Reporting Climate Change Risk
To Read Now
At this point, please complete Corporate Reporting and Externalities, an essay by Jeff Honhensee in the book, Is Sustainability Still Possible? State of the World 2013, by the WorldWatch Institute. (In case you are not familiar with it, the "State of the World" series is great! I highly recommend it.) You will find this reading under the Lesson 4 tab in Canvas.
In the reading above, Honhensee makes a strong case for corporate reporting of externalities as a company's responsibility to the public, which by definition bears the costs, as well as to its investors. Remember, externalities are the costs (or benefits) from an economic transaction that are borne by someone who did not play a role in said transaction, and those costs or benefits are not integrated into the price of the transaction.
It is particularly important from a sustainability perspective to consider all of the costs of economic transactions. The total cost to society is the social cost, the costs to those who took part in the transaction are the private costs, and costs to anyone that did not take part in the transaction are the external costs. This can be summarized in an equation:
- social cost = private costs + external costs
If all costs to society are fully integrated into the price of the good/service, then the social cost = private cost, and thus there is no external cost, and no negative externality. However, costs are often externalized, and so social cost often exceeds the private cost. In other words, the total cost to society is often not fully reflected in the price of a good/service. Pollution is the classic example of a negative externality. Let's say I run a good-producing factory that pollutes the air or water - however slightly - and this pollution results in costs (health issues, property values, food availability, etc.) to others, but I do not have to pay for this cost. In this scenario, my private cost is less than the social cost. The difference between those two costs is the negative externality. Negative externalities tend to be overproduced because the good/service is less expensive than it would be if all costs were integrated.
It follows that if all costs are internalized and all of those affected properly compensated, externalities are eliminated. This can be attempted through mechanisms such as fines for violations and other legal penalities, but these only work of the money from the fines are provided to those that suffered the externalized consequences. Unfortunately, this is rarely the case. In a perfect world, everyone impacted by every transaction would be compensated accordingly.
Positive externalities occur as well, and happen when the social benefit is greater than the private benefit. Unfortunately, these goods/services tend to be underproduced because the person who benefits pays more than they would if there were no externalized benefits. Education is a good example of this: You all are paying for your Penn State education, and you receive benefits from that (knowledge, confidence, possibly a pay increase or better job, etc.). However, society as a whole benefits from having an educated populace, e.g. by realizing more technological and business innovation. If all of these benefits were integrated into the cost of education, then it would be less expensive. Thus, education is generally more expensive than it would be if all benefits were integrated into the cost. Note that things like grants and scholarships help offset some of this, as does taxpayer-funded education.
Disclosure of Climate Change-Related Business Risks
Upfront acknowledgment of risks to the business can help management anticipate, and plan for, future developments and increases investor confidence. In other words, what may have been once seen as a pure externality can, with a turn of events, cost a company and its investor's real money. For energy companies, many externalities fall into the category of risks that may suddenly become costly to the business, but probably none more so than externalities related to climate change. Perhaps more importantly in the near term, potential nonmarket action - particularly in the public sector, but also via private political action - can pose significant business risk(s) to a firm. Most of these actions are related to climate change externalities.
The Securities and Exchange Commission (SEC) is tasked with assuring firms provide reasonable disclosure of business risks to their shareholders. In 2010, the SEC issued the first (voluntary) Interpretive Guidance on Disclosure Related to Business or Legal Developments Regarding Climate Change. The guidelines did not create new legal requirements but provide guidance on existing disclosure rules that may require a company to disclose the impact business or legal developments related to climate change may have on its business.
To Read Now
Read the SEC's January 27, 2010 Press Release regarding disclosure of climate change-related risks. This guidance is still seen as a major turning point in climate disclosure initiatives in the U.S.:
- "SEC Issues Interpretive Guidance on Disclosure Related to Business or Legal Developments Regarding Climate Change." U.S. Securities and Exchange Commission, Jan. 27, 2010
- (Optional) You may have the desire to read through the thick, but descriptive, legalese of the full SEC Guidance in the Federal Register.
