Understanding climate not merely as an element of sustainability, but rather from an external rating and internal risk management perspective for safeguarding and promoting a functioning, stable and integral financial system.
“The company has been deliberately refraining from sending printed Christmas cards for a long time.” This literal statement reflects a certain listed companies’ sustainability strategy. It surely seems insufficient for claiming that its corporate sustainability strategy will help the company thrive in a world increasingly shaped by climate change. With this example, it’s fair to ask: do companies have a clue on what to expect from climate-related changing market conditions and what does a suitable adaptation to such changes entail?
The pressure to answer this question will grow. “As we are increasingly faced with the catastrophic and unpredictable consequences of climate change and resource depletion, urgent action is needed to adapt public policies to this new reality,”states the European Commision in its Action Plan: Financing Sustainable Growth. The European Union, as well as several Financial Supervisory Authorities, call for nothing less than adjusting key corporate and financial decision metrics to incorporate climate-related risks.
Following this call, requirements for corresponding metrics go far beyond statically classifying companies as green or brown or any dualistic differentiation which does not touch upon the company’s potential to adapt to climate change. Rather, they need to measure how well-equipped a company is to handle climate-related risks under different future scenarios. We need to understand climate not merely as an element of sustainability and sustainability as a story in itself, but rather from an external rating and internal risk management perspective, seeing these as essential requirements for safeguarding and promoting a functioning, stable and integral financial system.
Facing this unprecedented demand to uncover the shades of climate-related risks for the corporate and financial world with transparent forward-looking information, the international financial market is loaded with uncertainty. Uncertainty that is dangerously exacerbated by the increasing impact climate change might have on a company’s future ability to generate value. So we might then ask: who is affected, and in what way, by climate-related impacts which could unfold in several ways depending on different future socioeconomic pathways? How can we establish thresholds for a company’s future operations, which might pose a systemic danger to financial stability, and how to handle them?
Climate change: a threat to our economies
Climate change serves as a perfect example of an issue that was in the past not strong enough to be considered a material risks and is now in the process of passing the threshold to financial visibility and therefore to materiality. Many national governments and institutions have exacerbated this process by acknowledging climate change as a factor posing huge risk to society, nature and economic financial stability.
If climate is to be considered a material risk for a specific company, this determination will result from modelling its business development strategies under complex X°C worlds. Scenario analysis, being understood as a tool to enhance critical strategic thinking, is a well-established method for developing strategic plans that make a company more resilient for dealing with a range of plausible futures. The higher the level of resiliency in the corporate world, the more likely it is that we will be able to respond to the challenge of safeguarding financial stability.
What lies behind scenario analysis are models that combine climate scientific insights of e.g. the IPCC, company data on e.g. sales, growth, emissions or machine activity data and worldwide available comparative business parameters such as e.g. gross value added (GVA). Resulting science-based climate metrics provide information on the extent a company develops along the requirements of the Paris Climate Agreement. Consequently, such metrics allow for determining if climate is a material risk for a specific company under a future scenario.
Science: The best tool we have
One of the best-known metrics in this area is the so-called Science Based Target of a company developed by the Science Based Targets Initiative. It tells a company exactly when and how much it should reduce its emissions to be in line with the 2°C target. Flexibility and decision-making authority over the strategic handling of such a climate target is provided by science-based models, such as the so-called X-Degree Compatibility (“XDC”) Model. The XDC Model indicates for a company how much the world would warm to by 2050 if all companies were as emission intensive as itself. Results are regarded as a groundbreaking way for assessing materiality of climate change for a single company, since they enable expressing the level of impact on and exposure to climate change under different scenarios and can therefore serve to report risks thoroughly.
The international community has agreed that the global average temperature must not rise more than 2°C compared to pre-industrial levels, which is considered to be the most the Earth could tolerate without risking catastrophic changes to food production, sea levels, fishing, wildlife, deserts and water reserves. The EU is already making a difference by means of the EU 2030 Energy and Climateframework, the Energy Union, the Circular Economy Action Plan, and the EU implementation of the 2030 Agenda for Sustainable Development as well as the proposal to revise existing guidelines on disclosures of non-financial information to further align them with the recommendations of the Task Force on Climate-related Financial Disclosures. It’s rather rare to find such determined action and massive speed at the political level. This is happening at such a high speed, that one hears people working at supervisory institutions alarmed at the fact that it seems that most companies don’t have a clue as to what to expect from changing market conditions and therefore will have a difficult time adapting to upcoming requirements in regards to thorough incorporation of climate related aspects and affectations.
Building on the understanding that an effective response to climate change goes beyond printing or not printing Christmas cards but rather calls for a thorough understanding of its link with financial stability, puts a huge deal of pressure on companies to understand this challenge and create suitable responses. This leads us to believe that understanding climate change with a certain level of maturity can be deemed as a valuable insider tip for building up a company which is able to generate value in a world shaped by climate change.
Hannah Helmke is the CEO and daringly honest and solutions-oriented partner of right. based on science. She never wants to lose her ability to observe. Her focus on economic activity in a world affected by climate change was the result of combining her disciplines Psychology and International Business.
Sebastian Müller is a doctor of law. For 4 years he gained experience in the field of investment tax law. Within right. based on science (“right.”) he works at providing the legal context that justifies the suitability of right.’s science-based X-Degree Compatibility (“XDC”) Model.