How Boards Can Use COVID-19 to Plan for Climate Change Risk
Companies have long struggled to adequately prepare for disruptive risks — risks that can manifest suddenly with severe consequences. The COVID-19 pandemic has exposed the magnitude of global unpreparedness to contain and adapt to widespread public health and economic shocks.
Companies and their boards everywhere are focusing on how to evolve their enterprise risk management (ERM) systems to surface and plan for future disruptive risks. As they do so, it is critical they build in preparedness for how to handle the climate crisis, potentially the greatest risk of all.
Climate Change Is a Systemic Threat to Financial Markets
Investors view climate risks as business risks. A 2020 survey of 439 institutional investors that include pension and mutual funds, banks and insurers found that more than half are already integrating climate risk into their investment processes, and 91% expect climate risk to be financially material to their investments in five years.
In his 2020 letter to CEOs and boards of portfolio companies, BlackRock’s CEO Larry Fink announced that the firm would make investment decisions with environmental sustainability as a core goal since “the evidence on climate risk is compelling investors to reassess core assumptions about modern finance.”
Investors are not only increasingly focused on climate risk, but also on how boards of their portfolio companies are overseeing such issues. A 2019 analysis of 215 of the world’s largest companies identified just under one trillion dollars of potential risk to their businesses from climate change and noted that half of these losses are expected to materialize in the next five years.
As a part of their responsibility as stewards of long-term corporate performance, boards have a critical role to play in ensuring that companies are aware of and able to navigate an ever-evolving risk landscape. This year, for the first time, the World Economic Forum and Marsh McLennan identified climate change in all top five risks facing the global economy, by both likelihood and severity of impact. Where an ESG issue such as climate change impacts — or has the potential to impact — the business, it is a director’s job to exercise risk-related oversight.
How to Oversee Climate Risk
Ceres recently released its report Running the Risk, detailing how corporate directors can shift from a reactive to a proactive oversight of financial risks posed by ESG issues, including climate change. The report identifies the key questions for directors to ask management throughout their oversight of the ERM process so they can improve their company’s resilience to ESG and climate risks. Management and investors can also benefit from these recommendations as they support and engage boards.
Boards can take a number of steps to mitigate the potential material impact of climate risk, including adapting business strategy and holding executives accountable for performance against these risks.
There are three main ways that boards can proactively hold management accountable for preparing for climate change as a disruptive risk.
Identification: Boards can ensure that management identifies how climate risks manifest over a variety of timeframes, as well as how they may multiply or be multiplied by other risks facing the enterprise throughout the ERM process. The board can also guide management to consult a range of sources to effectively identify climate change impacts on corporate financial performance and value.
Assessment: Where climate risks are identified, boards need to consider whether these issues have a material impact. Given climate has been found to materially impact the vast majority of sectors, boards should ask management to run materiality analyses that include both traditional financial factors and financial impacts from climate risks. Boards may also consider requesting various “scenario analyses” as to how the company’s performance will be impacted by various global temperature increase scenarios.
Action: Boards can take a number of steps to mitigate the potential material impact of climate risk, including adapting business strategy and holding executives accountable for performance against these risks. Boards can also structure themselves to most effectively oversee climate, including formalizing such oversight within a board committee and educating the board on how climate impacts the enterprise. Of critical importance is to understand that climate risks may require discussion by the full board, and should not be siloed within committees.
‘Building Back Better’ From COVID-19
With global governments passing the largest long-term stimulus packages in history — noted by the vice chairman of BlackRock to be “the greatest reallocation of capital of the 21st century” — there is an enormous opportunity to not just build back from this crisis, but to “build back better” to ensure that a portion of this capital is used to build resilience to climate change risk as opposed to funding sectors and industries that are not in line with climate science.
A historic number of companies are already taking action. In May 2020, more than 330 businesses — including more than a dozen Fortune 500 firms and representing a combined annual revenue of more than $1 trillion — urged members of Congress to pass a resilient stimulus plan that incorporates long-term climate solutions. It was the largest ever call to action from business leaders to Congress.
Unprecedented times call for unprecedented action. We need boards to integrate the growing climate crisis within their risk oversight role to best position the enterprise for financial resiliency and success.