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Nov 01 2021

Climate-related financial risk and corporate net-zero commitments

by
Sadie Frank +Danny Cullenward 
Sadie Frank
Danny Cullenward

CarbonPlan has published research designed to help provide insight into the critical ways that climate science is increasingly woven into finance, public policy, and corporate strategy. Examples include forest carbon offsets, biomass monitoring, forest risks, and soil offset protocols. We have also analyzed over 200 carbon removal proposals submitted to procurement processes run by Stripe and Microsoft.

As all eyes turn to the global COP26 negotiations in Glasgow, we thought it would be useful to share more about how our work intersects with emerging issues in financial regulation that are expected to be a key theme at the climate conference and in the years ahead.

Investors and regulators around the world are increasingly looking to understand how climate change could cause financial and economic harm. These potential damages, known as climate-related financial risks, primarily concern how climate change affects financial loss and instability, as opposed to public health or impacts to natural ecosystems. Even with this relatively limited focus, however, climate-related financial risks touch all aspects of the economy — from the residential housing market to insurance providers, retirement funds, and infrastructure.

Growing recognition of climate-related financial risks is leading to exploratory efforts in the private and public sectors. Publicly-traded investment firms like BlackRock have started to analyze how their multi-trillion dollar portfolios will fare under potential future worlds brought on by climate change, a process known as scenario analysis. This May, the Biden Administration issued an executive order calling for a whole-of-government approach to climate-related financial risk mitigation. Meanwhile, global regulators are beginning to focus on reducing climate threats to financial stability.

Climate-related financial risks usually come in two distinct flavors. The first is transition risk, which refers to risks that could emerge from the massive changes required to decarbonize our economy. This includes policy interventions that could affect a company’s profitability, like a price on carbon or mandatory regulations, as well as the risk that a company loses market share to greener competitors. The other main flavor of climate risk, physical risk, concerns financial losses from climate impacts like floods and wildfires. These physical risks can occur over longer time horizons through chronic risks (for example, prolonged drought and heat stress) or through acute events (like a powerful hurricane knocking out a power station).

While distinct, transition and physical risks can interact with each other. For example, if physical risks increase in the absence of emission reductions, future policymakers might rapidly implement reactionary policies to drastically limit emissions, thus ratcheting up transition risks. On the other hand, if transition risks are high enough to motivate corporate actions to reduce emissions, or if policymakers act quickly enough to require those changes, then physical risks will be lower.

Unfortunately, the conventional financial framing of transition and physical risk does not offer a prescribed pathway for emission reductions. Instead, climate change is treated as a risk management process focused on assessment and disclosure.

Under this framework, companies run their own climate risk assessments and then disclose this information so that investors can make prudent capital allocation decisions. The thinking goes as follows: if an energy company runs and discloses a scenario analysis that shows its fossil fuel reserves losing value under a range of climate mitigation policies, a climate-savvy investor might choose instead to fund a competitor building more renewables. Alternatively, a company that demonstrates its ability to manage expected climate impact costs could attract investment from investors who are concerned about physical risk exposure. Climate-related financial risk assessment could thus lead to more money flowing to emission-reducing activities or resilience investments.

Although the logic of disclosure might encourage shifts in capital deployment, the risk management framework does not require any particular outcome nor provide assurances that capital shifts produce meaningful reductions in emissions or vulnerability to climate impacts. Companies can hedge or reduce the risks they disclose in a variety of ways that have no real impact on emission reductions or decarbonization.

As a key example, some publicly traded oil companies are beginning to divest from certain fossil fuel assets. While this technically reduces the size of their individual carbon footprint — and by extension, any transition risks they disclose — these assets are frequently sold to other players who continue oil and gas production, often in murkier private markets that are not subject to public market disclosure requirements. Even when changes to capital deployment occur completely within a unified disclosure regime, some investors might nevertheless prioritize short-term profits from seasonal fossil gas over larger but more distant risks.

Thus, while climate-related financial risk management provides an important framework for integrating climate change into both corporate and regulatory decision-making, it does not directly require or guarantee decarbonization consistent with the Paris Agreement — despite the focus on transition risk disclosure. That conversation is emerging instead through net-zero commitments, which are increasingly popular with companies and governments.

The rise of net-zero commitments

Although rare just a few years ago, net-zero commitments now cover over ⅔ of the global economy, and new financial sector initiatives built around COP26 purport to manage 90 trillion dollars worth of assets committed to net zero. Powerful players in the financial sector, particularly the large asset manager BlackRock, have called for CEOs to disclose how their business model and strategies are net-zero compatible.

Net-zero commitments involve a pledge to become net zero by a given time — usually 2050, a date that roughly aligns with what is required to hold warming to levels set by the Paris Agreement. This means that by mid-century, a company will no longer pollute, or they will remove from the atmosphere whatever remaining carbon pollution they do not fully eliminate (the “net” in net zero — more on carbon removal below).

Getting to net-zero emissions is a process. According to a leading effort from The Science Based Targets Initiative (SBTi), a corporate net-zero target requires:

“Reducing scope 1, 2, and 3 emissions to zero or to a residual level that is consistent with reaching net-zero emissions at the global or sector level in eligible 1.5°C-aligned pathways. Neutralizing any residual emissions at the net-zero target year and any GHG emissions released into the atmosphere thereafter.”