From the press release:
Specifically, the SEC's interpretative guidance highlights the following areas as examples of where climate change may trigger disclosure requirements:
- Impact of Legislation and Regulation: When assessing potential disclosure obligations, a company should consider whether the impact of certain existing laws and regulations regarding climate change is material. In certain circumstances, a company should also evaluate the potential impact of pending legislation and regulation related to this topic.
- Impact of International Accords: A company should consider, and disclose when material, the risks or effects on its business of international accords and treaties relating to climate change.
- Indirect Consequences of Regulation or Business Trends: Legal, technological, political and scientific developments regarding climate change may create new opportunities or risks for companies. For instance, a company may face decreased demand for goods that produce significant greenhouse gas emissions or increased demand for goods that result in lower emissions than competing products. As such, a company should consider, for disclosure purposes, the actual or potential indirect consequences it may face due to climate change related regulatory or business trends.
- Physical Impacts of Climate Change: Companies should also evaluate for disclosure purposes the actual and potential material impacts of environmental matters on their business.
Why did the SEC decide to issue these new guidelines? A press release from Ceres and the Environmental Defense Fund (both 501(c)(3) non-profits), described it this way, "Today’s decision comes of wide-ranging climate-related business impacts – and strategies for addressing those impacts – in their financial filings. More than a dozen investors managing over $1 trillion in assets, plus Ceres and the Environmental Defense Fund, requested formal guidance in a petition filed with the Commission in 2007, and supported by supplemental petitions filed in 2008 and 2009." Addressing the way risks of externalities related to climate change are being included in corporate reporting is seen as a matter of protecting investors. For many, protecting the public and the environment would be sufficient cause. But here, the winning nonmarket strategy in the regulatory arena was the one that built a successful case, in the eyes of the SEC, by connecting the need to disclose climate-change risks with the need to protect investors.
To Read Now
As I'm sure you can imagine, the SEC's decision in 2010 has not been embraced by everyone. The article below provides some insight into one nonmarket approach to mitigate its impact.
- "A New Debate Over Pricing the Risks of Climate Change" The New York Times, Sept. 26, 2016.
As indicated in the article, assessing the financial risks posed by climate change are not limited to the U.S. In 2016, the Financial Stability Board (FSB) of the Group of 20, usually referred to as the "G20", asked its Task Force on Climate-related Financial Disclosures (TCFD) to "develop a set of voluntary, consistent disclosure recommendations for use by companies in providing information to investors, lenders, and insurance underwriters about the financial risks companies face from climate change." (The G20 is a forum of wealthy and economically emerging countries of the world. The official group is made up of government representative such as finance ministers, heads of state, and central bank governors. At the annual G20 meetings, the representatives consult with many international organizations such as the OECD, the World Trade Organization, International Monetary Fund, as well as private sector businesses, non-governmental organizations, and more. The G20 "traditionally focuses on issues concerning global economic growth, international trade and financial market regulation.") It has become apparent to G20 members that issues related to climate change pose risks to businesses worldwide, and the establishment of the TCFD is an attempt to provide guidance on how to manage those risks.
As of August 2018, over 390 organization had expressed support for the TFCD. There are companies and organizations from six continents in support, including banks such as Bank of America in the U.S. and Barclays in the U.K., energy companies such as NRG Energy in the U.S. and Royal Dutch Shell in the Netherlands, pension funds from all over the world, transportation companies such as Qantas (Australia airline) and Maersk (Danish shipping), and more. The TCFD is still very active, and gaining more member support every year.
To Read Now
The TCFD released its full report on December 14, 2016; you may be interested in reading it. For a summary of the report, please read the speech by the Chair of the G20 FSB below.
- "Remarks on the launch of the Recommendations of the Task Force on Climate-related Financial Disclosures," Bank of England, December 14th, 2016.
Planning for Climate Change Risk
With the risks of climate change-related externalities explicitly acknowledged, management is in a position to anticipate, plan for, and manage the risk (physical, policy, regulatory or otherwise). One way to mitigate these risks is by placing a price on carbon emissions, usually expressed in dollars (or whatever the relevant currency) per metric ton (tonne) of emissions. Carbon markets have been established at different scales throughtout the world, but companies are increasingly utilizing an internal cost to reduce risks and spur carbon reductions.
