Impact of Climate Change on Operational and Stakeholder Risks and how to adapt and evolve - Part 2

This is the last blog post of a two-part series that looks into both operational and stakeholder risks, and how companies can adapt and evolve. In case you did not read the first article, here is the link.

Operational and Stakeholder Risks

“The climate is changing. The proper political debate now would be how to deal with these risks.”

Steven Chu- Former United States Secretary of Energy and Professor of Physics at Stamford University

Referring to the holistic environmental climate eco-system in article 1, I thought I’d now unpick some of the items from that diagram and elaborate a bit further on the potential risks I envisage, as per the diagram below.

Operational “Business” Value Chain Risks ¹

• Price risks: refer to the increased price volatility of raw materials and commodities. Drought can raise the price of water; climate-related regulation can drive up the cost of energy. High-tech and renewable-energy industries could face price risks in materials be it for computer hard drives, televisions, wind turbines, solar photovoltaic systems and electric vehicles. Or to hedge against the possibility of rising fossil-fuel by having self-generating power for manufacturing, i.e., go “off grid” for both strategic and economic reasons.

• Transition risk: refers to the risk of embarking on a climate-change programme and not seeing it through to its end. Compliancy of companies by not having a pooled team of dedicated subject matter experts to help navigate the company’s climate change programme from cradle to grave, is doomed for disaster. This is also a reportable risk in the financial statements.

• Physical risks: are those related to damage inflicted on infrastructure and other assets, such as factories and supply-chain operations, by the increased frequency and intensity of extreme weather events, such as wildfires, floods, or hurricanes, etc… Such physical risks are not easy to control, but companies can take steps to prepare for the changes that could occur.

First, forecast a range of climate scenarios that highlight high-level risk probabilities by region, such as for flood, drought, or sea-level rises and for long-term changes in such factors as temperature, humidity, or rainfall patterns. The scenarios should help reveal which parts of the business are vulnerable. A variety of mitigating risk processes, technical standards and capabilities can then be put in place. In the long term, risk management could call for changes to supply chains (to build in geographic variability), including moving away from suppliers and/or locations that are highly exposed. This too is a reportable risk in the financial statements.

• Product risks: refer to core products becoming unpopular or even unsellable. Effects could range from losing a little market share to going completely under. Alternative cooling technologies could displace air-conditioning systems; holiday resorts that count on snow or cold weather could go under. This kind of risk is familiar; new products, by definition, displace older ones. The difference is that responding to climate-related pressures can change the entire business target operating model.

Day by day there are green products and services emerging to cater for cleaner cities, such as electric-vehicle charging infrastructure, bicycles, renewables integration, smart metering, smart grids, congestion-fee systems and high-performance building technologies. In B2C, especially in retail and consumer products, new segments are making inroads as cohort of customers want and are willing to pay for greener products, i.e., organic food from where and what they buy.

External Stakeholder Risks

• Regulation risk: refers to regulatory action prompted by climate change via groups’ like the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (Task Force or TCFD), Sustainability Accounting Standards Board (SASB), United Nations Environmental Programme (UNEP)- Global Compact framework and Global Reporting Initiative (GRI). This has been touched upon in Part 1.

• Credit Ratings risk: as the possibility of higher costs of capital due to climate-related exposure such as carbon pricing, supply-chain disruption, assets, or product obsolescence. While the credit ratings risk varies widely between and within industries, even companies with carbon-intensive activities can start to manage it, so as to improve its funding options and availability.

• “Business” Reputation risk: can be either direct, stemming from a company-specific action or policy, or indirect, in the form of public perception of the overall industry. In the climate-change context, reputation risk could be translated as the probability of loss following a business’s activities or positions that the public considers harmful or threatening. A poor reputation on climate will hurt sales through consumer boycotts and/ or global/ local community protests. It will also damage investor relationships with Private-Equity/ Venture Capitalist firms and make the company less attractive to both current or future investors during trade sales/ exits and buys. Including, difficulty in attracting talent/ employees due to the sectors perception.

How can Companies adapt and evolve? ¹

By adopting a sustainability approach, in which new products are designed to minimise waste and can be broken down for reuse or recycling, e.g., Ikea’s recent campaign on sustainability is a perfect example. Another is to redefine corporate strategy by looking at the future target operating model to align business interests with climate-change mitigation and adaptation. This too was touched upon in Part 1.

Efforts to offset climate change will inevitably structurally transform certain sectors (leading to Structural Unemployment), which will experience more volatile returns and increased rates of entry and exit as newer technologies or regulatory restrictions emerge, coupled with competitive landscape changes. The way a company reacts to changing technologies, people and culture, processes and business systems will determine its future financial performance. New technologies will create new competitive dynamics and transform ways of working in the next few years. Cash flows will also be affected either positively or negatively.

“If you can’t measure it, you can’t manage it.”

Chair of Task Force on Climate-related Financial Disclosures, Michael Bloomberg.

There are some practical steps companies could take to position themselves in a low-carbon world, this includes:

• Reviewing the company’s exposure to regulatory measures (bit it, carbon pricing, new standards, taxes and subsidies), new technology and changes in consumer behaviour. CxO’s will have to ask themselves, how specific changes could affect its company’s competitive position if other companies adopted new business operating models or how a company can gain a competitive edge by moving its future target operating model.

• Ensure there is a consistent strategy, to participate in both regulatory and policy discussions so as to engage employees across the company. Many employees will want sustainability to be part of the day-to-day operations of their companies too.

• FP&A scenario techniques could help paint an overall view of how the economy and markets might evolve under different climate change scenarios. Companies will succeed in managing the major transformations their sectors face only if they invest time in developing sophisticated forecasts to gain deeper insights into climate change related issues.

• Capital investment programmes should be geared towards carbon and energy-efficient technologies that will provide a competitive edge over their competitors and ensure their asset capitalisation projects do not result in impairments and distributable reserves problems.

• Engage external consultants², universities and/ or scientists to build collaborative external networks that can help companies understand and manage the impact of climate change during 2021.

• Companies will need to focus on how and when to signal the incremental value of their climate change programmes to Private-Equity/ Venture Capital investors. Each company will need to explain its overall level of preparedness for the future, the way climate change related events could affect its specific cash flows and what differentiates it from its competitors, including a very firm handle on financial management. Investors are looking for disclosures on climate change issues and rightfully are kicking up a storm about questionable assets (unusable due to climate-policy regulation or physical climate change), significant judgements on estimating useful economic lives, probability of impairments on non-current assets, expected credit losses, going-concern viability and lawful distributable reserves to pay out future dividends.

“If you don’t take climate action, the collapse of civilisation and the extinction of much of the natural world is on the horizon.”

Sir David Attenborough

To conclude, CxO’s need to understand their policy options, develop an internal strategic roadmap and revisit their current target operating model for climate change enablers and be able to properly respond to regulations and policy changes… or you can call upon a subject matter expert and ask for help and direction ².

Dee Singh Kothari is a senior partner in Kothari Partners

¹ Ideas expressed in this article are solely of the authors. The author nor Kothari Partner’s accept any liability for the incorrect application of these ideas either used by companies, employees or other individuals alike. ² At Kothari Partners, we have worked with various UK and overseas listed and PE-backed clients across various industries to consider how their business and finance services can bring them both cost reductions and performance improvement. Our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation. We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions.

For a confidential discussion please free to contact us, via our corporate website: https://www.KothariPartners.com