“Climate change is a complex and inherently systemic issue making it an extremely difficult risk and opportunity to manage.” — World Economic Forum’s Principles of Climate Governance
The massive build-up of ambition, expectations and momentum prior to the two-week Conference of the Parties to the United Nations Framework Convention on Climate Change in Glasgow (COP26) proved too weighty for the frail shoulders of mere politicians and leaders. More than 100,000 protesters took to the streets of Glasgow alone, significantly more than anticipated, while an estimated 500 representatives were present from the fossil fuel industry alone, significantly more than any single country.
The present outlook is a grave warning that global leaders simply do not have the capacity or political will or, for other reasons, are not able to set aside their differences and priorities to be able to effectively attain consensus about the action which is urgently needed in this existential crisis, as informed by science.
This could signify various responses:
• Governments which understand the enormity of the crisis and consequences will invest their time and resources in adaptation measures, to ensure a just transition within their spheres of influence.
• Civil society will endeavor to fill this vacuum and take the lead.
• Business strategies will continue to bifurcate sharply between those who understand the extent of the transition and those who do not and are essentially betting against society succeeding.
The unprecedented momentum of the past two years has been based on science and seen both prudential regulators (central banks, monetary authorities) and capital market regulators (securities commissions, stock exchanges) as well as allocators of capital (institutional investors, banks, insurers) demand for enhanced reporting and disclosure so they can make better informed decisions, as capital needs to be diverted away from businesses, industries, regions and countries which still have not internalized the enormity of this transition and are not prepared for a smooth transition.
The ultimate consideration is very clear: there can be no successful business on a dead planet [‘companies do not succeed in isolation’]. There is increasing evidence, especially from meta studies, that enterprises which have strong credentials in environment, social and governance (ESG) factors are delivering better risk-adjusted returns and financial performance. Non-ESG focused businesses will increasingly lose access to capital markets as allocators of capital signal that business and financial stability is synonymous with environmental stability.
Some of the key challenges facing many countries are:
• Lack of national and local climate-related data to make informed decisions, with such data needing to be accurate, timely and relevant.
• The absence of forward-looking scenarios which are relevant for their industry and region.
• Adequate policy signaling from legislators in decarbonizing the economy and the transition strategy, specifically necessary adaptation measures.
Science
Humans have relied on environmental and climatic stability for societies and civilizations to prosper and mature, yet the greatest existential crisis which human civilization is now facing involves the destruction of the natural conditions necessary for our own survival.
The effects of the triple crisis of climate, destruction of biodiversity and pollution are clearly established as arising from human activities. Changes in water cycles, rainfall patterns, sea level rise, the ocean and extreme weather events are further amplified by a rapid increase in urbanization and the destruction of the natural environment. Malaysia and Southeast Asia will be disproportionately adversely affected by rising temperatures.
Further, the Paris Agreement of December 2015 was not just about reducing emissions across all sectors, but about remaining within planetary boundaries, including the need to keep carbon sinks in nature intact and preserve nitrogen, water and phosphorus cycles. The majority of earth’s massive biosystems have reached or are very close to tipping points beyond which reversion will be impossible or could take centuries, including the Atlantic Ocean’s key circulation system with immense consequences for Earth’s climate if/when it collapses.
Scientists have been warning about the consequences of the climate emergency for many decades — ‘the world listened but did not hear’ — and guided that global emissions need to be halved by 2030, just over eight years away, and be net zero by 2050.
Landmark commitments to decarbonizing include OECD countries by 2050 while China, Russia and Indonesia have committed to net zero by 2060 and India by 2070. It is important that these commitments are based on the reduction of absolute emissions, versus emission intensity, accompanied by a declaration of when emissions will peak, while considering the different combinations of transition of physical risks.
To illustrate the sheer scale of reduction which is necessary, in 2020, with almost the entire world under lockdown, during the COVID-19 pandemic, the International Energy Agency estimated that emissions only reduced by 6%.
