Guest Blog: Closing the Climate Intelligence Gap:
Guest Blog: By Greg Rogers and Charlie Atkins (Full article can be viewed here)
Climate Change, Terrorism and Actionable
Intelligence
In its final report
to Congress in July 2004, the 9/11 Commission likened the threat from terrorism
to “global disease or environmental degradation, … challenges that are
transnational rather than international,” and recommended steps to unify governmental
agencies and information flows, both across the foreign-domestic divide and
within the U.S. intelligence community, so that the intelligence community can
“assemble the puzzle pieces gathered by different agencies to make some sense
of them and then develop a fully informed joint plan.” We posit that climate
change and terrorism are alike in that both present uncertainty about the
nature, timing and potentially catastrophic severity of future losses caused by
inimical forces, and both require collaboration and collective action across
national and organizational boundaries to overcome fragmented intelligence and
disjointed action.
Yet, there is no comparison
in the scale of the U.S. response in the 21st century to the dual
threats of climate change and terrorism. Within the first decade after 9/11, the
cost of the U.S. response to international terrorism was estimated by the New
York Times to be $3.3 trillion and counting, an amount equal to 20%
of then-current U.S. national debt and about $7 million for every dollar Al
Qaeda spent planning and executing the attacks. Climate change has received far
less resources, notwithstanding that it is already inflicting significant
environmental, human and financial losses, and these losses pale in comparison
to what might come. The far-sighted are anticipating broader global impacts on
property, migration and political stability, as well as food and water
security. The Pentagon
warns that climate change poses immediate risks to national security and
may exacerbate the dangers posed by terrorism. Climate change poses a greater
risk to humanity than terrorism. So why isn’t more being done to address it?
Climate
change poses a greater risk to humanity than terrorism. So why isn’t more being
done to address it?
One answer offered
in a 2015
speech to Lloyds of London by Mark Carney, Chairman of the Financial
Stability Board (FSB) and Governor of the Bank of England, is that the
catastrophic impacts of climate change will be felt beyond the traditional
horizons of most actors, imposing a cost on future generations that the current
generation has no direct incentive to fix. Another related explanation offered
by Carney is uncertainty—because we
cannot predict with certainty the nature, timing and severity of future climate-related
threats, technological innovations, consumer and market reactions, and government
policy responses, not all of the actors in government, business and finance
agree on how, when or even whether to respond. As Yogi Berra said, “It's tough
to make predictions, especially about the future.” Berra was right. Measuring, managing and communicating
uncertainty is not easy. Extreme uncertainty, more than irresponsibility, may
explain the world’s anemic response to climate change.
Extreme
uncertainty, more than irresponsibility, may explain the world’s anemic response
to climate change.
Harnessing the Power of Capital Markets to Combat
Climate Change
Carney, whose job
is to foresee and head off systemic financial risks worried that once climate
change becomes a defining issue for financial stability, it may already be too
late. At his urging, G20 Finance Ministers tasked the FSB in 2015 to explore
the role of finance in combatting the climate threat. This led to the 2017
recommendations of the FSB’s Task Force on Climate-Related Financial
Disclosures (TCFD).
The premise
underlying the TCFD’s recommendations is that increased transparency of
information on the climate-related financial risks facing individual
corporations and industries will trigger financial market mechanisms to
reallocate capital so as to avoid a sudden collapse of the global financial
system and over time reduce greenhouse gas emissions and thereby the risks posed
by individual corporations and industries to the environment. Assuming this
premise is correct in theory, as we believe it is, two major question are: can the
TCFD prescription deliver results “soon enough” in the real world; and what
steps, if any, can be taken to accelerate the desired outcomes.
Steps can and
should be taken now to accelerate the virtuous cycle envisioned by the TCFD and
that the appropriate actions can be discerned by answering three interrelated
questions: (1) What actionable intelligence is needed to mitigate systemic
financial risk from climate change; (2) where does this intelligence originate;
and (3) what are the barriers to the origination, reporting and assimilation of
this intelligence and how can these barriers be overcome?
