Innovest Strategic Value Advisors, Inc.

Value at Risk: Climate Change and the Future of Governance


Courtesy of Innovest Strategic Value Advisors, Inc.


Climate change is rapidly becoming one of the core challenges of the 21st century for corporate directors and institutional investors. As this report documents, in the absence of preventive and adaptive measures, multi-billion dollar financial losses are distinctly possible if not probable.

As the potentially devastating economic consequences for investors, individual companies and entire industry sectors come into clearer focus, the onus is being placed squarely upon company directors, pension fund trustees,
and institutional investors to respond.

Unfortunately, U.S. corporate directors and institutional investors are, virtually without exception, in a state of double denial. First, they are in denial about the very existence, much less the magnitude, of the threat itself. Second, and paradoxically, they also seem oblivious to both the practicality and the affordability of early mitigation measures.

Company directors and institutional investors in the United States currently control – and have legal responsibilities for – roughly $7.4 trillion of financial assets invested in corporate equities, and a significant proportion of it could be at risk from climate change.

The risks here are two-fold: (1) the economic/financial risk from the damages and remediation due to climate change itself (directly to companies and indirectly through general socio-economic disruptions in the US and abroad), and (2) exposure to the costs of greenhouse gas emissions in any regime to mitigate climate change. These are not necessarily applicable to the same corporate entities. The first set of risks affects companies vulnerable to sea level rise, weather extremes, temperature and precipitation changes, etc.; the second set of risks affects carbon-intensive companies, which would face the costs of any mitigation regimes.

Neglecting to assess these risks is neither prudent nor responsible. The more information on climate-related damage accumulates, the more the refusal to examine these risks carries the potential for breach of fiduciary duty. Corporate board members and institutional investors can no longer ignore corporate practices that, over time, could result in tens of billions of dollars of losses to companies and their shareholders. To fulfill their fiduciary duties, investors and directors now must understand which industry sectors and companies are exposed to the greatest risks, what measures if any are being taken to reduce them, and how effective they are likely to be.

Company directors and institutional investors in the United States currently control – and have legal responsibilities for – roughly $7.4 trillion of financial assets invested in corporate equities, and a significant proportion of it could be at risk from climate change.

In contrast to their European counterparts and competitors, U.S. companies and financial institutions are lagging behind. However, four powerful forces are converging rapidly to accelerate the need for action: strengthening
political consensus within governments for action to address the climate change threat; growing evidence that environmental and social issues are directly linked to companies’ financial performance; rising shareholder
activism; and increasing demands for greater corporate disclosure.

Sadly, U.S. fiduciaries have been slow to respond to these challenges. They have tended either to ignore the climate change phenomenon altogether, or to subscribe to the increasingly discredited view that solutions must inevitably be costly, both to individual companies and to the entire U.S. economy. When compared to the traditional U.S. enthusiasm for innovation and technological substitution, this is an uncharacteristically pessimistic and timid point of view with little grounding in fact. Recent studies by the National Academy of Sciences and others create serious
doubts about the economic cost thesis. Indeed, it is increasingly evident that the costs of inaction are likely to far outweigh the costs of action.

The bottom line, as this report documents, is straightforward: climate change represents a potential multi-billion dollar risk to a wide variety of U.S. businesses and industries. It should, therefore, command the same level
of attention and urgency as any other business risk of this magnitude.

But what, precisely, must company directors and institutional investors do to discharge their fiduciary duties in a responsible and prudent fashion in the face of the economic threats posed by climate change?

Corporate Directors

Both by law and by convention, company directors have a very clear set of duties. The most important of these are: to set and monitor overall company strategy and direction; to select, compensate, monitor, and evaluate the CEO; to protect the long-term assets of the shareholders; and to ensure the integrity and clarity of the company’s reporting to key stakeholders. In light of these duties, company directors should:

   1.Ensure that the company has sufficient expertise to make informed and responsible decisions regarding climate change. New conditions have arisen in the twenty-first century that are very different from those in which most corporate directors have professional experience. This means that most board members and company executives are under-informed and under-prepared for these new challenges. Board members should commit to ensuring that both the board itself and senior management have access to and use the necessary specialized expertise to make informed decisions in this area.

2. Insist that company executives undertake a thorough assessment of the company’s current and probable risk exposure to the financial and competitive consequences of climate change. As a first step, this will involve measuring the company’s greenhouse gas emissions throughout its entire value chain. The best available reporting framework with which to do this is the Greenhouse Gas Reporting Protocol. The Protocol was jointly convened by the World Resources Institute and the World Business Council for Sustainable Development, and is included in the comprehensive Global Reporting Initiative (GRI) Guidelines.

   3.Insist that company executives have also thoroughly examined the opportunities which climate change may also present for new or expanded business activity and/or cost reduction. Climate change is not only about risk; it is also about opportunities. A few leading multinationals have already shown impressive results cutting
      greenhouse gas emissions significantly at no net cost whatsoever.

   4. Require that the company benchmark itself against its industry competitors, as well as against best practice from other industry sectors. This will not only give the board and senior executives a much clearer idea of the company’s relative risk exposure, but could also be a source of concrete ideas about effective new initiatives.

