How can climate risk provide opportunities?

By

EY India

Multidisciplinary professional services organization

8 minute read 1 May 2018

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Growing demand for nonfinancial information, including disclosures of climate change risks, may present business with opportunities

The 2018 Global Risks Report,[1] released during the World Economic Forum in Davos earlier this year, highlights the fact that climate-related risks have grown in prominence over the years. The report indicates that risks related to extreme weather events, natural disasters and failure of climate change mitigation and adaptation are all rated as part of the top five global risks, in terms of likelihood and impact.

These results are not a surprise. We have seen governments ramp up their efforts to mitigate climate risks for some time now — both on the global level (e.g., through Paris Agreement commitments) and the local level (e.g., China emissions trading scheme). However, there is a growing accountability on businesses to address climate-related risks.

This is fueled by regulatory developments, increasing shareholder resolutions, legal action, recommendations made by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) and, perhaps most importantly, investor demands. Investors are increasingly seeking more nonfinancial information to assess the long-term value creation potential of portfolio companies.

Businesses, therefore, should be better informed on how they are managing their climate-related risks, including climate-related financial risks. In doing so, they may be able to respond better to growing demands from investors and create sustainable, long-term value.

This article discusses why greater transparency is warranted on the impact of climate risks and the opportunity that disclosure can bring.

Financial sector is driving greater disclosure of climate risks

The financial sector considers that climate change risks (including both physical and transition risks) represent a systemic financial risk to the economy (including sudden loss of asset values), which is not being adequately addressed by businesses. This aligns to EY’s annual investor survey[1] that shows stranded assets remain a concern for the majority of investors.

And this sector, including the investors and the asset managers who represent them, are often growing impatient. This validates what investors are telling us, globally, in our investor survey that more than one in four investors indicate an expectation of dramatic improvements in organizations’ disclosures on climate risks and how they are being managed.

But even regardless of this, investors are already considering climate risks in their decision-making and taking action. Sixty-two percent of them reported decreasing their holdings, or monitoring holdings closely, due to stranded asset risks. Examples of more direct investor action on climate change include the US$1 trillion Government Pension Fund of Norway, also known as the Oil Fund, which controls 1.5% of all global stocks. It announced a plan in November 2017 to completely divest from oil and gas (after having already sold most of its coal stocks).3 And in December 2017, the World Bank announced it would withdraw from financing upstream oil- and gas-related investments after 2019. 

Beyond the financial sector, other influencing factors are leading to better management and disclosure of climate-related risks, including:

  • Increasing shareholder requests for businesses to report on climate-related financial risks and activities to transition to a low-carbon economy
  • Stock exchanges and securities that have the ability to encourage or mandate better climate disclosure in listings
  • Credit-rating agencies beginning to consider climate risk as part of sovereign credit ratings

This has all sorts of ramifications for businesses impacted — including valuations of assets and liabilities, capital raising and financing (as shown in Figure 1 below). These shifting market dynamics are not only impacting assessment of risks, but also generating opportunities and opening up innovation and disruption. 

From risk mitigation to competitive advantage

While changes associated with a transition to a lower-carbon economy can present significant risks, they can also create huge opportunities for organizations providing climate-compatible approaches. Leading organizations can have better chances to capture these opportunities, which may come in terms of new businesses, products and services. In particular, embedding climate risk and opportunities into corporate strategic thinking can have the potential to increase innovation, anticipate and stay ahead of policy changes, and improve operational efficiency and resources management. In some way, successfully aligning over time with a “2°C strategy” can become an indicator of a company’s governance.

Our annual investor survey also indicates that most investors today clearly point out how management of environmental, social and governance (ESG) factors can help in identifying new opportunities and managing long-term investment risks.

In addition to satisfying investors’ demands, there can be significant other benefits to businesses from disclosing climate-related risks:

Benefits Description
Risk management
  • Embedding of climate risks (transition risks and physical risks) in an organization’s risk management
Familiarization for scenario analysis
  • Improved capability in quantitative modelling and data analytics
  • Greater rigor and sophistication in the use of data sets and assumptions supporting the definition of scenarios
External communication
  • Consistency of messaging across different external reporting mediums (e.g., investor relations, financial reporting, corporate reporting and sustainability reporting)

Shift the focus areas of external stakeholders

  • More aligning of content of disclosures with interest of long-term investors
  • Shifting of the focus of investors and shareholders toward forward-looking assumptions, methodology, opportunities and strategy

Educational journey and fiduciary

  • Increased directors’ awareness of their fiduciary duty
  • Educational journey for board members and investor relations personnel

What are companies doing?

Many companies are developing reporting tools and methodologies to identify and assess climate risks. Aligning with the TCFD recommendations, these corporations are including items on their exposure to climate risks and on their efforts to mitigate or to adapt to these risks in their annual reports.

Leading companies address climate risks and opportunities not only in terms of implications for reporting, but also in terms of their strategic anticipation and operational investments. Only a few companies are currently deploying a forward-looking scenario analysis to support their strategic vision of how to protect and to create value. These activities not only depend on the capacity of managers to anticipate changes, but also on their capability to implement the necessary transformations that can help reposition their business and support sustainable growth in the long run.

Will your business conform to a “wait-and-see” approach or will it look to increase gains from disclosing climate-related risks? 

Climate risks are more complex and longer-term in nature than most traditional business risks, and this has contributed to a lack of understanding and measurement on their potential impacts.

If an organization does not have a clear understanding of the range and magnitude of potential financial impacts from climate change, this may be increasingly detrimental to its financial performance.

So, where to start?

Disclosing climate-related risks likely requires changes to the governance and risk assessment processes (as per the TCFD recommendations). It may require several years for an organization to be in a position to generate valuable information for investors and shareholders to help them make informed decisions. The earlier your company embarks on this journey and provides a platform to help educate directors and management about climate risks, the better positioned your company will be to engage with investors and shareholders on the impacts and opportunities for your organization.

Companies that seek to understand their climate risks exposure can ask themselves the following questions:

In most cases, businesses would undertake detailed analysis across their operations in order to respond to the above questions. This can mean working alongside risk, governance and financial reporting teams to provide company-specific climate risk analysis and disclosures that fully meet the TCFD disclosure recommendations.

The results of these risks assessments should be designed to meet the requirements of the organization and can be qualitative or quantitative in nature.

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

  • Show references# Hide references

    1. The Global Risks Report 2018, 13th edition, World Economic Forum, 2018.
    2. Is your nonfinancial performance revealing the true value of your business to investors?, EYGM Limited, 2017.

Summary

Climate-related risks have grown in prominence over the years, and regulatory developments, investor demands, legal action and recommendations by the Task Force on Climate-related Financial Disclosures indicate that businesses should be better informed on how they are managing these risks. Disclosing this information not only helps assess the impact of risks, but may open up ideas for innovation and disruption that generates opportunities.

Sustainability, risk, governance and financial reporting teams need to work together to provide this information to boards and stakeholders to help educate them on climate risks, mitigation options and possible opportunities.

About this article

By

EY India

Multidisciplinary professional services organization