We argue that the
required intelligence is credible evidence of the resiliency of individual
corporations to climate risk (climate resiliency); that this intelligence
originates with long-term strategic planning and analysis, aided by an
understanding of the “real options” (explained below) available at the
individual corporation level; and that the principal barrier to the origination,
reporting and assimilation of this intelligence is fragmentation of knowledge
and information across the investment value chain, which must be overcome
through collective action and collaboration spear-headed by one or more entities
functioning as a “climate intelligence exchange (CIX)”.
We agree with the
recommendations of the TCFD and believe they can be reinforced by explicitly defining
the actionable intelligence needed by individual corporations and the financial
sector to measure and manage climate-related uncertainty, risk and resiliency. While
calling for disclosures about the resilience of the organization’s strategy,
the TCFD guidance does not explicitly explain how resilience is achieved, how
firm managers can measure it in financial terms, and how they should report it.
Transparency is not Enough
Greater financial
transparency will not alone provide this crucial intelligence. "Financial
transparency" refers to "timely, meaningful and reliable
disclosures about a company's performance.” Performance implies something
accomplished. Transparency is essential to the proper functioning of financial
markets, but corporations and markets cannot manage or price uncertain future climate-related
financial impacts by looking in the rearview mirror. Transparency alone is
insufficient. Actionable climate intelligence must focus more on what lies
ahead, not on what exists now or has happened in the past. Climate intelligence
must be predictive and must account for management’s flexibility to make appropriate
mid-course corrections as uncertainty becomes resolved over time.
Corporations
and financial markets cannot manage or price uncertain future climate-related
financial impacts by looking in the rearview mirror.
Corporate managers
and investors need a common understanding of what climate intelligence is. The
TCFD recommends that firms “describe the resilience of the organization’s
strategy, taking into consideration different climate-related scenarios, including
a 2°C or lower scenario.” Climate resiliency is the ability to recover from or adjust
easily to future disruptive technologies and government climate policies (transition risk) and extreme weather
events and changing climatic conditions (physical risk), the probability,
timing and severity of which are highly uncertain. Resiliency to these highly uncertain
threats demands optionality—the
ability of an organization to respond
appropriately as climate-related uncertainties become better understood over
time. Quoting Yogi Berra again, “When you come to a fork in the road, take it.”
Uncertainty, Resiliency and Optionality
The TCFD’s technical supplement on the use of scenario
analysis describes the relationship between strategic financial
planning/enterprise risk management, scenario analysis, and real option
identification and assessment to achieve climate resiliency, when it states:
Organizations should include scenario
analysis as part of their strategic planning and/or enterprise risk
management processes to identify options for increasing the
organization’s strategic and business resiliency to plausible
climate-related risks and opportunities through adjustments to strategic
and financial plans. [Emphasis added].
Scenario analysis is necessary but not
sufficient to attain resiliency. Scenario analysis is a means to an end
(resiliency) and not an end in itself. Unfortunately, when mistakenly viewed as
an end in itself, scenario analysis will axiomatically produce negative forecasts
from a continuation of “business as usual”. This is why corporate executives justifiably
oppose reporting the results of scenario analysis under the assumption that
corporate strategy will remain fixed in the face of change. It is a one-sided
game. Changing the forecast of the future economic and regulatory environment
without changing corporate strategy will always paint a dire future. This is
self-evident and no analysis is needed to prove the point. Instead, what is
needed is a way to value a corporation’s managerial flexibility and available options
when confronted with environmental change and new economic and regulatory
realities that result from it.
Resiliency requires
a multi-step process that begins with an expanded view of climate-related
uncertainties and risks to the organization. But it does not end there. Instead,
the risk assessment process provides a foundation for the creative application
of managerial flexibility to discover and create real options and to exercise
these options as uncertainties become
better known.
Simply put, climate change gives rise to
uncertainty and risk, which demands resiliency to uncertain future threats. Optionality
strengthens resiliency.
Climate change gives rise to uncertainty and risk,
which demands resiliency to uncertain future threats. Optionality strengthens resiliency.
Real Options
A real option is the right—but not the
obligation—to execute on a strategic option at some point in the future. Common
types of real options include options for future growth, options for sequential
investments, options to wait and see, options to delay, options to expand,
options to contract, options to choose, and options to switch resources.
For example, suppose
a firm owns the rights to land that fluctuates widely in price.
An analyst calculates the volatility of prices and recommends that the
firm retain ownership for a specified time period during which odds
are high that the price will triple. Management owns a call option, an option
to wait and defer sale for a particular time period. The value of the
land is therefore higher than the value that is based on today’s sale
price. The difference is simply this option to wait.
The “real options analysis process,” which is
itself a sub-process within a firm’s strategic analysis and/or risk management
processes involves the following four steps: (1) a base case financial analysis
of relevant assets, liabilities, projects, and strategies that calculates the
present value of expected future cash flows using traditional techniques; (2)
scenario analysis through simulation to depict the range of uncertainty over
time around the base case assumptions; (3) analysis of real options available
to management; and (4) optimization of alternative management policies over the
planning time horizon.
Real options analysis (step 3 above) is
the application of options valuation techniques to real assets such as capital
investment projects, operating assets and real (as opposed to financial) assets. It is an accepted methodology for use
in performing strategic planning and analysis that has long been embraced by
multinationals and is often employed together with other decision science and
corporate finance tools such as statistical analysis and stochastic scenario generation.
The TCFD implicitly
contemplated real options analysis when it recommended scenario analysis as
part of a strategic planning process to identify options for increasing
the organization’s strategic and business resiliency. TCFD’s recommendations
stopped short of explicitly calling for disclosures about real option
valuations, but they implicitly call for their use in “increasing the
organization’s strategic and business resiliency
to plausible climate-related risks and opportunities through adjustments to (their) strategic and
financial plans.”
Real options share
many common characteristics with financial options. But there are important
differences. Real options tend to have longer maturities (usually in years) and
often involve major million- to billion-dollar capital investment decisions.
The underlying variable of a real option is free cash flow instead of a traded
financial security, and managerial strategy and flexibility under conditions of
uncertainty are therefore key to the value of real options. There is no active
trading market or pricing for real options, and volatility must be predicted
using stochastic simulation of scenarios. For a clear explanation of real
options and real options analysis, see
Johnathan Mun, Real Options
Analysis Tools and Techniques for Valuing Strategic Investments and Decisions (Wiley. 2002).
Real options have
strategic value when the following conditions exist: there is uncertainty and
volatility; management has flexibility; uncertainty drives investment value;
flexibility strategies are credible and executable; and management is rational
in executing strategies. The first two criteria are self-evident. Without
question, climate-related outcomes are highly uncertain, and management has
some degree of flexibility to respond as uncertainties become better understood
over time. Conversely, the last three criteria require credible evidence from
management in the form of climate-related financial disclosures.
Off-Balance Sheet Assets
Real options are
intangible assets that can positively reflect a corporation’s climate
resilience. However, these assets do not appear on the balance sheet. Meanwhile,
climate-related asset impairments, asset retirement obligations, and contingent
liabilities—which all reduce a corporation’s net assets—do. For corporate
managers, it’s all sticks and no carrots.
Like financial
options, the financial value of real options increases with uncertainty and
expected future volatility. So long as
a firm is strategically positioned to take advantage of climate-related volatility, there is value in uncertainty. Real
options add flexibility and value to long-lived assets and long-term capital
investments and thus have many climate-related applications, including
renewable energy investment, R&D investment, coastal defense and flood risk
management, water resource planning, infrastructure investment, and government
climate policies.
The financial
value of real options increases with uncertainty and expected future
volatility. So long as a firm is strategically positioned to take advantage of climate-related
volatility, there is value in uncertainty.
Real options can
create value from climate-related uncertainty, turning risks into
opportunities. Like financial options, real options can be valued as assets in
dollars. Unlike financial options, the fair value of real options is not
reflected in financial statements prepared in conformance with U.S. generally
accepted accounting principles (GAAP) or International Financial Reporting
Standards (IFRS).
Real options
are intangible assets that can positively reflect a corporation’s climate
resilience, but these assets do not appear on the balance sheet. Meanwhile,
climate-related asset impairments, asset retirement obligations, and contingent
liabilities—which all reduce a corporation’s net assets—do. For corporate
managers, it’s all sticks and no carrots.
Lost in Translation
The lack of general
familiarity with the application of real options as practiced in the field of finance
and in corporate strategic planning and analysis raises the near certainty of
miscommunications between corporate managers and investors. For example, while
Carbon Tracker asks oil companies to assess and report the resilience of their
assets and operations under a 2°C demand scenario, assuming the lowest cost
supply will be consumed first, it does not explicitly contemplate management’s
flexibility to change business decisions and strategies as uncertainties become
better known over time. Meanwhile, BP’s CEO Bob Dudley complains about those that
“push for potentially confusing disclosures, raise the specter of a systemic
risk to the financial system from stranded assets, and campaign for divestment.”
He adds, “I know what will happen: we’ll get sued because we’re off the path
after a year.”
Investor calls for
stress tests under worst-case scenarios should not exclude consideration of
managerial flexibility to respond as climate-related uncertainties become better
understood. Else, the implied message is that firms should change their business
model now regardless of the financial consequences instead of planning for
optionality. Meanwhile, corporate managers may perceive significant legal risk
to disclosure of forward-looking and confidential information with no countervailing
reward from investors for the value of their real options and strategic
planning capabilities.
Investor
calls for stress tests under worst-case scenarios should not exclude
consideration of managerial flexibility to respond as climate-related
uncertainties become better understood.
Climate
intelligence must be “bottom up” in that it must start with in-house analysis
by individual corporations and development by them of informed business
strategies to cope with climate uncertainty. This fact is implicit in the TCFD‘s
three-step prescription for mitigating systemic climate risk. The first step
involves improvements in strategic planning, analysis and management with a
focus on resiliency. This step is a necessary prerequisite for enhanced
climate-related financial disclosure. It also holds the greatest potential for
mitigating systemic financial risk. If climate-related financial risks can be
broadly mitigated at the individual firm level through improved climate
resiliency, these risks won’t concentrate in the financial sector. The second
step is to expand climate-related financial disclosures to include credible
evidence of climate resiliency. This will require innovation to support the
effective auditing and communication of uncertainty in financial filings. The
final step is to improve the ability of asset owners and investment managers to
evaluate corporate business strategies that explicitly consider the risk of
climate change and the resultant economic and regulatory realities and fully
value the optionality available to corporate managers. In this way, asset
owners and investment managers may reward leaders and punish laggards on the
basis of climate resilience.
If
climate-related financial risks can be broadly mitigated at the individual firm
level through improved climate resiliency, these risks won’t concentrate in the
financial sector.
The Investment Value Chain
The investment
value chain—the flow of investment capital—from top to bottom consists of asset
owners, asset managers (who are supported by investment consultants and ratings
agencies), investee firms and real assets. To mitigate systemic climate risk,
information flows back and forth across the investment value chain must change
to incorporate information about climate resilience.
Today, information
flows up the investment value chain in the form of reports and statements from
investee firms containing financial results and earnings forecasts, which are analyzed
by investment consultants and ratings agencies and then acted upon by asset
managers who subsequently report their investment results to asset owners. The
buy/sell/hold decisions of asset managers in turn produce pricing signals that
travel down the value chain to inform investee firm decisions.
To mitigate
systemic climate risk, information flows across the investment value chain must
expand so that credible evidence of climate resiliency travels up the chain and
resiliency expectations and reflective valuations travel back down. Consistent
with the TCFD’s recommendations, corporate financial reports will need to include
forward-looking information on climate-related real option strategies,
capabilities and valuations, which can in turn inform resiliency ratings and
indices and resiliency-adjusted investment results.
