Managing Climate Risk

Brendan Harrison's Down to Earth landscaping company had to stop planting in St. Louis this summer. But he’d already hired workers for the season back in spring. How could he know he’d face the most extreme drought in at least a generation?

USDA's running tab of states and counties experiencing drought conditions.

This drought represents an interesting challenge in climate change that intrigues me. Prudent business leaders know they must treat climate change as a risk they manage in the same way as other risks. Thinking of climate change this way gives them access to the impressive resources of the risk management community (See for example, the Institute of Risk Management), and provides a framework in which to discuss the issues in a business-like fashion with their colleagues and subordinates. The challenge I face is helping these business leaders understand and properly address climate change risks.

At the most basic level, risks can be systematic or unsystematic. A systematic risk applies to a broad category of assets. Seems like a good description of climate change. For example, if temperatures are rising globally (a hazard risk), all of our facilities may be at risk of higher costs for air conditioning or cooling (a financial risk). Or if I am in the agricultural industry, all of my crops, in all locations may suffer productivity losses. Risk managers remind us that systematic risks are hardest to manage mostly because they can’t be avoided by diversification.

Complexities of climate change. Source: IPCC 2007

But can climate change create unsystematic risks? An unsystematic risk is one that may be specific to a particular industry or location. How can it be that climate change can create both systematic risk and unsystematic risk?  The answer lies in the hugely complex system affected by climate change. It involves everything from weather patterns, to sea level rise, and crop failures, and from heat stress on vulnerable populations to changes in disease patterns.

As an example of an unsystematic risk, consider the last item in that list, disease patterns. Higher temperatures can dry out some areas like the drought in over half the US; but makes others more humid, particularly areas near water bodies. And the increased humidity can help microbes that infect humans. The effect is local and is limited to certain times of the year, such as the hottest part of summer. That is an unsystematic risk.

If my company happens to have a factory nearby and my workers live in areas exposed to those microbes then it’s a risk for me. So climate change can create systematic risk that is hard to manage corporate wide, and unsystematic risk that may be off the radar screen of headquarters but can wreak havoc on the whole supply chain if my plant is a bottleneck and employees call in sick for an extended period (an operational risk).

These risks are widely appreciated in the financial community. For example, the Financial Times reports that two-thirds of asset managers consider climate risks in portfolio management. This proportion is likely to grow. Just this June, the British Government announced that firms listed on the Main Market of the London Stock Exchange would be required to report their greenhouse gas emissions.

The reasoning is that those emissions constitute a policy risk if they are subject to nationally or internationally imposed limits. Is it a systematic risk? It will be hard for individual corporations to address that risk since most of the emissions are inherent in the energy production system of the nation, and the world.

But it is possible. For example, many IT companies that are so dependent on huge energy supplies have diversified their energy sources away from fossil fuels towards wind, solar, hydro, and other renewable sources. Just switching from coal to natural gas can cut your greenhouse gas emissions in half. This would constitute a strategic risk for the coal company. So IT companies face a risk that, on the surface appears systematic but when approached imaginatively may turn out to be not so systematic, and become a differentiator among companies.

It may also become a differentiator among business leaders. Those who fail to deal with these risks will no longer be deemed prudent. Brendan Harrison may plan differently next year.

Planning for the Worst is Job One

The dog days of summer seemed to start a bit early this year. With fresh memories of “super derecho,” DC metro blackout, and lack of A/C in sweltering heat, I found myself enjoying some well-deserved leave time in Eastern Europe despite some unusually warm weather there as well. The good news is that there were no massive blackouts due to A/C loads, but the bad news is that there really wasn’t any A/C to speak of in the village. However, India didn’t have the same luck, with its residents, business, and economy enduring the “worst blackout in India’s history.” Reports of the transportation snarls, banking disruptions, and doubt over economic prospects seemed to surface rapidly. Returning last week, the news of US drought, call for disaster relief, and prospects of higher food prices seems to reinforce the universal lesson that brutal weather and climate impacts can have both very personal and national economic implications.

While many of us in the lower to middle latitudes are just trying to stay cool, keep the power on, and calculating corn futures, the Arctic ice pack extent numbers seem to be on track for record year, smaller than even 2007’s record.

