Some Key Assumptions

Note: If you originally arrived at this Climate Site from a blog post at www.practicalesg.com, the examples below will look familiar to you, although the list may have been modified since originally appearing on that site.

Selected Business Assumptions

What are some commonly held assumptions that are informing corporate and investor climate policies and responses, and why might they be worth revisiting? I’ll skim several of them below:

Assumption 1: The most important thing companies can do to advance climate change mitigation goals, and to mitigate their own climate risk, is to shrink their carbon footprints (whether Scopes 1, 2, or 3).

Auditing the Assumption: There has been a longstanding scientific focus on the global carbon budget associated with limiting average global temperature change to 2^oC or less. As can be seen in Science-Based Targets, for example, that focus on emissions has trickled down to become the key metric by which business efforts to mitigate climate change are evaluated. But do such emissions reductions reduce a company’s climate risks?

First, it’s questionable whether voluntary emissions reductions can ever scale sufficiently to materially mitigate climate change. Arguably, for this reason companies should have been focusing more on their policy footprints than on their carbon footprints. In addition, perceiving a company’s GHG emissions or emissions intensity as a proxy for climate risk is fraught with complexities. Emissions reductions at the company level will have no impact on the physical or systemic climate risks the company will face, and assuming that reducing emissions will reduce the regulatory and market transformation risks a company will face requires all kinds of assumptions about the form and timing of future climate policy. In the meantime, companies could even be competitively disadvantaged by acting too early to reduce their emissions.

Assumption 2:The work of the Intergovernmental Panel on Climate Change (IPCC) is the best source of information for business decision-making related to climate risk.

Auditing the Assumption: The IPCC delivers the consensus scientific view on climate futures; in other words, it emphasizes the “most likely” or “expected” climate change outcomes. The IPCC focuses much less attention on the “long tail” of the climate change probability distribution. In fact, the IPCC largely ignores key risk variables like “climate tipping points” because there is insufficient scientific consensus on their timing or likelihood.

Understanding the nature of the IPCC’s work is key to robust business risk assessment. The more risk averse your business perspective, the less relevant “expected” climate outcomes are and the more relevant the “grey rhino” and “black swan” risks are that are lurking in the “long tail” of the climate outcomes probability distribution. If you flip a fair coin 100 times, for example, you can bet heavily on the fact that you’ll get heads very close to 50% of the time. But if you’re only allowed one coin flip, risk adversity would cause you to be much more cautious about betting it will turn up heads. That should be the business perspective in approaching climate outcomes that could be very different from the “expected outcome,” and that offer no opportunity for a “redo.” The IPCC may not be the best source of that information.

Assumption 3: Resilience to physical risks of climate change should be the primary focus of business risk assessment and management, since as former Exxon CEO Rex Tillerson argued, “we’ve always adapted, we’ll adapt.”

Auditing the Assumption: There are several reasons to question this assumption. First, what if policy makers decided to implement the policies and measures required to limit average global temperature change to the 2^o C or 1.5^o C targets that are the topic of so much discussion today? How draconian would the associated policies and measures have to be for carbon pricing, stranded assets, land use practices, and many other variables? Second, agricultural and other systems upon which human societies depend today evolved over a 10,000 period during which average global temperature stayed within .5^o ^C of the average temperature. That stability has now come to an end as a result of human activities, and we can’t know for sure how much temperature change those systems can adapt to. Many scientists think that adaptation limits will kick in if we get anywhere close to 3^o C of average global temperature change, which happens to be a likely outcome based on current emissions trends.

Assumption 4: Business planning and decision-making should focus on the same 2^o C and 1.5^o C scenarios that are the topic of most international policy.

Auditing the Assumption: Companies should arguably focus on what they’re most likely to encounter in the real world, rather than goals and targets that may or may not come to pass. By many accounts, for example, the world is currently on track for between 3^o and 4^o C of average global temperature change, not 2^o C or less. In addition, human activities are “forcing” climate change at a rate at least an order of magnitude beyond what led to past cycles of climate change. Decision-makers would be prudent to question how exactly we can forecast the pace and path of human-induced climate change. It might be, for example, that prevailing climate forecasts turn out to have been premised on an under-estimate of the “sensitivity” of the climate to human forcing.

Assumption 5: The macro-economic impacts of climate change will be minimal to modest.

Auditing the Assumption: A lot of economic modeling to date has suggested that the economic impacts of climate change, even up to 10^c, will be modest, and overall GDP will continue to increase in the face of climate change. Some integrated assessment models have even suggested that the first couple of degrees of warming would increase U.S. GDP. Much of this is an artifact of the kind of economic thinking being referred to by Lester Lave in the slide below.

A practical example of this could be seen on the climate change panel of an American Economics Association conference a number of years ago. Presenters argued that given the small role of the world’s oceans in contributing to global GDP, the loss of the oceans to acidification and other climate threats would not pose a threat to world economy. Such thinking is of course dismissed by climate scientists and ecologists, and by a growing number of economists. The very fact that some economic models have suggested the economy could easily adapt to 10^o C of average global temperature change should make us rethink the whole idea of doing this kind of economic analysis.

Assumption 6: Market mechanisms such as carbon offsets will always be available to significantly moderate the cost of business compliance with climate policy.

Auditing the Assumption: Market mechanisms have been a key component of proposed climate change policies domestically and internationally for three decades, so the source of this assumption is easy to understand. But it effectively assumes that governments will never seriously tackle climate change; is that a bet companies want to go all in on today? If governments seriously pursue 2^o C or 1.5^o C targets the supply of carbon offsets would shrink dramatically. That’s because offsets by definition come from sectors that are not under an emissions cap, or subject to public policies and regulations. As countries get more serious about achieving climate targets, the supply of potential offsets will decline.

Assumption 7: Systemic climate risks are largely outside the ability of companies to influence or manage.

Auditing the Assumption: Systemic climate risks are arguably the “bull in the china shop” of business climate risk, and include drought-driven global food price spikes, political instability, and even future global pandemics.

While companies cannot effectively hedge against systemic risks on their own, the COVID-19 pandemic should make us question what companies might be able to do collectively. While many companies had pandemic responses plans in place prior to COVID-19, those plans were overwhelmed by the failure of governments to be effectively prepared. