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.
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 firstname.lastname@example.org or Charlie Atkins at email@example.com.
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