Where “neutralizing” is defined as taking “[m]easures that … remove carbon from the atmosphere and permanently store it to counterbalance the impact of emissions that remain unabated.”

This two-step process of first aggressively reducing emissions and then permanently removing any residual emissions is the backbone of a credible net-zero strategy.

Potential tensions

In practice, companies and their advisers focus on climate-related financial risks and net-zero commitments as as individual components of their broader climate strategy. This approach introduces a key tension. Climate-related financial risks are tackled through a process of identification, assessment, monitoring, and disclosure. A net-zero commitment is qualitatively different. Instead of reflecting ongoing management, a net-zero commitment is a public pledge to achieve a future outcome by a certain date. Achieving that outcome requires reducing emissions along a predetermined timeline, such as those developed in partnership with SBTi. But because the two processes are often not formally connected, it remains possible for a company to disclose climate-related transition and physical risks while not actually taking steps to reduce its emissions, even if it makes a net-zero commitment.

One unintentional irony is that companies that make a net-zero commitment also create a potential transition risk for themselves. A net-zero commitment implicitly assigns a company the task of creating a transition plan, and the resulting risk that this plan becomes subject to reputational and investor scrutiny, particularly as banks and asset managers set net-zero investing and financing targets. Thus, although net-zero commitments are often seen as either separate from external transition risk (or as a tool for mitigating it), the opposite can be true. The actual degree of transition risk depends, at least in theory, on the stringency a company’s voluntary net-zero commitments — as well as whether those plans are consistent with the standards investors, regulators, and the general public demand in the years ahead.

Net-zero commitments and carbon offsets

Companies with net-zero commitments have nominally signed on to implement plans to achieve their targets and reduce transition risk. Leading efforts like SBTi and Oxford Net Zero have produced frameworks and tools for helping companies map a path to net-zero emissions, all of which focus heavily on reducing emissions first and then procuring permanent carbon removal to counteract any unabated emissions. Under these frameworks, offsets are intended to be used only when all decarbonization options have been exhausted and only for the remaining emissions that are hard to abate — such as emissions from heavy industrial processes (for which clean alternatives do not currently exist) and not for reducing emissions from electricity use (where many options are available).

Many companies are now setting targets without clear options or pathways for emissions reductions, perhaps due to investor or reputational pressure. And instead of cutting emissions, many are turning to offsets first. This has led to a boom of interest in voluntary carbon markets, where companies in sectors like aviation and chemical manufacturing that cannot easily decarbonize without existential threats to their current business models seek instead to offset their emissions to reach net-zero. The resulting interest in voluntary markets surfaces deep tensions regarding offset use in such net-zero commitments, including which offsets are considered credible, and why.

As CarbonPlan has explored previously, carbon offsets produce two distinct kinds of carbon cycle interventions — efforts that physically remove carbon dioxide from the atmosphere (carbon removal), and efforts that avoid emissions in the first place (avoided emissions).

While this distinction might seem technical, it is of fundamental importance because only carbon removal is consistent with net-zero climate targets. The IPCC defines net zero as the point “when anthropogenic emissions of greenhouse gases to the atmosphere are balanced by anthropogenic removals over a specified period.” As the global community cuts emissions, it follows that there will be fewer emissions to avoid, and any efforts focused on continuing this avoidance merely slows down the transition. With very limited time for action, what’s needed instead is deep cuts in climate pollution, followed by efforts to match residual emissions that cannot be abated with permanent carbon removal.

Putting the pieces together

Unfortunately, today’s offsets markets don’t systematically track the distinctions between avoided emissions and carbon removal — likely because they were developed for less ambitious climate targets in previous decades. Meanwhile, the vast majority of today’s offsets don’t deliver carbon removal outcomes; fewer still promise to remove carbon and keep it out of the atmosphere on an effectively permanent basis. Simply put, the current supply of permanent carbon removal is extremely limited. Meanwhile, we and others have expressed significant concerns about whether the bulk of contemporary offsets markets deliver the outcomes they promise.

Questions about carbon offset quality are important in their own right, but they also matter for climate-related financial risks. To the extent companies rely heavily on low-quality offsets, they create their own transition risks. Should investors or regulators ever demand companies rely only on high-quality, permanent carbon removal, companies that plan to rely on cheap, low-quality offsets will find themselves scrambling to adjust to a very different and likely more expensive reality — an acute transition risk. On the other hand, if standards for net-zero-aligned offsetting remain amorphous and weak, most corporate pledges will do little to cut pollution and therefore do nothing to mitigate physical climate risks.

As we hope this post makes clear, the nexus of corporate climate-related financial risk and net-zero commitments reveals important contradictions and tensions that researchers, policymakers, and corporate leaders need to better understand. While often viewed as individual elements of climate strategy, financial risk and net-zero commitments are in fact closely linked to each other via transition plans and their use of carbon offsets, the effective governance of which is essential to producing credible disclosure regimes and effective private sector incentives.


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