Global calls for better corporate “climate risk disclosure” have exploded over the last 12-24 months. The underlying hypothesis of much of the risk disclosure conversation is that if companies disclose climate risks to shareholders, financial markets will price those risks into share prices, stock markets will become more efficient, and financial stability will be safeguarded. But how convincing is this hypothesis?
Companies clearly should have as good an understanding as possible of what the future might hold for their operations and their business model. That is the whole idea behind enterprise risk management in the short term and scenario planning in the longer term.
When it comes to climate risks, an understanding of potential “climate futures” can help companies anticipate and adapt to those risks they can plausibly hedge against. Such understanding can also perhaps lead companies to advocate for the public policies needed to mitigate the risks they cannot hedge against as individual companies.
But having studied climate risks for the better part of three decades, I’m intrigued by the idea that climate risk disclosure by itself can lead to a more efficient market and the protection of financial stability. There is no such thing as objective “truth” when it comes to climate futures and risks. In fact, it’s just the opposite for three key reasons:
I’ll focus here just on the second bullet item, and identify some variables that arguably should be part of the kind of comprehensive risk assessment that might allow climate risks to be effectively incorporated into share prices:
These are just some possible components of a comprehensive climate risk scenario. Many of these variables are inherently uncertain, and become much more so as one looks more than a couple of years into the future.
The number of “climate risk narratives” that can be extracted from even a modestly comprehensive climate scenario is enormous. One way to think about this is to realize that almost any company could come up with plausible risk narratives ranging from “climate change is not material to us,” to “climate change is an existential threat to our business model.”
Today’s risk disclosure conversation makes me think back almost 20 years to when a U.S. utility carried out the first climate risk assessment in the sector. The result of the assessment was that “climate change is not a material business risk.” Being one of the largest U.S. coal-fired electricity producers at the time, it seemed an odd conclusion even 20 years ago.
But it wasn’t hard to figure out how it had happened. It’s because the company’s climate scenario included two key assumptions: 1) that any emissions reduction mandates would be implemented very gradually, and 2) that the company would be able to purchase as many $4/ton carbon offsets as needed to meet any emissions reduction mandates. Based on those two assumptions, it’s easy to see why a company would conclude that climate change is not material.
And you know what? That risk assessment turned out to be accurate for the next 20 years!
None of the subjectivity of climate risk scenario planning as described above invalidates the importance of scenario planning to better inform corporate thinking and decision-making. However, that subjectivity does have implications for whether and how risk disclosure reflecting the results of scenario planning will lead to the “correct” pricing of climate risk into share prices. Indeed, the expectation of having to disclose the results of serious scenario planning exercises is almost certain to have a big impact on the scenario planning process and the resulting risk narrative -- and not in a way that contributes to correctly “pricing in” climate risks.
Furthermore, to compare the climate risks facing individual companies (as many investors want to do), you would almost have to mandate the details of the scenario against which all companies would carry out scenario planning. But there is no universal climate scenario that makes sense for all companies, even within a business sector. Even if such an approach could be implemented, there would still be a lot of variation in the risk narratives that individual companies would develop. The idea of easily comparable risk disclosure narratives is almost certainly a case of #greenwishing.
As originally noted, the idea that business "risk disclosure" can "effectively price climate change" into stock markets and economic decision-making and "safeguard financial stability" is little more than a hypothesis at this point. And it’s not a hypothesis for which I’ve seen a lot of evidence.
If climate change is perceived as a potentially existential threat to society, the idea of relying on business risk assessment and disclosure to significantly moderate that threat is pretty odd. Our best bet is to help companies understand the limitations of their ability to manage their climate risks through adaptation and resilience and the importance of advocating for policies that actually could mitigate the full spectrum of climate risks. Scenario planning can play a big role in helping companies come to that conclusion, no matter how non-intuitive climate policy advocacy might be for many business decision-makers.