How climate change leads to financial risk

Here’s an excerpt from this excellent piece by Peresfoni’s Kristina Wyatt:

We seem to have a basic disagreement over whether climate change presents financial risks and opportunities for companies. Those opposed to ESG transparency seem to believe that investments that consider climate change must necessarily sacrifice returns or carry added risk. The thinking seems to be that if you address societal issues such as the climate crisis, then you must be sacrificing financial returns. Others understand that climate change presents financial risks that must be considered in prudent investment decision-making. The legislation to block the consideration of ESG factors in investment decision-making puts plan fiduciaries in a difficult position.

It might be useful to examine some of the ways in which climate change presents financial risks and opportunities for companies and their investors.

Task Force on Climate-related Financial Disclosures (TCFD)

The Task Force on Climate-related Financial Disclosures provides the framework for the SEC’s proposed climate rule, the International Sustainability Standards Board’s climate standards, and the EU’s Corporate Sustainability Reporting Directive. It is the anchor framework for climate-related financial risk reporting around the world. It provides companies with a structure for analyzing how climate change presents financial risks and opportunities.

The TCFD framework categorizes climate related risks and opportunities as either physical or transition risks and opportunities.

Physical risks. Physical risks are those risks that directly result from the physical impacts of climate change. The TCFD encourages companies to think about physical risks in two buckets – acute and chronic physical risks. Acute physical risks relate to sudden, event-driven climate impacts. These might include the threat of hurricanes, tornadoes, tsunamis, wildfires, or flooding. Companies with significant operations in areas prone to such extreme weather events should consider these threats to their business. They need to plan for potential loss of facilities or operations. For example, if a company has critical production facilities in areas subject to frequent storms, it is prudent for investors to ask whether the company has plans to mitigate the risk. This is not a theoretical issue as climate disasters cost the US over $165 billion in 2022 alone.

Physical risks can also be chronic – manifesting more gradually and persistently. Chronic physical risks might include threats to business posed by temperature increases, sea level rise, and drought. Companies with operations that will be underwater will need to plan for those climate impacts. The same holds for companies whose crops will not be able to grow on the land currently used for agriculture, companies dependent on outdoor workers in inhospitable climates, and businesses dependent on water supplies in drought-prone areas. All of these risks manifest as financial risks that companies will need to consider in order to survive and prosper.

Transition risks and opportunities. Transition risks and opportunities arise as a result of the transition to a lower carbon economy. This is where a company’s measurement of its carbon emissions is particularly important. The TCFD provides some useful examples of categories of transition risks and opportunities, including policy, legal, technological, market, and reputational factors.

Legal and policy developments will significantly alter how countries and companies factor climate effects into their decisions as they work to meet their net zero commitments. For example, the EU’s Carbon Border Adjustment Mechanism will permit countries to impose carbon tariffs on goods entering the country, which will have a significant economic impact for some companies. Other legal and policy considerations include the financial impact of laws restricting emissions, and the impact of litigation against heavy emitters.

The emergence of lower greenhouse gas-intensive products such as electric vehicles as substitutes for more carbon intensive products such as internal combustion engine cars will alter demand for the more carbon intensive products. Automobile companies are already transforming their design and manufacturing plans to meet this shift in consumer demand. The Inflation Reduction Act is pouring money into the economy that will foster the development and scaling of such low carbon substitutes. As younger generations move into the workforce and increasingly drive consumer and investor demand, companies addressing the climate impacts of their goods and services stand to be the big winners. Studies indicate that  Gen Z cares more about sustainable buying than brand recognition, and Millennials and Gen Zers choose to work for companies taking action to address climate change. Companies that focus on these opportunities will gain competitive advantage, particularly as younger generations make up an increasing percentage of the consumer and labor pools.

In the end, prohibiting pension plan trustees from considering climate risks and opportunities is tantamount to forcing them to breach their fiduciary duty. That can’t be the result we want. Let’s instead think in a clear-eyed manner about the real financial risks and opportunities that we face and incorporate them into investment decisions to optimize long-term risk adjusted returns for workers who will depend on their retirement savings.