A changing climate for business

Climate change risk is no longer a fringe issue. It is now seen as a key factor in the ongoing health and success of a company, as well as an element in a company’s social licence to operate, Pauline Vamos writes.

Climate change risk is now recognised as a real peril to the ability of some companies to sustain their business models over the longer term. This is why shareholders and investors are key drivers of corporate behaviour, in spite of their disagreement on what the risks are and how they should be managed.

It’s worth starting with the superannuation industry, as the vast majority of working Australians are members of a super fund that invests in companies. Superfunds have become large-scale, long-term investors who hold diversified portfolios and are in an ideal position to ensure that companies don’t suffer financial losses from mismanagement of risks to their business – especially under-considered risks such as climate change.

As funds grow and increase in sophistication and experience, they are starting to exercise their stewardship muscles, either directly or through third party providers. There are often two motivations behind this engagement – the assessment of the systemic risk borne within portfolios (including stranded asset risk) caused by climate change, and an increasing concern about the general quality of life provided to fund members as they retire.

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The focus on climate risks by funds has escalated in the last couple of years, driven by an increase in members contacting them on issues such as climate risk and the Australian Prudential Regulation Authority (APRA) asking trustees about their approach to climate risk during supervisory visits.

The timing of this new focus has been driven by four factors.

First, the UN-backed Principles for Responsible Investment (PRI) launched in 2006 have gathered steam. Today, the signatories represent US $70 trillion of assets under management.

Second, the Task Force on Climate-related Financial Disclosures (TCFD), which launched its recommendations in June 2017, has provided guidance to companies and investors alike on how to disclose financially relevant risks related to climate change.

Third, a legal opinion published in Australia in 2016 by Barrister Noel Hutley stated, “it is likely to be only a matter of time before we see litigation against a director who has failed to perceive, disclose or take steps in relation to a foreseeable climate-related risk that can be demonstrated to have caused harm to a company”.

Fourth, a February 2017 speech by APRA board member Geoff Summerhayes, titled “Australia’s new horizon: Climate change challenges and prudential risk”, was the first public speech by an APRA official which addressed climate risk.

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Aside from these factors, there has also been a significant increase in community activism targeting companies. For example, a recent campaign in Australia by the group “Market Forces against Medibank” saw the health insurer announce in November 2017 that it would dump fossil fuel stocks from its portfolio, acknowledging the impact of greenhouse emissions on human health.

We have also seen a growing number of divestments on high emissions industries made by super funds, university endowment funds and even sovereign wealth funds. Late last year, the Norwegian central bank, which runs the country’s sovereign wealth fund, advised the government to approve the dropping of all oil stocks.

Finally, there has been an increase in shareholder resolutions which focus on company management and disclosures of climate change risks, such as those seen at Exxon, Santos, Origin Energy and BHP.

Climate change risk is no longer a fringe issue. It is seen as a key factor in the ongoing health and success of a company, as well as an element in a company’s social licence to operate. Increasingly, it is also seen as an opportunity by some investors, including those seeking alpha, to better understand which stocks are capitalising on a changing climate, or to invest in emerging technologies and financial instruments (e.g. green bonds).

This comes as no surprise, considering the effect on earnings from physical impacts of climate change. They are affecting ‘business as usual’, including operational disruptions, supply chain risks, asset impairments and other costs to businesses.

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These impacts are affecting a broad range of sectors, and predictions for more extreme weather events are only increasing. From Regnan research and engagement activities, we know that Tatts Group has experienced revenue losses associated with horse race cancellations due to bad weather; Myer has suffered losses as a changing climate has impacted winter apparel sales; and Rio Tinto lost production worth more than $1.2bn due to an intense La Niña event impacting the Pilbara during the 2016/17 wet season.

While businesses are affected here and now, companies are adapting more and more to the changing climate.

Aurizon, Australia’s largest rail freight operator, has been adapting to increasing severity and frequency of extreme weather events. Tropical Cyclone Debbie prompted new processes and infrastructure design to support quick recovery. These include more strategically placing inventory stockpiles with materials to rebuild any damaged tracks quickly, and rebuilding slopes affected by major land slips with a flatter gradient, high strength-rock and concrete armour.

Brisbane Airport, in anticipation of sea level rises and storm surges from extreme weather, has built its new runway 1.5 metres above the minimum regulatory requirements. It has also built a seawall and channels to reduce tidal flooding.

There’s still much room for improvement, and there’s a lot of scope for upskilling in the way climate disclosures are produced and assessed – by companies and investors alike – so climate risks can be better managed across the whole financial system.

Scenario analysis, in particular, does not go far enough, quality of disclosure is patchy, and very little is done on physical risks. This means that many readers aren’t able to adequately assess disclosures.

The key to getting the right outcomes is through proactive and outcomes-based company-investor engagement meetings. We need to move from a focus on emissions intensity to industry transition and pay more attention to adaption. As disclosure improves, so too will quality and impact of engagement.