To Read Now
- For a good synopsis of different types and examples of carbon pricing, read "Companies are moving faster than many governments on carbon pricing" by the Economist from January of 2018. (You may have to register for a free account to see the article.) If you cannot access the full article, the key content is quoted below.
- (Optional) Read "Microsoft Leads Movement to Offeset Emissions With Internal Carbon Tax" to learn about the robust internally-focused actions that Microsoft has taken, which was mentioned in the article above. (A .pdf link is also available in case you cannot access the link.)
- (Optional) For a glimpse at some of the international movement on internal carbon pricing, feel fre to read the Summary and Section 1 ("What is the purpose of assigning an internal price to GHG emissions?") of the Institute for Climate Economics' "Internal carbon pricing: A growing corporate practice" from November of 2016.
From the Economist article:
"Of the 6,100-odd firms which report climate-related data to CDP, a British watchdog, 607 now claim to use “internal carbon prices”. The number has quadrupled since CDP first began posing the query in its annual questionnaire three years ago. Another 782 companies say they will introduce similar measures within two years...
Corporate carbon-pricing comes in two main varieties. The first involves business units paying a fee into a central pot based on their carbon footprint. Microsoft, for example, charges all departments for every kilowatt-hour of dirty energy they contract or air mile flown by executives, to help meet firm-wide climate targets. This payment, equivalent to $8 per ton of carbon dioxide, is designed to encourage those who can cut emissions most easily to do more, and nudge everyone to do something, says Rob Bernard, who oversees the software giant’s environmental activities.
Tracking exactly how much of the power a business unit consumes comes from coal, say, is not always straightforward. Fee-based systems like Microsoft’s therefore remain rare. Although some smaller firms have toyed with them, Disney is the only other big multinational to use one. Many more firms use shadow carbon prices to stress-test investments for a world of government-mandated levies...
In his day job as chief executive of Royal DSM, Mr Sijbesma has made the Dutch food producer examine all proposed ventures to check whether the sums still add up if a ton of carbon dioxide cost €50 ($60), well above the going rate of €6 or so in the European Union’s emissions-trading system, which is kept low by an oversupply of permits. Where they do not, alternative feedstocks or cleaner energy suppliers must be found. If a project still looks unprofitable, it could be discarded altogether.
Businesses ranging from European supermarkets (France’s Carrefour and Britain’s Sainsbury’s) to Indian cement-makers (ACC, Ambuja and Dalmia) espouse shadow pricing. Some add flourishes. Besides assessing capital projects at €30 per ton of carbon dioxide, Saint-Gobain, a French maker of building materials, factors in a higher price of €100 per ton when choosing between long-term research-and-development projects. AkzoNobel, a Dutch chemicals giant, uses €50 per ton for most investments, but double that for those with lifetimes of 30 years or more.
These are some of the most ambitious schemes; many others lack bite. Plenty of firms which declare their shadow prices set them below $10 per ton of carbon dioxide. As John Ward of Vivid Economics, a consultancy, points out, that is “just high enough so it has no real impact”. Companies which use higher prices should treat them as more than a “spreadsheet exercise”, counsels one climate-change expert. Oil majors have priced in carbon for years when assessing exploration projects. But there is little evidence that high-price scenarios swayed their investment decisions."
According to the Carbon Disclosure Project (CDP), an English non-profit that publishes environmental impacts of companies across the world, reported that as of 2017 almost than 1,400 companies worldwide either utilized internal carbon pricing or will introduce such measures within the next two years. As indicated in the articles above, there are different ways that companies do this. Microsoft actually charges individual units within its company based on their energy-based emissions, then uses these (millions of dollars of) charges to implement energy efficiency (e.g., building efficiency upgrades) and clean energy (e.g., solar, wind) measures in company units. Disney, Shell, Novartis, and Nissan also use this model.
Many other companies are using internal carbon pricing when determining cost-benefit projections of potential projects and investments. This is what the Economis referred to as "shadow carbon pricing" and the Institute for Climate Economics referred to as a "shadow cost." Some of the world's major companies (including ExxonMobil and Shell!) price carbon internally. Though the price and application can vary widely by company, it has the effect of making projects that will result in lower emissions look more economically attractive than they otherwise would.