6 Climate risk management in the private sector

A focus on knowledge, scenario analysis and corporate governance will be of importance for private sector climate risk management. Expanded knowledge and sound decisions can reduce climate risk. It is likely that the private sector will benefit from drawing actively on climate risk information and knowledge since this is a new and important discipline in which new insights are developed at a high pace, scenario analysis and stress testing to strengthen the resilience of business models in the face of high uncertainty, and corporate governance because the high uncertainty and long time horizon associated with climate risk suggest that owners and lenders should actively address risk that may go beyond the planning horizon of many enterprises.

Different stakeholders are confronted with different climate risks, and must perform different analyses, although based on common principles. Physical climate risk may for example give rise to challenges for insurance providers’ pricing of claims risk, the localisation of enterprises in areas prone to flooding and landslips, and the resilience of integrated global supply chains based on limited warehousing. Uncertainty with regard to climate policy and technological developments makes it necessary for the oil industry to consider a range of very dissimilar oil and gas demand scenarios, including a scenario of steep decline in the use of fossil fuels. The potential for a dramatic restructuring of the transport system has implications for a great many stakeholders. Resilience can be strengthened by challenging entrenched perceptions about the future, through the use of tools such as scenario analysis and stress testing.

Climate risk affects the scope and scale of investments. Transition to a low-emission society means that some sectors and businesses are facing increasing demand and mounting investment needs, whilst for other businesses it may be more profitable to devote a smaller portion of earnings to investments and return a larger portion to their owners. When confronted with increased uncertainty and a distinctly provisional knowledge base, it may be appropriate for businesses to favour investments characterised by flexibility and swift payback over projects which involve a long payback period and which are difficult to modify along the way. Flexibility means increased resilience, and resilience is valuable when faced with risk we have little influence over.

The financial market is a key climate risk management arena for the private sector. Businesses need to consider climate risk when making their investment decisions, and investment funding is often raised in the financial market. The private sector will also use the financial market to adjust its desired exposure to climate risk, with the financial market allocating risk both through hedging arrangements and through diversification across assets. When one market participant reduces its exposure to a risk factor, the risk is reallocated to other market participants. It is therefore an important question whether or not such risk ends up with market participants that are well placed to manage it.

The financial market determines which businesses obtain funding. When businesses seek to raise capital, whether from the banking system or the capital market, they need to convince lenders and investors that their operations are viable also in a future characterised by a different climate and a low greenhouse gas emission regime. Businesses wishing to invest in projects relating to a low-emission economy also need to be able to demonstrate that their projects meet accepted profitability requirements. The transition to a low-emission economy necessitates large investments, and a considerable portion of such investments will be channelled through the financial markets. If financial market participants have a proper understanding of what risk climate change entails for various sectors and businesses, it will enable investors and the financial industry to contribute to restructuring by way of corporate governance, granting of credit, as well as development of new products and instruments.

A dearth of information inhibits the financial market and exacerbates climate risk. It is a prerequisite for well-functioning capital markets and an effective allocation of capital to investments that prices reflect available and relevant information, including information on climate risk faced by various types of enterprises. High and persistent uncertainty at many levels, with regard to climate change, climate policy as well as energy markets, impairs the ability of the market to price risk. Incorrect pricing of climate risk and incorrect allocation of capital may also increase the risk of financial instability in the longer run. Moreover, we know from experience that when financial imbalances are triggered, the interaction between the financial system and the rest of the economy may result in severe disruption.

The risk of financial instability depends on the timing and speed of the transition to a low-emission economy. Climate change represents a type of structural change that happens gradually and over a long period of time, which should in theory mean that financial market participants have ample time to modify their expectations and portfolios. If expectations concerning the transition to a low-emission society are upset by unforeseen shocks in the form of policy reversals, sudden price formation upheavals or technological breakthroughs, one result will be an increased risk of major market shifts and financial instability. As far as the previously mentioned future scenarios are concerned, financial stability will be less of a concern in scenario A of successful climate policy than in scenario B of later and more severe policy tightening. In scenario C of dramatic climate change, other risk is more dominant, but such risk may give rise to financial market disruption, which may itself exacerbate problems in other arenas.

