Climate-related risks are rapidly working their way up the agenda. Since the global transition to a low-carbon economy, business leaders have become more aware of the issues heading their way in the short term. But there is much more to be done.
Business leaders are increasingly switching on to the fact that if they fail to adapt their organisations, they will be exposed to a range of climate-related risks stemming from the global transition to a low-carbon economy, more volatile weather patterns, and major environmental change.
Our analysis shows that the value of organisations could fall by as much as 30 per cent over the next five years if this very real and immediate threat is not taken seriously. For some, a failure to act could trigger an existential threat as their value proposition loses relevance or their business model becomes unviable.
The issue comes down to a clear but challenging question: how can we address these imminent threats without de-prioritising other business goals? The process of mitigating against climate risk may be costly, potentially risky and challenging to surface when competing with business-as-usual priorities.
Our work with organisations from a variety of sectors has led us to believe that there are three main challenges: financial planning and strategic decisions rarely factor in climate change implications; climate change is often considered a medium or long-term concern, so action is not prioritised; and analyses of climate-risk mitigation strategies often overlook opportunities and upsides.
Here, we examine each in turn.
- The cost of doing nothing
Climate change-related risks are already impacting profitability, and this will intensify dramatically over the next decade for unprepared businesses.
Costs are being driven up by a range of factors, including higher raw material prices, due to more volatile weather; a rise in the global price of carbon; tighter emissions standards; increased risk of climate-related liability; and the capex required to transform operations to zero-carbon alternatives.
In the steel sector, for example, 86 per cent of direct operational emissions and indirect emissions from the consumption of external energy are covered by existing or planned carbon price schemes designed to drive up the cost of emitting carbon dioxide. If the global carbon price reaches $100 by 2040, research suggests that 14 per cent of the sector’s potential value will be at risk.
Meanwhile, revenues are being impacted by changes in demand as consumer preferences shift towards more sustainable products and weather patterns alter consumer behaviour. In some instances, climate change could undermine demand to the extent that it makes a particular product or business unviable.
Under certain climate scenarios, for example, our analysis predicts that water scarcity could become so acute in India – a key market for many global consumer businesses – that it may limit the use of, and therefore demand for, household products such as soap that rely on water in the consumer use phase.
Businesses that successfully embed these considerations into financial and strategic planning are aware that climate risk is a commercial priority as much as it is an environmental priority, and that climate mitigation has both costs and economic upside.
2. A near-term concern
The effects of climate risks will be felt more strongly and sooner than most businesses anticipate. This is especially true for transition risks: if the world is to achieve the Paris Agreement goal of limiting global warming to 1.5oC above preindustrial levels, then the shift to a low-carbon economy will be fast and sharp. Regulations, laws and market policies will need to ramp up dramatically even in the next five years.
Take the price of carbon as an example. Our analysis forecasts that, to achieve the 1.5°C ambition, the global average cost of carbon will need to rise to at least $80 per ton of carbon dioxide (or equivalent greenhouse gases) by 2025 – a staggering increase from the current average of less than $5.
The investment community is also driving rapid change as investors increasingly prioritise returns from low-carbon companies and shun organisations with significant exposure to climate-related risks.
Investors are demanding that companies create, communicate and act on robust plans to reduce climate risk exposures. Markets price in risk several years before it is likely to materialise so investor sentiment can change quickly and early.
Major investors are already punishing heavy carbon producers as they decarbonise their portfolios and, in the words of Larry Fink, CEO and chairman of Blackrock: “In the near future – and sooner than most anticipate – there will be a significant reallocation of capital.”
Climate action is therefore an urgent business imperative. Without climate-smart strategies, companies will see their market value eroded much sooner than is widely anticipated and find it increasingly more expensive to access capital.
- The cost of missed opportunities
There is one additional cost that is often overlooked: the opportunity cost.
Put more positively, organisations that pivot their business models to benefit from the immense change that is underway will future-proof their business models, capitalise on new consumer and technological opportunities and align with investor demands. Ultimately, they will maintain relevance in a fast-changing environment.
Implementing change on this scale demands considerable investment and is strategically risky: it will impact supply chains, product mix, operations and investment strategies. Each company will have challenging decisions about what tradeoffs to make and how fast to move but the companies that manage this transition successfully will be in a powerfully competitive position.
A strong business case for the board
How can businesses re-frame the climate question so that tackling climate risk does not pull in the opposite direction to other commercial priorities?
For many companies, the biggest challenge and the most important step is translating climate risks into usable business metrics that can inform business decisions. How will future earnings be impacted by increased drought in the locations that we source our raw materials over the next five, ten and twenty years? What percentage of our supply chain is liable to carbon taxes over the same timeframes and how will this impact our cost base?
Once climate risk is expressed in business metrics it becomes visible on the balance sheet and the business case for action is easier to make. Not only does this process make clear the cost of inaction, it also illuminates the economic benefits of taking mitigating measures.
The most advanced companies use this approach to make detailed and carefully planned climate roadmaps, bespoke to the particular needs of their business models and strategic priorities. They use models that combine their own company data with the latest climate science and global policy projections, to create plans that minimise the costs of climate change and maximise the commercial opportunities.
The experience of these leading companies demonstrates that taking an analytical approach gives leaders the confidence to understand the trade-offs at stake and to take fully-informed decisions. It also demonstrates that climate risk and commercial priorities are intricately linked.
While there is much uncertainty about climate change, one thing is certain: there may be some short-term pain but the costs of ‘doing nothing’ will be far greater – for the global economy, generally, but also for individual businesses. The organisations that realise and act on this will be the winners in the great transformation that is underway.