5. Develop, announce, and implement an explicit strategy on climate change that it is integrated into the company’s overall business strategy. This could mean anything from including “cost of carbon” calculation scenarios when examining potential projects to creating long-term strategies for changing the company’s portfolio of businesses to remain competitive in the coming transition to a carbon-constrained business environment.

6. Link executive compensation to the company’s performance on climate change objectives. Risk exposures, and therefore specific responses and quantitative performance targets, will vary with each company. What is important is that the targets exist, that they are both ambitious and realistic, and that executives’
      compensation is tied in part to their success in meeting or exceeding those targets.

7. Explore new strategic alliances and business arrangements. This could take many forms, from choosing new, less carbon-intensive suppliers, to new collaborations with NGOs, to investing in new carbon-mitigation

8. Ensure that the company develops and follows best practice standards for disclosing its climate change exposures to investors and to other external and internal stakeholders. Institutional shareholders and the company’s other key stakeholders reward companies for candor, transparency, and genuine efforts to improve their environmental performance, and will assume the worst when little or no information is forthcoming. The Global Reporting Initiative, recently launched as an international standard setting body, provides a comprehensive and widely accepted format for communicating with stakeholders on climate change and other social/environmental performance issues.

9. Create formal lines of accountability. Establish formal, board-level accountability mechanisms to monitor and
      report on the company’s progress in addressing climate-driven business risks and opportunities, and to ensure that any necessary remedial actions are taken promptly.

Institutional Investors

Institutional investors in the United States have a legal duty to act prudently and solely in their beneficiaries’ best interests. Embedded climate risk is a serious long-term threat to the preservation of investment value. For fiduciaries to fulfill their duties under these conditions they must:

   1. Seek expert advice on climate risk. Very few investment managers and securities analysts have the
      specialized skills or experience necessary to quantify companies’ exposure to climate risks. There are, however, a growing number of world-class authorities with expertise in the technical, policy, and financial aspects of climate change mitigation. Institutional fiduciaries would be derelict in their responsibilities if they failed to utilize those resources where necessary.
   2. Undertake a portfolio-wide assessment of risk exposures. Climate risk varies widely among industry sectors. Even within the same sector the risk can vary by as much as sixty times. As fiduciaries of other
      people’s money, institutional investors must understand and control their relative level of risk exposure. Over time, this should become part of investment managers’ overall risk management processes.
   3. Incorporate climate change considerations into overall investment strategies. Pension fund trustees need to state their policy toward embedded climate risk in their statement of investment principles. Mutual fund portfolio
      managers must incorporate climate risk into their assessments of individual companies, industry sectors, and entire investment portfolios.
   4. Request – and if necessary, demand – greater disclosure of climate risks by companies wishing to be considered as investment candidates. Clearly, investors cannot factor climate risk into their decision-making
      processes if they lack basic information on company-specific risk levels. In some European countries, such disclosure is now being mandated by legislation or demanded by the largest institutional investors.
   5. Encourage best practice among their portfolio companies. As owners of the firms in which they hold shares, institutional investors and/or their outside fund managers must encourage the senior executives of their portfolio companies to pursue best practice in climate change risk management. Such encouragement will most likely need to be both through private discussions and public support for shareholder resolutions. Institutional investors can also join their peers in informal alliances such as the CERES Sustainable Governance Project or the U.K.-based Carbon Disclosure Project that encourage companies to make their risk exposures and performance more transparent to investors and other stakeholders.
   6. Explore the commercial potential of new, “climate-friendly” investment products. Some innovative asset managers have recently created new mutual funds whose stock selection is oriented towards companies with superior strategic positioning and lower risk regarding climate change. These funds have already demonstrated both marketing and financial performance benefits.
   7. Channel more investment capital into “clean energy” opportunities. In addition to the large multinational companies which are the primary focus of the mutual funds described above, there are many promising
      investment opportunities among smaller companies which are developing and commercializing new clean energy technologies such as fuel cells, microturbines, and solar power. Most major institutions are already investing more heavily in unlisted, privately held companies in general anyway; all that would be required is a greater willingness to examine the growing opportunities specific to climate-friendly technologies. These companies are making a very direct contribution to minimizing the adverse effects of climate change, and the economic prospects of the best of them are attractive indeed.
   8. Promote the universal adoption of the Greenhouse Gas Reporting Protocol recommended in the Global Reporting Initiative’s reporting guidelines. The more that greenhouse gas reporting can be done using a common, standardized format, the easier it will be for institutional investors and other stakeholders to assess and compare company performance, and to encourage both top performers and laggards to move to a higher performance level.
   9. Support collective industry initiatives promoting a lower carbon economy. While institutional investors have considerable power and influence over company performance as individual actors, that influence can be increased many times through collective industry action. A number of fora already exist to do precisely this, including CERES, the Council of Institutional Investors, the Global Reporting Initiative, the International Corporate Governance Network, and the United Nations Environment Programme’s Finance Initiative, among others. In addition, investors can and should make their views known to both national governments and key multinational institutions such as the World Bank and its sister institutions.

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