Climate change and the board: Learning how to fix a slow motion crisis

Investors are renowned, and often ridiculed, for having the attention spans of goldfish.

A quick Google search for “what does long term mean in finance” yields answers ranging from one to five years, often with a sheepish acknowledgement that this isn’t really long term, in the real world.

But finance — like food, news, rumor, and work — does seem to march to an ever-faster drummer. It should therefore be no surprise that finance as a whole might have trouble coming to terms with how to deal with the impact on value of climate change. Unlike our previous global technological crisis (the Y2K bug), this one will play out over decades, even centuries, and even if we fix it, it will be decades before that impact will be apparent.

So, it is impressive that the proxy season of 2018 clearly demonstrated that climate change has become a mainstream issue in finance. Climate change is a long-term issue from the point of view of human life spans.

It’s a termites-in-the-woodwork problem, which can be far more difficult to muster resources to solve, compared to wolf-at-the-door problems like Y2K. But we are making progress.

Why? The value at risk is enormous—and so are the opportunities. The Economist Intelligence Unit estimates the value at risk to be between $4.2trn and $43trn between now and 2100.

The Organisation for Economic Cooperation and Development (OECD) estimates that global GDP could be reduced between 2%-10% by the end of the century due to climate change.

For investors, a substantial portion—over half—of the risks of climate risk are not hedgeable, according to a study from Cambridge University. On the bright side, reducing emissions presents trillion-dollar opportunities as well — $23trn, according to one estimate by the World Economic Forum.

These are the kinds of things that investors understand, and an agenda that investors and boards can drive, according to a new report, Getting Climate Smart: A Primer for Corporate Directors in a Changing Environment, from Ceres. Market risks and opportunities in trillion-dollar magnitudes are matters that companies should see as strategically important, making them issues for corporate boards. There are many things that boards can do to understand these risks and opportunities, and integrate them into corporate strategy, including conducting materiality assessments, recruiting climate-competent directors, and assuring that boards have resources and education sufficient to understand climate change risks and opportunities. Companies and boards have many resources available to understand how they might be affected by (and affect) climate change, including the new framework for climate-related disclosure published last year by the Task Force on Climate-Related Financial Disclosure (TCFD). However, there is no generic guide that will be as good as a committed, climate-smart board in assessing the points of tangency between climate change and any specific company’s business risks and opportunities. Governance matters. Another recent Ceres report, Systems Rule: How Board Governance Can Drive Sustainability Performance, notes that companies with strong board systems to oversee sustainability are better positioned to deliver strong sustainability performance—and that, in turn, is associated with better financial performance.

There’s some good evidence on what happens to financial performance when companies take on climate change specifically as a set of strategic risks and opportunities.A recent paper from faculty at Stanford and Yonsei University showed that a portfolio with long positions in carbon-efficient companies and short positions in carbon-inefficient companies generated a positive abnormal return of 3.5-5.4% per year, and that “these carbon-efficient firms tend to be ‘good firms’ in terms of financial characteristics and corporate governance.’” A report commissioned by the Swiss Federal Office for the Environment found that ten of 11 climate-friendly indices outperformed their respective conventional benchmarks, and eight of the 11 also outperformed on a risk-adjusted return basis. These studies demonstrate that reducing emissions does not have to harm returns and is more often than not associated with outperformance rather than underperformance.

That idea, and that evidence, is likely responsible for the results of the 2018 proxy season on climate change. Andrew Logan of Ceres points out that the season established a few firsts: the first North American company board to endorse a shareholder proposal on climate change; investors rejecting a company’s contention that its inadequate disclosure of climate risk was good enough; the first company to consider what limiting warming to 2 Degrees Celsius means to the value of its assets. One of the biggest untold stories of the 2018 proxy season was how few climate related shareholder proposals went to a vote. It wasn’t because investors are less interested in it, but just the opposite: it no longer takes a shareholder proposal on a proxy to move companies forward on climate change.
This kind of success rarely happens without pushback. There have been moves in Congress to limit shareholder proposals. The SEC has issued new guidelines addressing the conditions under which shareholder proposals can be excluded, raising concerns and creating some puzzlement as to consistency and clarity. A new business group is claiming that shareholder engagements do not represent “main street investors,” and an industry group has published a study purporting to show that shareholder engagement does not create value, using a flawed methodology consisting of a sample of a mere ten proposals over a four-year period.
Don’t be misled by the backlash. Those who claim that engagement does not create value can do so only with their own flawed research. Research that is peer reviewed, on the other hand, and that looks at a robust sample of 847 engagements, finds that successful shareholder engagements are associated with higher sales growth, without harming profitability. 2018’s proxy season shows that investors are growing more interested in addressing climate risks, and that is good for investors of all stripes, from Main Street to Wall Street.
In short, climate change will affect the value of companies. Inattention to its risks can and probably will destroy value. Managing and mitigating those risks while taking advantage of opportunities presented by climate change can be a value creator. The best way for companies to take advantage of these opportunities and mitigate the risks is to establish formal board mandates for sustainability, assure that sustainability and climate expertise are readily available to (and on) boards, and to establish mechanisms for accountability, such as linking executive pay to performance against sustainability and climate goals.

Julie Gorte is Senior Vice President for Sustainable Investing, Impax Asset Management and Pax World Funds