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.