PwC on Getting Serious About the Realities of Climate Risk

Originally published at pwc.com. PwC is a Hall of Fame company.

 

The race for net zero has captured the imaginations of countries and companies alike. And not a moment too soon: The latest report from the UN’s Intergovernmental Panel on Climate Change finds that greenhouse gas emissions (GHGs) must peak no later than 2025 to avoid the most dangerous and irreversible effects of climate change.

But even as governments and companies ramp up their decarbonization commitments, there’s another pressing challenge that’s not getting nearly enough management attention. Outside of the most carbon-intensive industries, too few CEOs are looking closely enough at the physical and transition risks that a changing climate poses to their companies. And these risks can be eye-opening. Consider these real-life examples:

  • A conglomerate came to learn that extreme weather events could cost it several hundred million dollars a year as soon as 2030. Most of the company’s risk exposure is in its supply chain, and out of its direct control.
  • A large retailer identified dozens of its critical facilities at elevated risk of extreme weather, and saw how a global transition to a low-carbon economy could more than double the company’s transportation costs by 2030.
  • A global industrial equipment maker learned it must redesign a flagship product and then retrofit its installed base — or else the product is likely to malfunction in areas where climate change is making conditions wetter.
  • As drought and declining snowpack levels threaten low-cost hydroelectric power sources in the western United States, a number of technology companies are reappraising their mix of sustainable energy sources to fuel power-hungry data centers.

Climate risks such as these are not only worrying business challenges for CEOs and other leaders, but deeply human challenges, too. One case in point: The massive investments that B2B companies have made in back-office service centers in countries such as India — parts of which face life-threatening heat and humidity spikes in the coming years.

In this article, we’ll highlight how a few companies are using a better understanding of their climate risks (both physical and transition) as a springboard to a more robust and effective climate agenda, one that helps mitigate risks, spot opportunities and can offer insights into the separate but related challenges of their own decarbonization. Along the way, we’ll explore how the actions and motivations of key stakeholders are pressuring companies to act, and we’ll look at the difficult trade-offs that CEOs must weigh — including those involving the social and human implications of climate change. The transition ahead needs to be both swift and just.

Start with climate risk

In our conversations with CEOs and other senior business leaders, we often encounter a curious disconnect. Leaders know about the looming physical dangers of climate change in a general sense — a litany of climate hazards that includes extreme storms and coastal flooding as well as increased heatwaves, droughts and wildfires. Indeed, the World Economic Forum’s Global Risks Report 2022 (which tracks the risk perceptions of global leaders in business, government and civil society) found that “extreme weather” was considered the most likely risk to become a critical global threat over the next two years.

Nonetheless, we find that leaders have much less of an understanding of the specific impact that climate change could have on their business — for example, the physical risks to operations, infrastructure or to a company’s supply chain, let alone to the business-related transition risks that a societal and economic shift to a decarbonized world would bring (such as changes in demand, the impact on energy prices, building renovation requirements or potential competitive impacts on logistics chains).

Whether the disconnect is down to the complexity of the problem, the cognitive biases that prevent us from accurately judging probability and risk, or some other mix of factors, we can’t say.

Whatever the cause, climate risks should factor more heavily into a CEO’s thinking, and start informing all of a company’s climate-related decisions. After all, the risks are present whether leaders know it or not. For some companies, extreme weather events and other physical effects of climate change are already having detrimental impacts. It’s therefore a big mistake for senior executives to conclude that these challenges can be put off for another day. And if leaders do think of procrastinating, a range of stakeholders are standing by to refocus corporate attention, as we’ll see next.

Three pressure points

CEOs may not be thinking hard enough about climate risks, but key corporate stakeholders are doing their best to change that. And whether stakeholders’ motivations are informed by climate risk, decarbonization commitments, or both, it’s imperative for business leaders to pay closer attention.

This starts by appreciating the speed at which the stakeholder landscape is changing. Several signs suggest a tipping point that could catch unprepared leaders by surprise — for at least three reasons financial institutions are getting serious about finding climate risks hidden in their portfolios; governments are seeking to live up to big decarbonization promises; and sweeping new climate reporting requirements are taking shape quickly — and in some cases are already affecting the real economy. A review of recent developments in these areas — and their implications — can help leadership teams start to challenge old assumptions and prioritize action.