Credit: National Snow and Ice Data Center

This summer’s season’s record ice melt seems to validate the Navy’s call to develop their Arctic Road Map and war game the national security implications emerging from greater Arctic access.  Earlier this March, the Naval War College (NWC) released the findings report from the multinational Fleet Arctic Operations Game (FAOG), which held last September. Prior to its release, Admiral Jonathan Greenert, Chief of Naval Operations, suggested that the war game emphasized the need for international maritime cooperation. However, just this week, the NWCs’ Weekly Maritime News Survey referred readers current articles discussing Russian and Chinese interests in the Arctic.

If the FAOG war game enhanced multilateral collaboration, recent discussions on the Air-Sea Battle (ASB) framework have certainly not enhanced our mil-to-mil relationships with the Chinese military. While this reported ASB scenario focuses on a hot conflict with China, the DoD’s Office of Net Assessment's model may hold promise to help inform the capabilities need for the Arctic operational needs identified in the FAOG war game. These professionals are paid to think through the worst case scenario so our military services can make the case for balanced capabilities that can mitigate the impact of low probability, high-consequence security risks.  

In my chapter on Climate and National Security, I’d emphasized the need to use scenarios and war gaming to not only think about a changing climate’s known unknowns but supporting our national security professionals in identifying the needed capabilities, gaps, and solutions, such as multilateral collaboration with our arctic allies (and competitors) who have those assets. Incorporating climate implications into our national security scenarios and war games is timely and needed to think about the threats of a 21^st Century future security environment.



Credit: DiGirolamo, SSAI/NASA GSFC and
Allen, NASA Earth Observatory



For example, a friend sent me an article during my leave about the rapid melt event in Greenland during the second week in July.

While current science can’t definitively tell you whether this rapid melt was a result of 150-year cycle, climate change, or some combination of both, the implication is that our military scenario makers can use such phenomena as inspiration, particularly when considering “worst-case” scenarios. As with the Arctic, war games focused on mild (0.5-meter sea level rise), moderate, or worst-case (7-meters) Greenland ice sheet melt can be valuable in thinking through the enormous national security implications, needs, capabilities, and gaps from such sea level rises. Regardless of nature of the threat, our military’s planning and preparing for the worst is job one.

Once we’ve done that, it brings us to early warning systems but that is a post for another day.

Mixing Things Up: Changes in the U.S. Power Generation Fuel Mix are Helping to Reduce GHG Emissions

As an economist, a big part of my career has been spent trying to understand trends and changes to the status quo, and how their impacts are felt. I recently began looking at power generation fuel substitution and some of the changes occurring in this area.

For many decades, the U.S. has been slowly decarbonizing the fuel mix it uses to generate power. Here’s a chart I put together that shows the relative shares of coal, oil, natural gas, nuclear, hydropower and non-hydropower renewable sources over 50 years, between 1960 and 2010.




As you can see, coal, oil and hydropower lost market share, while natural gas, nuclear and non-hydropower renewables gained. Overall, the carbon intensity (carbon/BTU of energy) of the U.S. power generation mix dropped by roughly 15 percent from the beginning of the period till the end.

We can also see from the chart that the trends were particularly strong in the first decade of the 21st century, from 2000 to 2010. But what’s happened since then? A second chart shows the same trends from the beginning of 2011 through May, 2012 (the latest available data from the U.S. Energy Information Administration).




Over this short time period, coal continued to lose market share while natural gas and renewable sources other than hydro gained. Because of this substitution, the carbon intensity of the U.S. power generation fuel mix dropped by another 13 percent.

What is likely to happen to this carbon intensity in the future? The Department of Energy has projected the future U.S. power generation fuel mix through 2035 and believes that it is likely to continue towards higher proportions of natural gas and renewable sources and a reduced share of coal. If that happens, U.S. power generation fuel carbon intensity will continue to decline.

Though this declining carbon intensity doesn’t solve the greenhouse gas problem, it helps. And a lot of it is happening because market forces in the U.S. are pushing power generators to make the indicated fuel substitutions. Things aren’t necessarily the same in every country, but in many the same market forces likely will push local power generators to make similar substitutions.