This is the story of how a smart executive did great climate change reporting but completely missed it's dangers.
Over coffee the other day, I had a conversation with an executive for a mid-market manufacturer. We were talking about the company's reporting & disclosures around CO2 and other climate liabilities. The conversation went from CDP and GRI to how the company has incorporated internal tools that make its monitoring an automated processes. She was proud of her team's accomplishments and said that in many ways they were now on autopilot. Then just at that moment she pivoted and said, "We've been getting board & investor pressure to disclose our climate liabilities. I feel like we've turned the corner... that we have a really clear understanding of how we impact the environment."
"Great." I said, "So what about how the environment effects you?" Her face soured.
The good news is that carbon disclosures are largely standard for companies of a certain size. In the Fortune 1000 it's virtually obligatory. The bad news is that climate liability is way more involved than just knowing how much water and wood you use or how much CO2 and waste the company creates. Planning for climate change is broader than that. It means knowing how your customer demographics are going to shift and what kind of assets you need to protect. It means watching your cost of capital so big climate-related CAPX can be made both at a maximum discount rate and on a time scale that doesn't freak out investors. In short, it means not just what your organization needs to do to help mitigate global issues, but also when, how and what you need to do to adapt.
When Risk Management Isn't Enough
Readers know from prior posts that the discipline of risk management is the best current framework under which an organization can navigate climate change concerns. This is still true but the conversation I mentioned made clear the need for some additional words on how risk management alone can fail us.
The latest IPCC report and other good sources of climate data have been a big help for companies concerned about the future. Unfortunately, still lacking is clear, granular information from which narrow and specific plans can be made. This presents a challenge. Traditionally risk management begins by plotting likelihood of risks against scale of impacts. That looks something like this:
While this is a good starting point the problem is that "likelihood" is a function of time and and "scale" is a measure of ranking outcomes. So how do we convert regional long term data (even very good data) into investment decisions with defined periods and clear risks? To put a finer point on it consider the example of that most banal of set-pieces, an office building.
Let's assume that an office building is sited somewhere that the data tells us will experience an increase in daily temperatures of 0.7°C over the next 10 years. Let's further assume that the estimate is dead-on accurate. What plans do you make? How many more days of air conditioning will be required? How many fewer days of heating? Does it mean more general warmth or is it more extreme days? and how many? What does it say about an expectation of power outages? What about the frequency of extreme weather events? It's difficult to get the granularity we need from the initial fact about the future.
These first questions relate to the issue of measuring outcomes but many others pop up relative to likelihood. Imagine for a moment that you have good answers to the questions just posed. So what? To make any kind of action plan you still need to know if the 0.7°C rise is happening linearly, if it's expected late in the decade or if the change will be soon and sudden. Even knowing that isn't enough because big shifts don't happen in relation to incremental change, they happen at tipping points. At specific temperatures ice melts and reservoirs lose more water than they take in. At a certain rate of rainfall storm water becomes a flood and fertile fields need watering. For these reasons, the rate of change and where within those changes tipping points get reached are critical for investment decisions.
Returning then to our office building, how can a wise manager scope her operating expenses if the starting assumption is that the future won't be the same as the past? How's a wise tenant to know the frequency of power outages or days shuttered due to extreme weather? How should she scope for climate control and insurance? This is far worse for the building owners and architects who have many years or even decades to plan for. How does a realistic proforma get structured?
Addressing climate change as a risk management issue is still the smart move at the macro scale. Giant, carbon-intense businesses need to be pressured to define their exposure to climate regulation as a bridge between disclosure and risk management. Structurally however, risk management is better suited to dealing with the problem of climate change than it is to modeling a process for how a company will adapt to it.
It's just damn hard.
You can see from our example the difficulty a responsible executive has when trying to address calls for disclosure (and we haven't even addressed how changes to consumer demand and market demographics should be viewed). We're going to have to get used to a world of dynamic and probabilistic disclosures which may be challenging for many in the investment community. Disclosure is intended to inform but a climate variable world must beg the question, "Does dynamic, probabilistic disclosure inform the market or just create greater confusion?" It will be incumbent on executives to create clarity and talk both about what is known and where they see blind spots. Risk has defined characteristics and can be framed easily in reporting. Improved language will be required to answer questions about uncertainty and hazards that lack clear metrics. Regardless of the form those answer take, we may have to settle for a more complicated reality. One where intensive planning complicates disclosures and may leave the reader with more questions but actually signals healthy, realistic management.