It is becoming increasingly evident that climate change is going to be one of the most important drivers of economic change over the next 50 years. Vast amounts of shareholder value will be destroyed as companies – and even whole industries – fail to make the necessary adjustments. But even larger amounts value are likely to be created by the companies and technologies of the post-carbon economy.
It is vital, then, that investors begin understand how climate change will affect corporate earnings over both the short and long term, and how well individual companies are managing their risks in this area. Friends Ivory & Sime (FIS), a major London based investment house, has established a partnership with Andersen’s Greenhouse Gas Emission Trading Service to investigate the impact of climate change for investors. Our work to date has focused on the following questions: Is there a relationship between climate change and shareholder value? How well do companies and investors understand the risks climate change poses? What strategic responses are open to companies?
Climate change and shareholder value
It is already clear that market conditions are shifting. As awareness about climate change in the financial community grows, those companies most impacted will be expected to adjust their strategies to take account of additional and potential revenue streams associated with carbon restrictions and potential emission trading schemes.
With the exception of a few leading organisations, such as oil majors BP and Shell, little work has gone into analysing these changing market conditions and assessing the financial consequences of managing greenhouse gas GHG) emissions. This is not surprising, given that governments are only just beginning to put in place frameworks to address GHGs.
However, as carbon levies are introduced and emissions trading markets develop, it is clear that a quantifiable relationship will emerge between attempts to tackle climate change and impacts on company revenues. So firms will need to assess the financial implications of carbon to inform decision making and thus the creation of shareholder value.
Figure 1 outlines some examples of how changing external influences can affect the cash flow analysis of a company which is directly impacted (either operationally or via its products) by climate change.
The nature and extent of the impact climate change may have on a company’s cash flow will vary considerably depending on the sector in which it operates. However, this diagram goes some way to illustrating the link between climate change and shareholder value and highlighting where the connections may be. It does not, though, shed any light on how climate change relates to corporate risk.
Climate change as a corporate risk issue
To develop a better understanding of the risk perceptions and the potential risks and opportunities from climate change, we conducted an in-depth benchmarking study examining 14 UK based companies across the energy, pharmaceutical and consumer goods sectors.
The study set out to inform investors’ thinking on the implications of climate change for the firms in which we invest. It was primarily questionnaire-based, exploring nine questions across three main areas: perceptions of climate change and its impact on the company’s shareholder value; identification of climate change risk and opportunity; and risk mitigation and management. In almost all cases, the initial questionnaire was supported with interviews with companies.
The results of this study clearly show that leading companies are beginning to acknowledge the risk that climate change (and attempts to mitigate it) may have a substantial effect on their long term business success – 91% of companies questioned see climate change as a risk (see fig 2)
While most companies focus their concern on the impact of climate change on their operations, a number of companies – exclusively those in the energy sector – see it having a significant effect on demand for their products and services.(see fig 3)
One key role for investors as far as climate change is concerned relates to the role they have in holding companies to account for their management of risks.
Although the overwhelming majority of respondents identified climate change as a risk, there was considerable variation in how this risk was identified, measured, and reported. Some companies have already begun to integrate climate change into their main business risk identification and measurement frameworks, whereas others had yet to recognise climate change as a direct business issue.
This is a key area for investors to be aware of, and to take action on.
In the UK, recently produced guidelines, published in the Turnbull Report on the Combined Code of the Committee on Corporate Governance, specify that companies should ensure they have effective systems in place to identify, evaluate and manage their “significant” risks.
However, our study indicates many companies may be some
way from effective management of climate change risks. The emerging consensus in the investment community regarding risks arising from social and environmental issues suggests that companies should:
- establish effective systems for the identification of significant risks, and disclose to shareholders what they are;
- make clear statements of policy expectations and objectives with regard to significant risks;
- put in place effective management systems for the implementation of these policies;
- make disclosures about the effectiveness of these management systems; and
- ensure that the above measures are directed by the board.
The findings of our study indicate that the majority of companies comply to some extent with the elements of this good practice framework, but there are large gaps, particularly with regard to risk identification, for issues of corporate social responsibility and their disclosure. Given the potential scale of climate change risks, FIS and other investors are likely to want to raise concerns about the quality of risk management in this area with many companies in which they invest. In this context, it is worth noting that the Association of British Insurers has recently published guidelines for the effective governance of risks to companies from social, environmental and ethical issues (see page 7). It is expected that these guidelines will be endorsed by major UK asset managers, and that they will provide a focus for debate about the effective management of climate change risks.
But, for institutional investors, the impact of climate change will extend far beyond the governance and risk management process. Large institutional investors are effectively permanent shareholders in many of the world’s largest companies – their investment strategies make it almost impossible for them to dispose of their holdings in these companies. As such, the strategic positioning of firms in regard to climate change is also crucial – and, here too, investors have a role in encouraging companies to consider their response.
Developing a response will depend on the nature of companies’ operations, range and value of opportunities that are perceived to be available, and the strategic intent of the business. Figure 4 outlines possible corporate models which could be used to provide a method of comparing sectors and companies.
There are many ways investors and companies can analyse and compare firms’ strategic responses to climate change. The model identified here is just one possible way that comparisons can be made and communicated – more are likely to follow.
In summary, investors are at last beginning to engage in the debate about climate change risks, but they have a lot to learn. They will need to develop a better understanding of the impacts of climate change on sectors and companies so that these aspects can be better taken into account in investment decisions. Investors will also need to start to capture the potential risks and opportunities arising from climate change in their existing financial analysis at both a sectoral and company level.
They will also have to ensure that companies have effective systems for the identification of significant risks and disclosure of these risks in a way that allows shareholders to build them into their financial models. These steps will be achieved with greatest effect if investors and companies work together to form a consensus of what needs to be done and how.