The Obama Administration’s new ambitious target to reduce greenhouse gasses provides an example of a future where greenhouse gas emissions (GHGs) are increasingly likely to become financial material for the private sector.
However, while natural capital risks can also become financial material for companies, it is important to distinguish how they differ from those corporate climate risks.
How climate change risks are becoming material:
In the long run the expected effects of more frequent and/or more volatile floods, droughts and storms will affect companies in the real economy as well as lenders, investors and insurers substantially. Such operational risks may cause losses to the global economy of US$ 4.2 trillion in discounted, present value terms out of total assets of US$ 143 trillion, according to value at risk (VaR) research by the Economist Intelligence Unit. This highlights the financial relevance of climate change risks for the asset management industry and beyond. However, in the short-term, corporate climate risks could arguably be mainly regarded as the probability of a political decision whether or not to limit greenhouse gas emissions.
Obama’s Clean Power Plan to reduce GHGs by 32% by 2030 from 2005 levels means that it will make investments in coal and other forms of carbon-intensive energy generation less financially viable. This would in turn boost the deployment of capital to renewable energy production and energy efficiency, supporting the transition to a low-carbon, more resource-efficient economy. If political leaders would set an ambitious climate agreement for the whole world, this would de-facto lead to the creation of a ‘carbon budget’ (as GHGs need to be limited in order to have a reasonable chance to avert a temperature increase of 2C compared to the pre-industrial level). Such a carbon budget could lead to asset stranding in the coal, oil and gas industry as 60-80% of reserves of listed firms cannot be exploited, which would in turn affect their market values.
However, it is not only governments that are enforcing the transition to a low-carbon economy with its associated risks and opportunities for the private sector. Recently, a civil society group backed by a number of organisations sued the Government of the Netherlands due to lack of progress on the reduction of GHGs. In a landmark ruling the judge decided that the Dutch government is now legally obliged to limit GHGs by 25% in 2020, compared to 1990 levels. When put into place this may have as similar effects on power utilities and other carbon-intensive industries as the recent government-induced action that took place in the United States.
Hence, while operational risks are not currently insignificant- with insurers and reinsurers now systematically calculating the costs of extreme weather events and other natural disasters on the global economy- corporate climate risks are perhaps in the short-term more relevant from a political and legal risk perspective, while operational risks and the associated costs will further rise especially without strong abatement efforts. The effects of these types of risks on the corporate sector are not homogenous; those carbon-intensive industries such as coal, oil and gas, as well as power utilities and the mining industry will be forced to transition to a low-carbon means of operating in order to weather these changes; thus creating opportunities for corporate entities that are ahead of the curve compared to their sector peers.
How do these risks differ from corporate natural capital risks?
Impacts such as deforestation and dependency on the earth’s natural resources (i.e. water extraction for industrial use) has for a long time remained predominantly a reputational risk issue for companies. There are numerous examples where mining companies, agribusinesses, forestry enterprises and other types of businesses have been criticized by N.G.Os and others for failing to adequately address environmental and social concerns. Lenders and investors too have been on the radar of civil action groups for providing the financial means that have led to these significant environmental and social impacts.
However, I would argue that this is gradually changing, especially for those ecosystem services that can be regarded as crucial inputs on which companies in different sectors depend. Water can be regarded as a key natural capital resource for which its financial reality can increasingly be calculated due to growing water stress. Such operational risks can become especially material for water-dependent industries such as mining, food and beverages, power generation, drinking water utilities and others. Such a natural capital risk becomes financially material if it affects standard financial metrics such as EBIT (Earnings Before Interest and Tax) or costs the company in question.
For example, the south of Brazil is experiencing the worst drought in 80 years, severely affecting São Paulo state which accounts for a third of Brazil's economy and 40% of its industrial production. The agricultural sector, including production of coffee and sugar (for ethanol), has been seriously affected. An article in The Guardian in February highlighted that production of Arabica coffee beans fell 15% last year, which given that Brazil is by far the biggest producer , pushed up the global price of the commodity by almost half. While rising population density and higher water consumption are among the reasons cited, there is increasing evidence that continued deforestation in the Amazon leads to decreased rainfall. As a result of the ongoing drought, the Brazilian water firm Sabesp saw the outlook on its credit rating changed to negative by Moody’s, S&P and Fitch. More firms with credit ratings could potentially be affected if the drought severely impacts earnings and/or costs to such an extent that it affects a business’s creditworthiness.
In the above example the complex marriage of a severe weather event coupled with deforestation affects water stress, which in turn affects agricultural output as well as power generation. Two practical tools by the Natural Capital Declaration (NCD) that will be launched in September aim to enable financial institutions to integrate water stress directly in the valuation of listed equities (jointly done with Bloomberg) and corporate bonds (jointly done with GIZ and VfU).
Natural capital impacts such as deforestation, on the other hand, are much more difficult to quantify in financial terms than natural capital dependencies that are often part of the production process of companies, because the effects in terms of additional GHGs, biodiversity loss and water regulation are likely be felt by other entities. A new UNEP report titled 'Bank and Investor Risk Policies on Soft Commodities' has attempted to provide a conceptual framework to articulate the business case for agribusinesses as well as lenders and investors to decouple impact on forests from soft commodity production such as palm oil, soy and beef. In addition to the report, financial institutions have the ability to use a new Excel-based practical, self-assessment tool by the NCD to develop, update and strengthen soft commodity risk policies. While the tool will enable the financial industry to gain more insight into their own risks and opportunities, this will have be followed with a more quantitative assessment of how deforestation (or other types of corporate impacts) can be quantified in standard financial metrics such effects on earnings or costs.
Unlike corporate climate risks, it appears that natural capital risks are transitioning from being predominately focused on hedging reputational risks to trying to deal with operational risks, which can increasingly become financially material, even in the absence of government regulation!
By Ivo Mulder, UNEP
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