stakeholders, all of which consider climate change:
- Standards bodies and frameworks such as TCFD, GRI, SASB, CDP and GRESB define metrics and principles regarding what should be reported on.
- Regulators such as the US Securities and Exchange Commission (SEC) propose rulings and laws by which countries, industries and businesses must comply.
- ESG ratings agencies such as MSCI, Sustainalytics, FTSE Russell, S&P Global set criteria by which organizational ESG performance can be assessed, and assign scores that can be used to understand companies’ ESG performance relative to their peers.
- Investors, banks, and other funders who have ESG-linked investment mandates and who are seeking to invest sustainably.
- Consumers, who via their growing awareness around ESG topics and changing buyer behavior, can alter market demand for company products and services.
- Activists, who may be very invested and involved in drawing attention to certain areas pertaining to ESG, and seeking to influence consumer and business behavior in accordance with their aims.
As the multi-pronged influence of ESG grows, businesses are facing the need to comply with and report against multiple standards required by various stakeholders, at different times and in different formats.
The complexity of managing ESG, including climate risks, has grown rapidly over the last decade and is now at the point where specialized software is needed to manage the various operational aspects of data collection, storage, collaboration, analysis and display, and packaging and reporting.
As the planet continues to warm and climate risk intensifies, ESG software will carry on evolving to incorporate relevant measures of importance to the various stakeholders, and help businesses manage their ESG processes and performance accordingly.