Understanding and Evaluating a Company’s Climate Risk

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Energy Capital Ventures

As the impacts of climate change grow stronger and policy becomes more active in shaping allowable emissions, investors will place a higher emphasis on the physical and transition risks faced by companies Global market shocks such as  the war in Ukraine, supply chain disruptions caused by the pandemic, and the wave of  inflation plaguing the Western world in the last 12 months have taken a front seat in investor minds and climate issues have become secondary, if they are issues at all. However, companies that incorporate climate mitigation and decarbonization efforts will likely be viewed favorably by investors in the long term, as their business model will be more resilient to physical and transition risks. Businesses that more quickly implement effective risk mitigation strategies will have an advantage over their competitors.

Climate Risks Deserve Attention from Businesses

The Harvard Business Review has identified several places where the value of businesses will likely be threatened by the effects of climate change:

  1. Regulatory Risk: Companies must commit to the same emissions reduction targets as the countries they operate in and cannot exceed their emissions allotments. As a result, sudden political urgency can trigger rapid policy changes that catch companies by surprise.
  2. Supply Chain Risk: A company’s suppliers can also be vulnerable to future changes in environmental regulation. Supply chain disruptions or policy adjustments can cause increases in material and energy costs.
  3. Product and Technology Risk: As climate becomes a higher priority, lower-emission and sustainable products and technologies will become more competitive, while those with larger environmental footprints will struggle.
  4. Litigation Risk: Companies that emit significant amounts of carbon are more likely to face lawsuits for not adequately addressing climate change, such as this  2004 case where states asked utility companies to reduce their emissions annually by three percent for 10 years. In addition to the companies themselves, directors and officers can also be vulnerable to shareholder-related litigation.
  5. Reputational Risk: Consumers are likely to increasingly take a company’s environmental record into account when making purchasing decisions.
  6. Physical Risk: The changing climate itself can interfere with business operations. This can impact operations that directly depend on the physical environment and the elements, such as in the agriculture, fishery, forestry, real estate, and tourism industries. Natural disasters are also likely to increase insurance premia.

Facing these risks, companies have been voluntarily committing to climate action plans in an effort to curb their greenhouse gas emissions.

Strategies to Reduce Climate Risk Exposure

The Harvard Business Review generated a set of steps that companies should follow in order to enact emissions reductions plans:

  1. Quantify Carbon Footprint: Before taking action, a company must obtain an accurate measurement of its emissions and identify the sources of these greenhouse gasses. With this information, the company can gain a better understanding of how it can lessen its environmental impact and track its progress towards its emissions reductions targets.
  2. Assess Carbon-Related Risks and Opportunities: Once the company has a more complete picture, it can determine which of its operations are vulnerable to climate-related risks. The process of examining risks also allows companies to explore potential climate solutions and opportunities to reduce emissions and promote sustainable growth. Greenhouse gas targets help companies save money by increasing operational efficiency and decreasing the amount of energy consumed. This reduces production costs and can even boost sales, improving a company’s competitiveness. Preemptively setting internal regulations can also help a business adapt to future environmental regulations.
  3. Adapt Business in Response to Identified Risks and Opportunities: Companies should develop strategies to reach their emissions reductions targets and execute them. Companies must make several important decisions, such as whether to take a “top down” or “bottom up” approach, the number of targets to set, how to incorporate these targets with other environmental management activities, the extent to which the company should rely on market mechanisms to achieve its goals, and how to use research and development resources to drive the process of change. There are several reduction strategies that can be used. By adopting an internal carbon pricing system, a company assigns a price to carbon emissions attributable to the business that can be factored into investment decisions. Because energy consumption often accounts for the majority of a company’s directly measurable emissions impact, many businesses opt to improve their energy efficiency in order to meet their targets. In addition, there is a wide range of innovative financial tools to help fund decarbonization projects. Green and sustainability bonds serve as vehicles for institutional investors to put capital into projects that address climate change.
  4. Find Ways to be Competitive: In order to be successful, a business must make more effective changes that are executed more quickly than other companies. This applies to both reducing a company’s exposure to climate risks and finding profitable business opportunities that address these risks.

As more businesses incorporate sustainability into their mission statements, some strategies for reducing environmental impact have been determined to be the most effective. Fortune identified some characteristics of companies that underwent the most successful sustainability transformations:

  • Companies worked to redefine their values for customers. By establishing a link between sustainability and better outcomes for customers, sustainability can be incorporated into a company’s business strategy. This makes it a higher priority issue for the business.
  • Companies initially prioritized quick “wins” to create momentum. Rather than distributing focus across all operations within a business, initially focusing on making significant progress in a few aspects of these operations can be more effective in the long run. For example, rather than gradually decarbonizing across the supply chain for all brands a company works with, it may be more efficient to fully decarbonize a few brands at first. The overall emissions reductions resulting from these two strategies are equivalent; however, the values of the fully decarbonized businesses will be higher. This can be used to promote the company’s sustainability priorities and generate revenue to fund further emissions reduction efforts.
  • Company-supported sustainability efforts across their entire value chains. Businesses interact with one another across their supply chain networks. Large companies set net-zero targets that extend into their supply chains, requiring that the mid-size businesses that support them get on board with sustainability goals. This connects customers and suppliers in the pursuit of environmental protection goals.
  • Companies use technology to their advantage. Many businesses underestimate the pace at which green technology evolves. Companies that lead sustainability efforts are more willing to take the risk to adopt these technologies so that they can leverage them to make progress towards their climate goals.

A Climate Focus Ultimately Benefits Business

By incorporating sustainability into the core of their business strategy and values, companies can reap significant long-term benefits. As policy shifts towards a “net zero”  world, companies large and small will have to adopt lower-emission practices. Companies that take the lead in sustainability will have a competitive advantage by setting standards ahead of governmental environmental regulation and by appealing to the climate conscious portion of their consumer base.

Research conducted by the Boston Consulting Group found that “being in the vanguard of sustainability can unlock the doors to new growth opportunities.”  Addressing climate risks has the double benefit of reducing a business risk exposure while increasing the profitability of its operations.