In January of this year, BlackRock CEO Larry Fink penned an open letter about the dangers of climate risk, calling on investors “to reassess core assumptions about modern finance.” As the world’s largest asset manager, with $7.4 trillion under management, BlackRock’s yearly letter to CEOs is taken very seriously by the investment and business communities.
Fink cites research by the United Nations Intergovernmental Panel on Climate Change, the BlackRock Investment Institute, and McKinsey, among others, for painting a clear picture of the financial impacts that climate risks will increasingly have. To have such a leader in global finance, an industry not known for its climate consciousness, addressing the threats posed by climate change represented an important normative shift and signaled the ascension of climate risk considerations into the corporate mainstream.
As Fink puts it, “climate risk is investment risk,” providing further evidence of how much more seriously the world is beginning to take the climate crisis. This year, BlackRock joined the Climate Action 100+ initiative, whose signatories pledge to reduce emissions to Paris Agreement compliance, further illustrating the firm’s growing commitment to addressing climate risk.
But what exactly is climate risk? Simply put, it’s the recognition of the potential financial dangers posed by climate change. It’s important to note that climate risk doesn’t just incorporate the long-term, physical risks posed by natural disasters, but also the short-run financial, economic, and regulatory transition risks associated with shifting to a decarbonized economy and society. Kevin Stiroh, Executive Vice President of the New York Federal Reserve Bank, defines physical risk as “the potential for losses as climate-related changes disrupt business operations, destroy capital and interrupt economic activity.” Transition risk is “the potential for loss resulting from a shift toward a lower-carbon economy as policy, consumer sentiment and technological innovations impact the value of certain assets and liabilities.” Assessing climate risk means analyzing the scope, consequences, and potential policy responses to anthropogenic climate change.
Why do financial climate risks matter?
The concept of climate risk is already becoming more mainstream. At the 2020 World Economic Forum in Davos, Switzerland, S&P Global held a sobering presentation on climate risk, estimating that “more than 40% of the world’s largest companies have sites at high risk from the physical impacts of climate change.” In the U.S. alone, 60% of S&P 500 companies, with a market capitalization of $18 trillion, were “at high risk of at least one climate-related physical event.”
It’s not just businesses that are vulnerable. Utility company PG&E’s 2019 bankruptcy, dubbed the “first of many climate change bankruptcies,” put banks on alert as well. The consulting firm Oliver Wyman argues that “banks should treat climate risk as a financial risk, not just as a reputational one,” and that they “should integrate climate considerations into financial risk management.”
A McKinsey report states that in the face of unavoidable climate change, banks must “manage their own financial exposures and to help finance a green agenda, which will be critical to mitigate the impact of global warming.” Both, the report continues, will require “excellent climate-risk management.”
Historically, banks and other businesses have often dealt with climate change largely as an act of corporate social responsibility (or greenwashing, for the cynics). In one instance, British Petroleum, infamous for the 2010 Deepwater Horizon oil spill, received backlash for its first global advertising campaign in almost a decade, with critics calling it deceptive. In the series of ads, BP touts its commitment to clean energy in a bid to appear more climate-conscious, despite the fact that their green investment represents only three percent of the company’s total expenditure.
Now, banks and other financial institutions are realizing that the climate crisis poses real financial risks that need to be addressed by more than a PR campaign and choice donations. In a boon to the environmental movement, it seems that climate change has finally mutated in the global consciousness from just an environmental and moral issue into a financial one as well.
What can be done about it?
There are already companies actively assessing climate risk. Helen Bertelli, whose firm Benecomms is running the marketing campaign for The Climate Service, a climate risk analytics company, is working to understand these risks. Bertelli indicated that companies are beginning to feel and see the effects of climate change, and want to know how that will impact their bottom line.
“When investments are at stake or people’s livelihoods are at stake, there’s a fiduciary duty to make sure you’re anticipating risk and taking steps to work towards it,” she told Climate XChange.
The coronavirus pandemic shocked financial markets all over the world, sending stocks plummeting. In Bertelli’s view, savvy investors and businesses, now sharply cognizant of the tremendous impacts of sudden shocks on the economy, are seeing the parallels between COVID-19 and climate change and are trying to understand their exposure. According to Bertelli, The Climate Service is seeing a “huge amount of interest” in its service, which provides users with detailed models of their transitional and physical climate risk.
Beyond assessing risk, changes will need to be made at the institutional level to incorporate said risk into everyday practice. Banks, McKinsey states, are under “rising regulatory and commercial pressure to protect themselves from the impact of climate change and to align with the global sustainability agenda.” Some banks will take steps to address climate risk on their balance sheets of their own volition (and economic common sense), but, if the 2008 financial crisis has taught us anything, there will always be those who want to push the envelope of what they can get away with for as long as possible.