The UN’s Intergovernmental Panel on Climate Change’s 6th Assessment Report issued in August 2021 is much more comprehensive, with over 234 authors having assessed more scientific evidence than ever before. It was described by the secretary-general as a “Code Red for Humanity” and compacted the expected range of warming to be between 2°C and 4.5°C.
[In the five previous assessments, the IPCC estimated the range of warming would be between 1.5°C and 4.5°C. The 6th Assessment Report is an unprecedented warning that limiting warming to 1.5°C is no longer an option, based on current declared national targets, the majority of which are not yet backed by legislation or frameworks for implementation. The minimum threshold of warming of 2°C is already locked into the ecosystem.]
So, the implications are clear: climate has already warmed by 1.2°C in 2021 [during a La Nina phase] and there is a high likelihood of achieving 1.3°C of warming during an El Nino year in 2022, which will cause massive upheaval around the world.
Therefore, with warming of 1.5°C well within range, it is increasingly clear that a decarbonization strategy alone is insufficient; in a crisis where no business or industry sector will be untouched, there is an urgent need to consider the needed resources, scenarios and strategies to ensure adequate adaptation measures for the impacts of climate change which would likely be prohibitively costly, damaging and deadly.
Direction of travel
Emissions can be traced to sources, indicating those industry sectors and businesses which are significant emitters.
As carbon is unequivocally recognized as an environmental pollutant which is destroying the natural conditions necessary for our own survival, this leads to a real and present danger that corporate earnings are misstated where it fails to capture the price of carbon. Further, nations which have declared climate ambitions and targets are reluctant to be accused of outsourcing their emissions.
Thus, there are increased concerns of drastic action in the near future, such as the inevitable policy responses from governments that have a vast arsenal of policies they could implement at short notice, including regulations and taxes.
Virtually every transition scenario is built on the pillars of electrification of multiple activities [such as transportation, heating, buildings, industrial processes], increased source of green fuels [such as hydrogen, renewable energy] and preservation of carbon sinks and biodiversity [halt to deforestation, restoring degraded ecosystems].
Asia, which accounts for 36% of global GDP, has made great progress in economic development and poverty reduction, but it is also responsible for around 80% of the world’s coal consumption and up to 60% of current CO2 emissions.
Thus, a critical global fault line is the lack of financing of clean energy investments in developing countries. Fatih Birol, the executive director of the International Energy Agency, observed that while rich countries were cutting their emissions, some developing countries would continue to increase theirs unless they could gain more in shifting to a low-carbon economy.
“More than 90% of emissions in the next two decades will come from emerging economies, but they are less than 20% of global clean energy investments,” he said. “If we can’t accelerate the clean energy transition in these countries, I believe this will be the most critical fault line in global efforts to reach climate goals.”
There are recent laudable efforts in the region to enable the early decommissioning of coal power plants but a persuasive argument has been advanced, based on the principles of equity, that the party responsible for any damage must be accountable for the reparation, also described as ‘common but differentiated responsibilities’.
The argument is that those countries which have contributed historically to the bulk of accumulated emissions have an opportunity to demonstrate leadership in limiting emissions, restoring ecosystem stability and extending assistance [whether soft loans, grants or knowledge transfer] to those countries which will be adversely and disproportionately affected, through no act of their own.
This is a persuasion to reduce emissions but meanwhile, significant work is needed within each jurisdiction to ensure adaptation measures are well underway.
Existing plans to limit global warming rely too much on “increasingly unrealistic assumptions” that societies will be able to remove huge amounts of carbon from the atmosphere while simultaneously maintaining incessant economic growth over the next 50 years, according to a May 2021 study in Nature Communications. These strategies appear to be speeding the planet deeper into the climate crisis, the authors said.
Another option is economic degrowth — strategies to shrink the economies of rich, developed countries while maintaining the wellbeing of the people and environments they are based on — which appears to be less risky, and possibly, a better way to simultaneously meet both the goals of the Paris climate agreement and a growing population on earth.
