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After COVID-19, climate change is the next challenge

Climate Quantified
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By Nick Dunlop | February 24, 2021

Tech companies helped organizations adjust to the global pandemic. The next big challenge is helping address climate change.

COVID-19 makes us realize that certain things can ignite fundamental societal and economic shocks that cause us to ask, “What’s next?” The deadly virus has not run its course — far from it, in fact — but we already know what the next big challenge is: climate change.

Technology companies, which have played a huge role in helping organizations continue to operate amid the pandemic, also have the potential to take a massive role in addressing climate change. Particularly, big data and machine learning could help both financial services and corporates determine their climate risk.

Climate change is what many of us consider a “grey swan” event. Unlike an unpredictable black swan event, climate change is perfectly predictable. It’s something that we’ve known about for decades — the human role in atmospheric CO2 concentration has been accurately measured since the late 1950s. Yet, despite the existential threat, we as a society are not doing enough to address the climate change problem.

This is not to say we haven’t made progress. Many financial institutions and other companies increasingly understand their exposure to climate risks and are reducing their carbon footprint. The pace will pick up as more companies find themselves in a four-way squeeze among:

  • Regulators
  • Institutional investors
  • Consumers and employees
  • Risk management and a growing “protection gap”

 Even in countries where there is skepticism about the effects of climate change, companies must contend with these four issues. Regulations are unavoidable. Stakeholder expectations can no longer be ignored. And the protection gap looms as sea levels rise and flood risks grow, fires burn out of control, and demand explodes for breaking down environmental risk in ways that are more understandable and manageable.

COVID-19 adds a degree of urgency and complexity to our thinking around climate change. Think, for example, of the pandemic’s huge impact on the traditional retail business model and global supply chains. Companies around the world are moving faster than anticipated to adjust business models to a threat that was recognized in the abstract but not often in business planning. Technology companies played a role in helping organizations quickly adjust to the unprecedented circumstances of the global pandemic. We can learn from these experiences as the climate crisis worsens and use COVID-induced change to embrace new business models that deal with the “what’s next” of climate change.

Regulators fear systemic challenges

Regulators, initially among the Group of 20 (G-20) countries, have come to view climate change as a systematic challenge to the financial system. Many are asking insurers and other financial institutions to identify and quantify their exposure to climate change, devise a reporting framework and develop risk mitigation procedures.

While not in itself a body of regulations, the intent behind many regulatory efforts reflect the 2017 recommendations from the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). TCFD recommendations cover corporate governance, organizational strategy and financial planning, climate-related risk management and metrics used to assess and manage climate-related risks and opportunities.

In a recent call to action for financial regulators, a Harvard Law School Forum on corporate governance noted that climate-related systemic risks threaten to destabilize capital markets with significant consequences for financial institutions and the larger economy. It cited studies indicating that the U.S. economy alone could contract 10% by 2100 with unmitigated climate change. The Forum concluded that the insurance sector is “particularly vulnerable” as well as banks and financial institutions that have lent to carbon-intensive companies.

Investors apply ESG principles

Investment and sustainability professionals at Willis Towers Watson prepared a paper, Sustainable Investing: Show Me the Evidence, which identified extensive research suggesting that sound sustainability standards can lower a company’s cost of capital and improve operational performance.

Superior performance would catch the eye of any investor, but many asset managers and investment advisors have taken things a step further by reducing or eliminating investments in companies that fail to apply environmental, social and governance (ESG) principles and to develop more sustainable, climate-resilient portfolios.

In a 2020 client letter, BlackRock, the world’s largest asset manager, said climate change has become a major investment factor in terms of how the asset manager considers both physical risks and risks associated with transition to a low-carbon economy. In a 2020 letter to CEOs, Larry Fink, BlackRock’s chairman and CEO, summarized his thinking this way: Climate risk is investment risk.

Mr. Fink believes investment risks presented by climate change are set to accelerate a significant reallocation of capital, which will in turn have a profound impact on the pricing of risk and assets around the world. The company is actively reducing its ESG exposures as in, say, coal production. Vanguard, Morgan Stanley and other investment managers and advisers are taking similar steps.

A growing consumer role

Consumers are becoming increasingly influential by buying products from companies that apply sustainability principles. They are voting with their money to align with businesses that demonstrate a more thoughtful, multi-stakeholder approach to capitalism.

Boston Consulting Group, in a recent survey, found that leading consumer companies intend to preserve their sustainability focus even as they wrestle with the devasting effects of COVID-19. They know that consumer pressures will not vanish because of the pandemic and conclude that walking away from sustainability now would pose significant future business risks.

Nielsen, the analytics company, has estimated that the consumer market for sustainable products will exceed $150 billion in 2021. A study cited by the Harvard Business Review found that “sustainability-marketed products” grew faster than conventional options in more than 90% of categories among consumer packaged goods.

The ‘protection gap’

Climate change is happening on a scale that conventional risk management practices are unable to address. Financial institutions and other companies best positioned to identify, measure and manage climate-related risks typically have a joined-up approach that involves broad company involvement across multiple disciplines.

Risk management basics come into play, of course. Risk managers have valuable experience in property risks, for example, that are likely to grow in magnitude as the planet warms, weather patterns change, and sea levels rise. But protection gaps may arise if a company fails to adopt a broader approach that should include heightened use of risk analytics and modeling, climate risk audits and stress testing, and ESG-based asset analysis investment strategy and implementation as well as talent and rewards strategies to support climate-related organizational objectives.

Technology companies have a massive role to play in addressing climate change. Consider Planet Labs Inc., which is using microsatellites, machine learning and other technology to reveal flood risks. In a demonstration using such techniques as a high-resolution satellite base map and machine learning, the company identified where construction would be especially susceptible to flooding in a climate-changing world. Planet Labs envisions how this may lead to such innovations as new forms of microinsurance, climate-resilient municipal bonds and other financial instruments.

Big data will be taking an increasing role, too. If any subject needs crunching enormous amounts of data, and developing insights linking science and finance, it’s climate change. Big data and analytical know-how are essential for helping financial institutions and corporates build risk models and pricing models. It’s a monster job.

Clearly Swiss Re, Munich Re and other major reinsurers are scientifically all over this, and other insurers are now making serious decisions on what to insure and what to invest in. While some insurers will struggle with this challenge, we’re seeing interest in their learning more about the implications of climate risk, and they are starting to make strategic decisions to manage their ESG profile.

I recently heard the CEO of a global company say businesses that don’t pay attention to ESG won’t be around in five years’ time. His comment was eye-opening but feels about right to me. The speed with which we see climate risks develop can be quite alarming. If you’re not immersed in the subject of climate change, you will be in for a desperately bad shock when it comes upon you.

Best performing companies — and the math proves it — are those that take ESG, sustainability and inclusive capitalism models seriously. Clearly this is the route — and maybe the only route — to understand the future impact of climate change on your business. The important thing is to pay attention to climate change, ESG principles and the tools, strategies and business partners you will need to future-proof your business. Fail to do that, and someone will roar past you.

Author

Nick Dunlop
Managing Director, Willis Towers Watson

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