Climate Change Is an Enterprise Risk Multiplier
Boards are not strongly concerned about the impact of climate change on their businesses in the short term. This might be the conclusion reached from a cursory read of the 2019–2020 NACD Public Company Governance Survey, which found that only 13 percent of directors ranked climate change in their top five risks for 2020, placing climate far down the corporate risk register (see Figure 1).
However, this conclusion fails to recognize the full range of ways in which climate change is redrawing the corporate risk landscape. Companies not only face physical risks from climate change, such as sea-level rise or increasingly extreme weather, but they also face a range of transition risks. These include policy or regulatory changes, competitive and investor pressures, and shifts in consumer preferences as greenhouse emissions are cut for a low-carbon future. Through these channels, climate change is amplifying many of the traditional risks that boards are most concerned about.
Enterprise risk and the low-carbon transition
Take, for example, the risks of business-model disruption (ranked 1) and technological advancements (ranked 5). The old business model of electric utilities, based upon the generation and transmission of electricity from fossil fuels, has been upended by distributed, renewable technologies that are now cheaper than coal. The automobile sector is now preparing for a wave of technological disruption from electric vehicles, autonomous vehicles, and shared mobility platforms, which together offer the prospect of lower emissions and greater efficiency.
Low-carbon disruptions do not begin and end with the sectors initially affected; they sweep along supply chains with consequences for companies providing parts, services, or raw materials. For example, the switch to electric vehicles will reduce vehicle repair and servicing revenues and destroy markets for suppliers manufacturing parts for internal combustion engines and gearboxes. Innovations to reduce the carbon footprint of buildings, such as sustainable construction materials, energy efficiency technologies, and onsite renewables, could have impacts felt far beyond the real estate sector, threatening the demand for carbon-intensive materials like cement and steel as well as the demand for electricity and natural gas. In the power sector, the growth of renewables hasn’t simply disrupted utility business models, it has hit coal miners and railroad companies as well.
Moving down the list of the top concerns in Figure 1, climate change also has major implications for regulatory risks (ranked 6), as the plethora of regulations governing carbon-emitting activities attests. A third of the US GDP is covered by carbon pricing policies which charge companies for their emissions. Thirty-eight states, plus the District of Columbia, have set renewable energy standards, and 43 states and the District of Columbia implemented policies to promote electric vehicles during 2019 alone. Sudden or far-reaching regulatory changes present the greatest risks. Oliver Wyman, for example, recently estimated that global implementation of a $50 tax on carbon could cost banks up to $1 trillion from loan defaults in high-carbon sectors.
Meanwhile, mounting concerns about climate change have begun to influence consumer behaviors (ranked 9), driving growth in the demand for sustainable products and the emergence of new norms such as “flight shaming,” which has already affected European air travel and has now spread to the United States, where it reportedly has airline executives worried. Climate change is also fueling a new wave of investor activism (ranked 12).
Even competition for talent (ranked 3) is affected by climate change. Companies in high-carbon sectors are finding it harder to attract young talent, a finding corroborated by recent research which found that the most popular companies to work for, and those that are the most attractive to young talent, outperform their peers on environmental issues.
Questions for the board to ask management
How material is transition risk for the company and its customers?
What impact will a low-carbon transition have on the company’s strategy? How is management assessing the impact of a low-carbon transition on enterprise risks?
What are the most material transition-related scenarios for the company—for example, is there likely to be a particular regulatory change or shift in customer sentiment?
Enterprise risk and a changing climate
Climate change is also multiplying physical risks associated with natural catastrophes and resource security. Climate-related disasters are increasing steadily. Morgan Stanley estimates that global, climate-related disasters cost $650 billion from 2016 to 2018. Of this, two-thirds were borne by North America. Results from a survey conducted by Marsh and RIMS at the beginning of 2020, and published for the first time here, reveal that more than half of respondents expect to be affected by tropical storms, hurricanes, typhoons, or tropical cyclones in the next five years, and 29 percent expect to be hit by coastal flooding.
These events can have severe and long-lasting consequences. Assets may be destroyed and loss of power and damage to the transportation infrastructure can interrupt business operations. Even if companies emerge relatively unscathed, they can still be vulnerable to downturns in the local economy.
Small- and medium-sized enterprises may be particularly vulnerable because they typically have less working capital to draw upon in the aftermath of a disaster and often lack adequate flood insurance. The Federal Emergency Management Agency estimates that between 40 and 60 percent of small businesses forced to close by disasters never reopen. After Hurricane Harvey hit Texas in 2017, the following quarter saw 13.5 percent of businesses lost from the disaster area. The National Oceanic and Atmospheric Administration has since estimated Harvey to have cost $125 billion, with scientists finding that climate change could be responsible for three-quarters of the bill.
Climate impacts are also a growing concern for major corporations, which are experiencing rising costs from the effects of water scarcity, supply-chain logistics, and commodity market volatility, to name a few. Last year, 215 of the world’s largest companies reported $400 billion of profits at risk from a changing climate.
Questions for the board to ask management
Does the company assess the risk of climate-related impacts along its entire value chain, for example, on its own assets, operations, suppliers, and customers?
What are the most material climate-related impacts the company is exposed to, and how is it managing these risks?
How are physical risks expected to change under various future climate scenarios?
How is management incorporating an assessment of future physical risks into decision making, such as long-term sourcing strategies?
Emerging from COVID-19
Board oversight of climate risks is particularly important in the wake of the coronavirus pandemic, when senior management is likely to be preoccupied with the tactical and operational matters of surviving the crisis. During this time, many companies will be especially vulnerable to climate impacts because balance sheets are stretched thin, supply chains are fragile, and lockdowns may challenge businesses’ and authorities’ ability to implement emergency responses. Meanwhile, transition risks are evolving rapidly due to government stimulus measures, market dynamics, and changes in consumer behaviors brought about by the crisis (see Figure 2).
Companies attuned to these shifts in climate risk will be better able to weather imminent climate effects and gain a competitive edge as the economy emerges from the pandemic and charts a new course toward decarbonization. Now is a critical time for boards to ensure that climate risk is properly integrated into recovery strategies.
Questions for the board to ask management
- How have climate risks changed as a result of the pandemic (see Figure 2)?
- What climate-related disasters will the company be exposed to in the near term? What resilience measures are in place?
- How have climate risks been considered in pandemic recovery strategies?
Implications for board oversight
The threats outlined above are not in themselves new. Successful businesses have long managed risks associated with natural disasters, access to water, and the availability of raw materials. Similarly, competitiveness rests on businesses’ ability to anticipate and respond to technological advancement, business-model disruption, and changes in regulation and consumer behavior. Climate change means that these traditional risks are becoming more severe, more multifaceted, and more interdependent, and that these trends will continue for the foreseeable future.
This has clear implications for the board and its responsibility to oversee corporate strategy and ultimately protect long-term shareholder value. Climate change should not be thought of narrowly as “more extreme weather,” nor should it be placed in a bucket alongside more familiar enterprise risks. These approaches fail to recognize its role as a risk multiplier.
Boards need to ensure that management understands how climate change is reshaping the company’s entire risk landscape, and they must be assured that this is reflected in corporate strategy. An integrated approach to climate risk starts at the top.
This is the first blog in a five-part series. Check back next week for more insights from MMC on board oversight of climate change.
Rob Bailey is director of climate resilience for Marsh & McLennan Advantage.
Lucy Clarke is president of Marsh JLT Specialty.