Some conversations are still focused on raising awareness and encouraging a willingness to pay [also described as a ‘green premium’], which might not be an accurate way of describing the consumer’s purchasing decision. It stands to reason that with an existential crisis, there are many opportunities to generate significant value, especially where staggering amounts of capital are looking for sustainable investment opportunities which, in turn, will need appropriate risk allocation models. Businesses which are able to provide products and solutions which are simply better value for money, more attractive and efficient, while being sustainable and good for the planet, will clearly have an edge and break away from competitors.
Many countries have already experienced the devastating consequences of climate change: floods, droughts, heat waves and storms. We will not be able to self-isolate from these events. While we urgently need to focus on the quality and integrity of these promises made by nations and alliances, and ensure that commitments actually support the real economy transition, it is clear that business leaders are the key drivers of this transition.
Business leaders
Thought leaders in business are responding decisively to help address the clear and present dangers of the climate emergency, demonstrating they can be a force for good, advocating for and supporting long-term value-accreting zero-regret investment decisions to future-proof their business and communities, as well as increasing our collective climate resilience.
First-order implications which need addressing are physical and transition risks, including an understanding of what the extent of exposure is and an assessment of resilience to adverse climate events [such as fire, floods].
As mitigation efforts alone are no longer sufficient, leaders need to deepen their thinking and efforts on second-order implications including the availability of foreign labor, institutional stability and other significant social impacts such as mass climate migration, huge social disorders, which can escalate very dramatically and very quickly.
However, while such leaders are evolving their transition strategy to be a competitive advantage, there are laggards among the boards: one of the key findings from a recent Deloitte Asia Pacific survey was that 72% of audit committees had not completed a comprehensive climate change assessment.
In Malaysia, the central bank [Bank Negara Malaysia], which joined the global Network for Greening the Financial System in 2018, is very clear: the climate crisis poses a systemic risk to the financial system; it is simultaneously foreseeable and yet unpredictable. The prudential regulator is relying on licensed entities to be high-impact contact points with customers in raising awareness on sustainability [‘force for positive change’], starting with the recently-issued Principle-based Taxonomy, which will also increase capacity as institutions grapple with implementing these principles internally.
The upcoming International Sustainability Standards Board standards in June 2022 will be a game-changer, having galvanized multi-stakeholder inputs in less than a year. The prototype disclosure requirements issued by the Technical Readiness Working Group during COP26 requires a level of granularity which we are certainly unaccustomed to, including detailed transition plans; how investments in research and development relating to mitigation, adaptation and identifying opportunities are being advanced internally; how assumptions underlying the accounts are aligned to Paris; which scenarios were used for the assessment; inputs into the scenarios; and policy assumptions.
Directors also need to be fully alert to misalignment of interests and attention between the board and management. As climate risks are longer-term and often extend beyond the considerations of the typical business planning cycle, this can lead to a phenomenon former governor of the Bank of England Mark Carney described as the “Tragedy of the Horizon”.
It is abundantly clear that the costs of inaction are significantly more than the costs of action but, despite the increased ambition recently demonstrated in the nationally determined contributions, which signatories to the Paris Agreement are required to submit, and industry-wide commitments [most noticeably Glasgow Financial Alliance for Net Zero or GFANZ with an eye-watering US$130 trillion of assets backing it], all of the stated intentions need to be translated into legislation or policies; almost none of the assets are net zero today or fossil fuel-free while new fossil infrastructure is still being supported and financed, most famously the auction of a colossal 81 million acres to be leased by the US government for oil and gas production in the Gulf of Mexico, just four days after COP26 in Glasgow.
To be clear: a decarbonization strategy is a subset of the transition strategy. When we are not pricing in the cost of pollutants or environmental destruction which critically impairs our ability to be resilient, are we misstating earnings of corporations worldwide? And if so, who are the stewards of the business who would be responsible for that?
Many investors are naturally using this difficult conversation as a proxy to the quality of management: starting with understanding of the issues [climate literacy] and measuring internal carbon, waste and water footprints as well as energy efficiencies, closely followed by benchmarking to best practices, reporting and disclosure in accordance with the Taskforce for Climate-related Financial Disclosure and finally, setting science-based targets for carbon emissions and/or a declaration of operating within planetary boundaries.
