Good Corporate Governance and Climate Change Risk
Mindy S. Lubber,
In recent years global climate change has evolved from a largely technical issue to one of the most critical, widely discussed challenges for public and private sectors alike. Within the private sector in particular, climate change has rapidly developed into a major strategic and operational issue for both industrial corporations and their investors. Compelling evidence now exists that the competitive and financial consequences for individual companies under business-as-usual scenarios will be immense. Both the impacts of climate change itself and the need to cut greenhouse gas emissions will create new risks. Indeed, even within the same industry sector, corporate exposures to the risks of climate change can vary greatly. In short, the financial impacts both for individual companies and for entire industry sectors are real and potentially very serious.
In other words, thinking about global climate change is no longer a "what-if" exercise. It is a growing strategic priority for boards of directors, institutional investors, and others with a stake in companies' long-term fiscal health.
On the policy level, governments and other policy-setting bodies continue to advance evermore tangible schemes for companies to reduce greenhouse gas emissions from industrial sources. These policies are driven in part by the hardening scientific consensus on the reality of climate change. The Third Assessment Report (2001) from the International Panel on Climate Change (IPCC) is unequivocal about the alarming increase in greenhouse gases in the atmosphere over the past century and the major role of fossil fuel emissions in causing that rise. The Report also reports broad consensus that greenhouse gases produced by human activity are the principle cause of increasing average global temperatures leading to serious disturbances in the earth's climate.
Now the global financial community is awakening to the fiscal dimensions of the business risk of climate change. According to the European insurer Munich Re, the annual cost of climate change related claims could reach $300 billion annually by 2050. Another major insurer, Swiss Re, announced in November that it will no longer provide directors and officers liability coverage for climate change related claims to companies that lack climate change policies.
Shareholder concern about how companies plan to navigate the risks of climate change is also on the rise. In the United States, shareholders, including New York City and the State of Connecticut retirement system, two of the largest U.S. institutional investors, filed 19 climate change resolutions in the 2002 proxy season, twice as many as in any of the previous eight years. The average support for these resolutions also doubled.
Despite the scientific consensus and dramatic environmental and financial implications, many in the U.S. continue to toy with a wait-and-see attitude toward climate change, downplaying its risks and exaggerating the short-term costs of action. Ironically, this "pro-business" stance of delay and denial about climate change could bring far more harm than good to American businesses and their millions of shareholders.
The reality is that risks from climate change are already embedded, to some degree, in every business and investment portfolio. Now is the time for those who safeguard shareholder value to define how and where climate change creates risk for their companies, assess the extent and effectiveness of steps to reduce that risk, and push for better climate risk management.
Every sector of the economy will likely be affected in some way by climate change. Specific industries are especially vulnerable to the direct effects of climate change, such as sea level rises, weather extremes, and temperature and precipitation changes.
Many companies, especially the carbon-intensive companies at the heart of the energy value chain and industries with massive power needs, need to assess and plan for a carbon-limited future and the attendant costs of emissions reduction and mitigation. Despite the U.S. decision to turn its back on the Kyoto Protocol, countries continue to ratify the treaty and it is likely to go into force. Germany, the Netherlands, France, Sweden, Canada, Australia, and Japan are currently establishing concrete national emissions abatement plans, and the European Union aims to get 50% of its energy from renewable sources by 2050. The European Union and the United Kingdom are setting up emissions trading regimes. Especially for companies that operate globally, it will be more cost-effective to start now on measured, timely progress on emissions reductions, rather than play catch-up later.
The competitive risk of inaction could be dramatic. Companies could find themselves arriving late to emerging markets for alternative energy solutions, transportation solutions, and all the subsidiary markets driven by these major ones. Or lagging firms could lose customers as customers choose firms that take action on climate change. The laggards could find their reputations damaged and brands diminished.
With a clear understanding that the dimensions of climate change risk are large enough to be a fiduciary responsibility, boards of directors can begin to exercise that role by assessing companies' current and future exposure to financial and competitive risks driven by climate change. They should be sure they have access to specialised expertise on climate change impacts and risk reduction options. Outdated information can lead to serious understatements of risks and overstatements of the costs of taking action.
Boards should also encourage senior management to identify opportunities for cost savings and business opportunities. Alcoa is working on ways to drastically reduce smelting energy needs. Inert anodes could be operational in five years; a fuel-cell approach, in ten to fifteen. Cummins Engine is supplying compressed natural gas engines to the Chinese government so that several thousand of Beijing's diesel buses can be switched to cleaner-burning gas.
Once risks and opportunities are clearly understood, a board can take the lead in developing and announcing an explicit strategy on climate change that is integrated into the company's business strategy. The strategy should be accompanied by best-practice standards for disclosing climate change risk exposure to investors and other stakeholders. And, of course, boards can guide the implementation of the climate change strategy, creating formal lines of accountability for meeting objectives and managing and responding to risks and opportunities.
As the owners of 60% of the total outstanding equity of the largest 1,000 corporations in the U.S., institutional investors should feel no hesitation about taking a more active stance on climate change. Since they hold shares for the long term, they build value for shareholders as much through influencing company policy rather than through playing the market. Wherever climate change threatens a company's long-term value, institutional investors have a clear responsibility to encourage action.
Internally, institutional investors should first undertake a portfolio-wide assessment of exposure to climate change risk, and then integrate climate change considerations into risk management practices and explicit investment policies. As very few investment managers have the specialised skills to quantify companies' exposure to climate risk, they should seek guidance from authorities with expertise in the technical, policy, and financial aspects of climate change risk and mitigation.
Externally, institutional investors can work with portfolio companies and potential investment targets to encourage better disclosure of climate risks and timely action on reducing risk and capitalising on opportunities. Both private discussion and public mechanisms such as shareholder resolutions are valuable in shaping company policy.
Institutional investors can also actively seek "clean energy" and "climate friendly" investment products. Mutual funds oriented toward companies with an advanced climate change strategy and lower climate risk exposure have shown early promise, building on the well-documented performance edge found in environmentally advanced firms. Investment opportunities may also be found among small, privately held companies developing and commercialising new clean energy technologies such as fuel cells and microturbines.
Informal alliances such as the CERES Sustainable Governance Project and the U.K.-based Carbon Disclosure project are also avenues for institutional investors to promote better corporate performance and transparency in climate risk management. A common framework for emissions reporting, such as the Greenhouse Gas Reporting Protocol as incorporated into the Global Reporting Initiative's Sustainability Reporting Guidelines, makes it easier for investors to assess and compare company performance and encourage improvements.
Looking at the emergence of climate change as a business risk issue, boards of directors may see much that seems familiar. What has changed is that the horizon for concrete action, which has long been unclear, is now plainly visible. Given the potential magnitude of the risks of inaction, fiduciaries should act now to protect the wealth of the shareholders they serve.
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