1. Growing financial pressures

Financial institutions of all stripes are getting serious about climate change. For instance, consider the Glasgow Financial Alliance for Net Zero (GFANZ). This coalition of banks, insurance companies, asset managers and asset owners has pledged to cut emissions from their portfolios and lending to reach net zero by 2050, with an interim target set for 2030. Formed only in late 2021, GFANZ members already represent about US$130 trillion — 40% of the world’s financial assets.

Although the most immediate decarbonization impacts are being felt in GHG-intensive industries (coal companies are finding it harder to attract capital, for example, because many financial-services companies have already announced their divestment), the effects are now spreading more widely. Financial institutions are starting to make investment decisions based on the climate-linked risks of their portfolios. Here’s how Christian Ulbrich, the CEO of US-based real estate services company Jones Lang LaSalle, described the challenge in an interview with “strategy+business” magazine: “There is no easy solution for many buildings because of the way they are constructed — it is financially unattractive to try to decarbonize them. But if you sit on those assets, they’ll very quickly become stranded assets. The speed with which financial institutions are declining to finance those buildings and investors and fund managers are deciding not to buy them is amazing.”

The upshot for CEOs and their leadership teams is clear: The pressure from financial institutions will soon start to touch everything from a company’s credit rating, valuation and cost of capital to its ability to borrow and get insurance. Too many leaders have not come to grips with the implications of a business world where climate risks are transparent, public, financially material for shareholders and ultimately part of a board’s fiduciary duty to manage.

2. Stronger government commitments

Governments are also ramping up decarbonization commitments. Today, an astonishing 90% of the global economy falls under a net-zero pledge, up from just 16% in 2019. Such promises can only be met with a massive realignment of economic activity. Although most net-zero commitments target 2050, countries are laying out interim goals and pressuring companies to do likewise. Proposed UK Treasury rules, for example, would force large UK companies by 2024 to detail how they plan to meet their own net-zero targets (with companies in high-emitting sectors doing so in 2023).

Although the prospect of mandates and blockbuster regulatory moves get the lion’s share of corporate attention, a host of seemingly smaller actions could cause C-suite surprises. These include green taxation policies, incentives for innovation and end-of-life recycling requirements. A recently enacted UK plastic packaging tax, for instance, has caught some manufacturers and importers flat-footed as they race to gather recycled-content data from their extended supply chains, or even from their own operations.

More is on the way. The European Union Green Deal — a group of policies and initiatives adopted in late 2019 to help make Europe the first climate-neutral continent—  includes more than 1,000 new or modified levies. At a global level, our PwC colleagues have mapped more than 1,400 environmental taxes and incentives across 88 countries and regions as part of an ongoing research effort. To explore interactive snapshots of 21 of these countries, see Green Taxes and Incentives Tracker.

3. Better nonfinancial reporting

As lenders, asset managers, investors and insurers get sensitized to the climate risks in their portfolios, they are demanding more transparency from clients and customers. The result is an unprecedented desire for effective nonfinancial reporting.

One popular choice is the Taskforce for Climate-Related Financial Disclosures (TCFD). TCFD was established in 2015 by the Financial Stability Board, and has been embraced by financial institutions, which remain an influential part of the 3,100 companies in 93 countries that now support it. TCFD rules essentially require businesses to identify, manage and report on climate-related risks — using scenario analysis — as well as to report the level of carbon embedded in the footprint of the business. The TCFD framework provides a useful starting point for companies eager to start understanding the climate risks and opportunities they should anticipate. TCFD reporting is starting to be enshrined in law, first in New Zealand and more recently in Japan and the United Kingdom — with more countries on the way.

Similarly, the European Financial Reporting Advisory Group (EFRAG) and the International Financial Reporting Standards Foundation (IFRS) call for standards that require the reporting of financial vulnerabilities from climate change — in terms of both physical and transition risks.

Not to be outdone, the US Securities and Exchange Commission recently gave initial approval to a rule that would require public companies to disclose annually the “actual or likely material impacts” on the business caused by climate change. The rule — still in draft form — also requires disclosure of a company’s direct and indirect GHG emissions (so-called Scope 1 and Scope 2 emissions). The largest companies would need to go further and report GHGs generated by suppliers and end users (Scope 3 emissions) if these emissions are considered material or are included in other decarbonization targets the company has set.

As these developments suggest, companies have their work cut out for them. Greater scrutiny will increase demand for greater corporate action, as stakeholders start to gain the information they need to reward good climate performance — and penalize poor.

Navigate the crosscurrents

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