Climate governance
The best practices of corporate governance require the majority of the board of directors, including its chairman, to be independent non-executive directors. These non-executive directors need to be sufficiently climate-literate to guide the direction of travel of the business they are accountable for as well as grapple with the forward-looking concepts of double materiality — where issues material to environmental and social objectives may develop financial consequences over time — and dynamic materiality — “what appears financially immaterial today can quickly prove to be business-critical tomorrow”.
In January 2019, the World Economic Forum issued the Principles of Climate Governance which have proven to be a valuable framework for boards to adopt in developing climate resilience and recognizing the opportunities which are arising. Issued in the format of a set of principles with guiding questions for directors to consider, they walk the board through key considerations which recognize the important role directors are to play in embedding climate literacy across board committees and throughout the organization.
These principles are “intended to enhance the discussions on climate competence of directors to the extent that climate risk considerations become embedded in normal board processes. This should enable better-informed investment decision-making, more systemic thinking and an integrated approach to crafting and implementing [a] business strategy that is informed by consideration of climate impacts in both the short and long term.”
Principle 1 — Climate accountability on boards
The board is ultimately accountable to shareholders for the long-term stewardship of the company. Accordingly, the board should be accountable for the company’s long- term resilience with respect to potential shifts in the business landscape that may result from climate change. Failure to do so may constitute a breach of directors’ duties.
Principle 2 — Command of the (climate) subject
The board should ensure that its composition is sufficiently diverse in knowledge, skills, experience and background to effectively debate and take decisions informed by an awareness and understanding of climate-related threats and opportunities.
Principle 3 — Board structure
As the stewards for long-term performance and resilience, the board should determine the most effective way to integrate climate considerations into its structure and committees.
Principle 4 — Material risk and opportunity assessment
The board should ensure that management assesses the short-, medium- and long-term materiality of climate-related risks and opportunities for the company on an ongoing basis. The board should further ensure that the organization’s actions and responses to climate are proportionate to the materiality of climate to the company.
Principle 5 — Strategic and organizational integration
The board should ensure that the climate systemically informs strategic investment planning and decision-making processes and is embedded into the management of risk and opportunities across the organization.
Principle 6 — Incentivization
The board should ensure that executive incentives are aligned to promote the long-term prosperity of the company. The board may want to consider including climate-related targets and indicators in their executive incentive schemes, where appropriate. In markets where it is commonplace to extend variable incentives to non-executive directors, a similar approach can be considered.
Principle 7 — Reporting and disclosure
The board should ensure that material climate-related risks, opportunities and strategic decisions are consistently and transparently disclosed to all stakeholders — particularly to investors and, where required, regulators. Such disclosures should be made in financial filings, such as annual reports and accounts, and be subject to the same disclosure governance as financial reporting.
Principle 8 — Exchange
The board should maintain regular exchanges and dialogues with peers, policymakers, investors and other stakeholders to encourage the sharing of methodologies and to stay informed about the latest climate-relevant risks, regulatory requirements, etc.
Conclusion
Capital markets are pulling climate risks forward in their assessments of value. Allocators of capital are demanding for increased reporting and disclosure to enable capital to be allocated to those businesses, management teams, industries, regions and countries which appear most capable of making a smooth transition to a greener economy, while diverting capital away from those businesses which still do not appear to comprehend the enormity of this existential risk.
As long-term stewards of the enterprise, directors are tasked with identifying material risks and effectively managing them, as well as those opportunities which will arise as a result of the climate emergency. It will be very difficult for any director to claim they were not fully aware of the material financial risks arising from this critical transition.
Thus, directors need to balance competing board priorities against a backdrop of limited time and capacity to address all strategic topics and the constant pressure to meet expectations of all stakeholders.
When responsible and conscientious directors and businesses accurately anticipate the direction of travel, we can be a force for good.
Sunita Rajakumar is the founder of Climate Governance Malaysia.