To mitigate
systemic climate risk, information flows across the investment value chain must
expand so that credible evidence of climate resiliency travels up the chain and
resiliency expectations and reflective valuations travel back down.
Many investee firms
will require new processes to produce this information for internal use, and
all will require new processes for external disclosure. The scope of resiliency
disclosures may range from qualitative descriptions of climate-related strategic
planning and analysis to audited financial valuations of real options. The
financial sector will require new processes to incorporate these disclosures
into their analysis and investment decisions. These are no small challenges.
The Climate Intelligence Gap
The gap between the
current “as is” and the desired future “to be” states described above is the
“climate intelligence gap”. Similar to the challenge of responding to terrorism
following 9/11, closing this intelligence gap will require collaboration and
collective action across the entirety of the investment value chain to overcome
fragmented information and disjointed action.
In addition to the
formidable educational challenge of broadly disseminating knowledge on the
theory and application of real options analysis, there are significant
structural barriers to the origination, reporting and assimilation of climate
intelligence that must be overcome. These barriers fall into three
categories—the characteristics of real options, the lack of reporting
standards, and the specialization divide.
Real options have
several characteristics that pose challenges for credible financial disclosure.
Because they are proprietary in nature, firm managers may be reluctant to
disclose details about real options they consider to be confidential. Another
challenge is credible valuation. Real options are not traded and thus there are
no market comparables to enable mark-to-market valuations. Instead, valuation requires
mark-to-model measurements based on non-observable inputs, judgment and
specialized expertise. Rigorous independent third-party assurance will be needed
for credibility.
Today, there are no
reporting standards for real options. Unlike financial options, real options
are not recognized under GAAP and IFRS. There are no mandatory disclosure
guidelines for real options under national securities laws and regulations. There
are no financial audit guidelines. Because real options analysis has
historically been a purely discretionary internal management practice, there is
wide diversity in practice across industries and firms.
Last, and most
important, there is specialization divide that splits the investment value
chain. Financial options exist within the domain of finance. Real options exist
within the domain of business strategy. General familiarity and expertise in
real options analysis does not extend beyond corporations and the strategic management
consultants that advise them. Asset owners, asset managers, and the consultants
that advise them, therefore lack a widely shared understanding of the core
intelligence needed to mitigate systemic climate risk. As a result, the top end
of the investment value chain does not know what financial disclosures they
should be asking for, and investee firms have no expectation they will be
rewarded by investors for disclosing such information. There is a structural divide
preventing the origination, reporting and assimilation of climate intelligence.
This must change.
Asset owners,
asset managers, and the consultants that advise them, lack a widely shared understanding
of the core intelligence needed to mitigate systemic climate risk. Asset owners
have common Interests and the collective power to change this.
Bridging the climate
intelligence gap will require an integrated and collaborative approach that
spans the entire investment value chain. This calls for a change agent—one or
more new or existing consulting/ratings agencies to operate as a new type of climate
intelligence exchange positioned between the asset owners and managers on one
end and investee firms on the other. Such entities would have expertise in
finance and business strategy in order to bridge the specialization divide.
Call for Action
We close with a call
for action by asset owners. Like the U.S. government following 9/11, asset
owners have a common Interest and the collective power to close the climate
intelligence gap. Because climate risk is systemic and cannot be mitigated
solely through diversification, active and passive asset owner/managers alike have
a shared interest in mitigating climate risk. If they act collectively, a
relatively small number of the largest asset owner/managers have the AGM voting
power to specify additional disclosures needed to mitigate systemic climate
risk. What’s missing is an agreed set of proper demands.
To learn how you
can support the Climate Intelligence Exchange contract Greg Rogers at grogers@era-tos-thenes.com
or Charlie Atkins at catkins@era-tos-thenes.com.
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