Environmental Risk Readiness: Strategies for Top Executives and Boards
Climate change presents multifaceted risks to businesses, impacting operations, markets and supply chains. Short-term risks include exposure to extreme weather events and shifts in consumer preferences. Additionally, regulatory uncertainties and investors' consideration of climate risks pose significant long-term risks.
Environmental risks can lead to substantial financial losses for companies, affecting their financial performance and shareholder value. These risks encompass both physical and transition risks, each with distinct impacts on businesses.
Physical risks involve damage to assets from extreme weather events and broader climate trends such as global warming and rising sea levels. These can be categorized as either acute or chronic physical risks. Acute risks stem from severe weather events like floods, hurricanes, and wildfires, while chronic risks arise from long-term shifts in climate patterns. These risks can affect companies' operations, supply chains and markets, leading to increased costs and disruptions.
The physical impacts of climate change have tangible financial implications. However, perhaps even more important to investors than physical risks are the additional transition-related risks. Transition risks arise from changes in technology, market sentiment, consumer preferences and regulations during the transition to a low-carbon economy. These risks can impair asset values, decrease profitability and result in stranded assets.
Board Education and Awareness
The board’s key roles include promoting long-term value and defending the company’s reputation. An integrated approach to climate risk starts at the top, and boards need to ensure management understands how climate change is reshaping the company's risk landscape and that this is reflected in corporate strategy.
Corporate governance structures play a pivotal role in addressing climate risks and integrating sustainability into business strategies. Investors are placing greater emphasis on board competency in addressing climate-related risks and opportunities. Shareholder resolutions are urging companies to appoint board members with environmental or climate expertise. To enhance focus on sustainability issues, some companies (for example, Shell, Nestlé and Unilever) have established sustainability committees within the board structure.
In addition to proactive governance measures, boards must navigate increasing regulatory requirements related to climate risk reporting and disclosure. Implementing emerging disclosure frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD) enables companies to communicate climate-related risks effectively and is a particularly useful reference for boards. The TCFD (2017) recommends voluntary climate-related financial disclosures should focus on governance, strategy, metrics and targets, and risk management. Compliance with these reporting standards is crucial for maintaining trust and credibility in the market.
As concerns about climate risks mount among investors and regulators, and demands for disclosure of climate risks grow, boards that fail to effectively oversee climate risks may be vulnerable to shareholder action and litigation.
Integrated Risk Management and Strategic Alignment
To navigate environmental risks, companies should adopt an integrated approach to risk management while aligning strategies with sustainability objectives. As a basic starting point, companies must understand their exposure to physical and transition risks. However, they must also understand the exposure coming through their supply chain (counterparties, suppliers, customers and partners).
Embedding climate risk into strategy is essential for long-term value creation and competitiveness. Some options boards could explore include:
- Integrating sustainable practices into operations, product management, portfolio of products and services, financing, and marketing practices.
- Actively incorporate climate risk considerations into strategic planning processes to safeguard against potential disruptions and capitalize on emerging opportunities.
- Integrating climate risk considerations into capital budgeting processes enables companies to make informed decisions that mitigate risk and enhance long-term value creation.
- Strengthening supply chain resilience: Identifying vulnerabilities in the supply chain due to climate risks is essential for maintaining operational continuity.
- Assess the exposure of each business unit to transition risks and develop strategies to mitigate potential impacts.
- Embedding sustainability principles into business models. Leveraging sustainable innovation, such as renewable energy solutions or eco-friendly packaging, enables companies to meet evolving consumer preferences and regulatory requirements while driving business growth and enhancing brand reputation.
- Mergers and acquisitions (M&As) are a powerful tool that companies can use to improve their sustainability performance and generate new business opportunities. However, to maximize the chances of success, it is important to carefully consider the sustainability factors involved in each transaction.
- Integrate strategy and finance tools. Instruments such as green bonds, sustainability linked loans, or sustainable supply chain financing help to align incentives with sustainability goals and drive meaningful change.
Navigating the Transition
Understanding and managing climate risks is critical for businesses to maintain resilience and long-term sustainability. By integrating climate risk considerations into strategic planning, risk management frameworks and investment decisions, companies can navigate the complex landscape of environmental risks and position themselves for success in a changing climate.
Despite the acknowledgment of climate-related risks across sectors, there is significant uncertainty around many aspects of climate change. Maintaining organizational resilience is paramount in navigating the evolving environmental landscape, marked by regulatory changes and market uncertainties. Embracing agility enables swift responses to emerging challenges and opportunities. Companies should stay abreast of evolving environmental policies, tax implications and compliance requirements. Flexibility in adjusting operational strategies ensures alignment with evolving regulatory landscapes.
Boards of directors play a central role in steering companies through the complexities of climate change. By integrating climate considerations into governance structures, boards can enhance resilience, foster innovation and drive sustainable value creation for all stakeholders.
IESE-ECGI 2024 Corporate Governance Conference
The 2024 IESE-ECGI conference will take place in Madrid on April 15, 2024. This year's conference theme will be "Towards a New Model of Boards of Directors"and will focus on the following topics:
The role of strategy in the board’s effectiveness
Board dynamics and the board as an effective team
Interactions between the board and the firm’s shareholders
How the board should deal with new disruptive realities such as climate change, digital transformation and geopolitical risks
BlackRock has published their updated proxy voting policy guidelines and engagement priorities for the 2024 annual shareholder meetings, that in their view, drive long term financial value. Board quality and effectiveness, strategy and purpose are among their top concerns. Read more here.
Rising geopolitical risks, technology transformation and climate change are creating a context of uncertainty that is adding more complexity and transforming boards of directors’ agendas. Confronting these challenges will require more dedication and commitment by boards of directors. A new article published by Glass Lewis discusses how having a director commitment policy can serve to mitigate risks related to overboarding and contribute to the promotion of board refreshment. Read the full article here.
Nominating / governance committees are gaining relevance for ensuring adequate governance structures and board composition. A recent guide published by PwC gives some insights on the role, responsibilities and expected agenda of these committees. Read the full guide here.
On March 6, the SEC adopted the long-awaited final rules on climate-related disclosures. The rules require significant qualitative and quantitative disclosure in annual filings related to climate risks and have already been challenged by several states in the US. A summary of the new disclosure obligations, the changes from the original proposal and comparison with other climate disclosure regulations can be found in the executive summary published by Deloitte here.
IESE'S RECENT RESEARCH.
Anton, M., Ederer, F., Gine, M. and Schmalz, M. Innovation: The Bright Side of Common Ownership? European Corporate Governance Institute – Finance Working Paper No. 965/2024. Read here.