Companies with high carbon exposure may be vulnerable in the transition to a low-emission society. There are a number of examples of slumping market value of enterprises in sectors experiencing technological shifts and regulatory upheaval. Global financial markets are held to be relatively efficient, thus implying that company valuations will reflect the profitability and uncertainty expectations of investors, including climate change and climate policy implications. Companies with large direct or indirect exposure to fossil energy sources may seem especially vulnerable in a scenario in which climate policy is tightened and the demand for petroleum products declines significantly more than expected. Those petroleum reserves that are the most expensive to extract can in such cases be expected to be abandoned upon transition to a low-emission society. It is likely that such marginal reserves are of little significance to the current market valuation of oil companies.

Companies based on renewable energy are also exposed to transition risk. Uncertainty with regard to how various energy prices will evolve and which technologies will prevail also represent risk factors for companies focusing on a low-emission society. Rapid technology development and declining costs mean that investments made today may risk being quickly outcompeted by newer and cheaper capacity. Hence, the risk of misguided investments and a «Green Bubble» in renewable energy are also relevant issues when assessing climate risk factors in the financial market.

Climate risk and transition to a low-emission economy necessitate good reporting and corporate governance. It is a challenge that incentives and time horizons are not necessarily concurrent for owners and executives, or for capital owners and managers, whilst it may be challenging for owners to get access to sufficient information about, and control over, how duties are discharged. Such principal-agent problems are a general challenge in financial markets, but may be of special relevance to climate risk in view of the long-term nature of such risk and its potential for generating major structural market changes.

Corporate governance may be of special relevance for industries facing restructuring. In the long run, it must be assumed that strict and effective global climate policy aimed at reducing demand for fossil fuels will result in swifter restructuring of the global petroleum industry than under a benchmark without stricter climate policy. A key challenge for investors is to assess the extent to which such restructuring will take the form of restructuring of existing companies or the gradual downscaling of such companies and the development of new ones. If one is faced with a situation in which oil companies are confronted with reduced access to attractive and profitable projects within their traditional core business, both research and experience indicate that one runs a risk of weaker capital discipline and lower returns to owners. This means that active follow-up is required on the part of owners in order to ensure that future investments, whether in the traditional core business or in any new business areas, offer adequate profitability. There has been a steep increase in global investor initiatives to address this challenge. These initiatives focus on improved climate risk management, value chain emissions reduction and improved reporting. More transparency surrounding the transition strategies adopted by companies in response to the climate challenge is intended to enhance the scope of investors for imposing discipline on the capital use of companies.

Good corporate reporting on climate risk is of key importance. Statutory requirements and established market standards shall facilitate corporate reporting that provides market participants with relevant information they can base their investment decisions on. Corporate reporting of climate-related risk has thus far been heterogenous and fragmented. This gave rise to an international effort to examine how companies can report on climate-related risk in a better and more systematic manner. FSB (a cooperation forum for the financial supervisory authorities of the G20 countries) appointed the Task Force for Climate-related Financial Disclosures (TCFD) to develop a framework for the reporting of climate-related risk. The TCFD report was completed in 2017 and has been widely endorsed internationally.

TCFD recommends a framework for reporting of climate-related risk that can help companies identify climate-related threats and opportunities. By including climate-related information in ordinary corporate reporting, one facilitates more informed decisions on the part of investors and others with regard to climate-related threats and opportunities. Reporting on how they factor climate risk into their strategy processes, and on how such risk is identified, measured and managed, may make companies more aware of what risk climate change may pose to their business model. A key recommendation from TCFD is that companies should stress test their business models against reasonable climate policy scenarios, and specifically against a scenario in which the temperature increase is limited in line with the ambitions under the Paris Agreement. Such stress tests may be of considerable value to investors, since companies will have to show how they are going to make money if the climate policy ambitions are met. The Commission is of the view that the recommendations in the TCFD report can also be of relevance to the public sector.