Climate risk’s political applications
Outside of finance, political action needs to be taken to require climate risk assessments in sectors critical to national security, public health, and everyday life — such as electricity generation, infrastructure, and education. For example, the federal government could examine the vulnerability of highways to climate-change-fueled natural disasters. But in such a polarized political environment, particularly around climate change, how can climate risk become politically mainstream?
Acknowledging and dealing with climate risk isn’t an ethical decision, or even a partisan one — it’s simply good business. CEOs and boards all across the world make rational, apolitical decisions everyday: where to best allocate funds. Assessing and dealing with climate risk is no different, despite the polarization of climate change.
Climate risk’s ascension into the broader financial consciousness allows for powerful new cases for climate action to be made. Think of traditional arguments against climate change: disputing the veracity of the science, claiming the problem is too expensive to fix, downplaying the danger, or making it a partisan issue.
A counter-argument centered around climate risk helps dispute all of these. Climate risk is a non-political, economic understanding of exposure to climate change, meaning partisan arguments don’t apply as easily. Instead, the climate crisis is understood as an increasingly clear financial risk that should be heeded, planned for, and avoided as much as possible. After all, the risks will remain, whether individuals understand the realities of climate change or not.
Financial risks from climate change could garner conservative support for mitigation
For conservatives who believe the threat of the climate crisis to be overblown, or who deny it’s very existence, a climate risk argument pits ideological beliefs against an even more motivating factor: economic well being. While many politicians have disputed climate science as a politically-motivated tactic to pander to their conservative base, brushing climate risk aside is much more difficult, as doing so could have a significant impact on finances.
Duke Energy, one of the largest electricity companies in the Southeast, has infrastructure that is at risk from physical damage as a result of disasters fueled by climate change, particularly hurricanes. In the past, when a hurricane destroys physical infrastructure, Duke usually goes to the respective utilities commissions and asks them for permission to increase rates, like they did in 2018 when Hurricanes Florence and Michael caused over $700 million in damages in North and South Carolina.
There’s nothing inherently wrong with this. Duke Energy was hit hard by environmental factors out of its control and, in order to fulfill it’s duty to its shareholders and protect its bottom line, needed a way to recoup its costs. In an economic system where Duke is incentivized to provide stable returns and reliable electricity, it’s rational for them to seek compensation for climate-related expenses. However, that doesn’t mean that building back in the same way, without changing their exposure to climate risk, is what’s best for the company, their customers, and the planet.
Climate risk in North Carolina
Imagine a scenario where the North Carolina Utilities Commission, having ruled that Duke Energy failed to properly accommodate climate risks into their planning, doesn’t allow the utility company to fully recoup its costs. This would align with the Commission’s stated responsibility to “provide fair regulation of public utilities in the interest of the public.”
There’s already precedent for this. The California Public Utilities Commission (PUC) penalized PG&E for it’s conduct ahead of destructive wildfires in 2017 and 2018, although critics argue that the PUC ruling is much too lax and doesn’t do enough to prevent future misconduct. It isn’t so far-fetched on Duke’s end either. This year, according to the Energy and Policy Institute, the utility giant “failed to consider climate-related risk in [a] North Carolina rate case.”
A Commission ruling that Duke couldn’t recoup all of its losses would cause the company’s stock price to fall as the market responds to a drop in revenue and a reduced confidence in Duke’s ability to deal with climate risk. Duke Energy would then be forced to deal with the threat climate change poses to their business model in order to survive.
In order for this to truly be successful, the bounds of rational behavior must shift so that it no longer is acceptable for Duke to avoid the costs of inaction. While the utility giant may not pursue climate action for marketing reasons or out of the goodness of their heart, they are much more likely to do so when it is in their business interest. And such a change wouldn’t be pressured by nonprofits or environmentalists clamoring for climate action, but instead by the company’s own shareholders.
The scenario I just painted is what the team at Vote Solar have been trying to accomplish. In testimony to the North Carolina Utilities Commission, Vote Solar emphasized the need to manage climate risk, pointing out “the exposure faced by [Duke Energy] to climate-related risks due to, among other things, the vulnerability of physical assets to more frequent and intense extreme weather events,” and argued that Duke’s analysis of its climate risk is “woefully inadequate.” After settling with VoteSolar, Duke Energy agreed to establish a Climate Risk and Resilience Working Group.
While this win is merely a first step and incorporating climate risk into all financial decision-making is only just beginning, it shows that major utilities cannot afford to fully ignore the climate crisis any more. As it becomes part of conventional risk assessment, exposed utility companies won’t be the only ones looking to protect themselves. In an era rampant with the denial of science and disdain of expertise, climate risk could be the tool that spurs action among those most hesitant and brings us closer to the change we so desperately need.
