Risk Management’s Role in the Climate Transition

Awareness of climate change and its current and potential future impact has grown quickly. The rise of climate activism began a trend of public companies stating carbon reduction goals (see Figure 1).

Today, most shareholders and employees expect their organization to have some form of climate goal. In most cases the one stated goal is simple and has a long horizon, with little to no detail of how it will be accomplished.

Source: SBTi Monitoring Report 2023

While this trend seems positive, it must be recognized that there can be unintended — and often negative — side effects from these goals. For example, as GARP Risk Institute’s Jo Paisley noted in her recent article on how the financial system impacts climate change, “Let’s consider an asset owner that sells a stake in a high-emitting counterparty, such as a coal-fired power station. Although it may make the portfolio look greener, this will not have any impact on real-world emissions (and might even make things worse if the purchaser plans to increase the output of the power station).”

Mark Griffin

If we want to make sure that there are systemic reductions in greenhouse gas emissions, we need to think at the system level. This is recognized by the Transition Plan Taskforce, which noted in October 2023 that since firms operate in an interdependent system, focusing on just net-zero target setting incentivizes so-called ‘paper decarbonization’. In other words, they are greening their own balance sheet in a way that may not necessarily contribute to greening the economy.

Thus, at a system level — which is what matters for decarbonization — the transference of ownership of high-carbon assets to other actors in the system, who may be less well placed to bear the risk or phase out their use, can be counter-productive to an economy-wide transition.

The Scale of Paper Decarbonization

Unfortunately, the sale of carbon intensive assets to private interests, or paper decarbonization, has become the path of least resistance in the current environment. Consistent with this is the rising level of interest in investing in private markets by both institutions and individuals (Figure 2). Almost any trade publication or newspaper will list yet another fund manager, pension fund or institutional investor who is targeting private investment.

Source: Bain & Company 2023

One of the challenges here is disclosures about the carbon footprint of these assets are hard to obtain. A recent MSCI blog, however, points to concentrations of high-emitting companies across the limited range of disclosures from private capital funds. Furthermore, a report by Bloomberg reported more fossil fuel deals being undertaken by private credit managers, since banks have been exiting these assets.

Once carbon-intensive assets are sold to private interests, they will be managed for maximum return, and public scrutiny of their operation is unlikely to return. So, from an economy-wide and societal perspective, the train wreck of paper decarbonization continues in plain sight.

The Role of the Risk Management Function

Assume for a moment that a business has committed to move a particular climate metric to zero by 2050 and has given no more specific guidance than that. In the absence of specific year-by-year targets, staying ‘on pace’ translates to moving the metric about 4% a year. In this situation, if paper decarbonization transactions moved the metric down 10%, that would represent two and a half years’ worth of apparent ‘progress.’

The actual ‘greening’ of a business, process or investment is often difficult and involves considerable time, capital and risk. This heavy lifting tends to move climate metrics much more slowly than transactions and strategic decisions do.

The risk management function of a publicly-scrutinized business would normally set internal target metrics which align with any external commitments, whether the commitment is earnings guidance or other financial performance, or climate goals.

However, the risk management function must also champion thoughtful metrics, thresholds and reviews to ensure real progress is made towards reducing climate risk, in alignment with a company’s strategic plan.

Some concepts for risk managers to consider include:

• Ensure any reliance on carbon credits is clearly shown in the climate metrics.

• A like-for-like efficiency measure, similar to a retail analyst’s measure of same store sales, should be calculated at each distinct business unit. This would show actual progress and not be masked by volume or business mix changes.

• To the degree possible, some of the metrics should pertain to the part of the strategic climate transition plan that can be executed without reliance on outside factors or players. Some companies have begun to miss their climate goals, often attributing this to factors outside their control.

• An overall Red / Yellow / Green assessment of genuine progress should be designed. (“Steering the Ship: Creating Board-Level Climate Dashboards for Banks” is a useful resource for considering what information to provide to boards).
   

Parting Thoughts

Proper metrics should not reward paper decarbonization transactions that create immediate headroom towards climate goals. Business risk management should reject a paper decarbonization approach, paying attention not just to the emissions of their own company and its supply chains, but also to entities to whom there is equity or credit exposure.

In this way, the risk management function will not miss its unique opportunity to ensure that the climate transition is effective and beneficial to all.

Mark Griffin, CFA, FSA, is a retired Chief Risk Officer and Chief Investment Officer. He has worked on both sides of the Atlantic, and on both the “buy side” and “sell side.” He holds the Financial Risk Manager certification and the Sustainability and Climate Risk certificate.