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Two Steps Forward

What does 'climate risk' actually mean?

climate risk

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If you stick around the world of sustainable business long enough, you’re sure to see an immutable march of memes — terms that rise up and become popularized, often without agreed-upon definitions. Then, over time, they become used, and overused, to the point where they lose much of their meaning. Or, at least, they can mean whatever you want them to mean.

Some of those memes get traction — "zero waste" and "net zero" are two relatively recent examples having their moment. Others come and go — "responsibly sourced," anyone?

Now comes "climate risk," a term that has been kicking around for years — I first wrote about it back in 2013 — but that has risen to a point where major financial and governmental institutions around the world are baking it into their policies and programs.

Last week, for example, the U.K. government proposed mandatory climate risk-related governance by large pension plans, to be disclosed in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). The proposed scheme requires pension funds to analyze the implications of a range of temperature scenarios on their holdings and "to prompt strategic thinking about climate risks and opportunities."

The U.K. move is part of a larger trend taking place in Europe, according to a report issued last week by Mercer, the actuarial and benefits consulting arm of Marsh & McLennan Companies. It found that European pension funds’ awareness of, and desire for, action on climate change-related investment risk has surged, with 54 percent of those surveyed actively considering the impact of such risks in their investment allocations, compared to just 14 percent in 2019.

It’s no longer just about 'What business is doing to the climate.' It’s also about 'What the climate is doing to business.'

Why now? There’s no single precipitating event. Rather, the surge of attention to companies’ climate-risk profile appears to be the tipping point of a yearslong pursuit to flip the script on the conversation about business and climate change. That is, it’s no longer just about "What business is doing to the climate." It’s also about "What the climate is doing to business."

That understanding is heating up in lockstep with the planet itself. But it’s not always what it seems.

So, what does "climate risk" actually mean?

Minimize or manage?

First, it’s important to understand that "risk" means different things in business than it does in our personal lives. For most individuals, the word is synonymous with "danger" — the risk that we might be infected with coronavirus, for example, or that we could fall into financial distress because of a job loss or some other event. Or that something we don’t want others to know gets found out.

Risk, in that context, is something to be minimized or avoided altogether.

Not so in business. Risk is part of the everyday landscape, referring to things that could negatively affect a company’s financial performance or even cause it to fail. In finance, risk refers to the degree of uncertainty inherent in an investment decision. In general, the higher the risk, the greater returns sought by investors, who want compensation for taking such risks.

Therefore, in business, risks are not something to be avoided but something to be managed: You want to measure, assess and track them, not necessarily avoid or eliminate them. Without taking risks, companies would never grow or, in many cases, prosper.

Within the TCFD framework, climate risk is seen through the eyes of investors and financial institutions — that is, how will their loans and investments fare in a world of climate-related disruptions? The framework’s stated goal is "to price risk to support informed, efficient capital-allocation decisions."

Climate change poses significant financial challenges, and the risk-return profile of companies exposed to climate-related risks may change significantly as more companies are affected by climate change, climate policy and new technologies. A 2015 study by The Economist Intelligence Unit estimated that as much as $43 trillion of manageable assets may be at risk globally between now and the end of the century.

So, the TCFD framework is about protecting those assets and the companies that own them. It's strictly about disclosure to protect investors and lenders, not reducing impacts to protect people and the planet. According to the TCFD:

[P]ublication of climate-related financial information in mainstream annual financial filings will help ensure that appropriate controls govern the production and disclosure of the required information. More specifically, the task force expects the governance processes for these disclosures would be similar to those used for existing public financial disclosures and would likely involve review by the chief financial officer and audit committee, as appropriate.

Nothing there about companies actually lowering their emissions or otherwise investing in climate solutions, only about disclosing the potential risks to a company’s finances from the growing climate crisis.

Thus, a company reporting on climate risk under the TCFD protocol isn’t necessarily committing to fight climate change. Rather, it is declaring, "We understand the potential impacts of climate change on our business and have made our financial projections with that in mind."

Business as usual?

In theory, companies might make different business decisions to avoid those risks. But not necessarily: They could decide to incorporate those risks into investment or operational decisions in order to maintain business as usual. So long as a company discloses those risks, investors may be satisfied.

So, an oil and gas concern such as Chevron or the South African mining company Gold Fields can report its climate risks using the TCFD framework without necessarily changing its operations or emissions one bit. As Chevron Chairman and CEO Michael K. Wirth wrote in the introduction to his company’s TCFD disclosure:

This report demonstrates that we proactively consider climate change risks and opportunities in our business decisions. We have the experience, processes and governance in place to manage these risks and opportunities, and we are equipped to deliver industry-leading results and superior stockholder value in any business environment.

No gauzy verbiage there about leaving the world a better place. It’s drilling and refining as usual — but with fuller disclosure.

The climate-risk bandwagon has the potential to effect change. As I noted recently, financial institutions are beginning to link borrowers’ sustainability performance to the cost of loans — better performers get lower rates — which could spur companies to change. As climate impacts worsen and the risks grow, investors and lenders may well press companies to more aggressively reduce the greenhouse gas emissions associated with their operations and value chain.

So, the question to ask about disclosing climate risk is what difference it actually will make — and what it will take for companies to go beyond simply managing risk to actually reducing their contributions to the climate crisis. How many "once-in-a-century" wildfires, droughts, hurricanes or floods will it take before companies recognize that the stability of their facilities, supply chains, operations, employees and customers is being jeopardized? Or that the infrastructure they rely on — roads, bridges, tunnels, railways, airports, electric grids, water works, broadband fiber — cannot be taken for granted in a climate-changing world?

Disclosure is good: Sunlight is the best disinfectant, as the saying goes. But without actually addressing what’s causing the infection in the first place, the patient’s prognosis may be doomed.

I invite you to follow me on Twitter, subscribe to my Monday morning newsletter, GreenBuzz, and listen to GreenBiz 350, my weekly podcast, co-hosted with Heather Clancy.

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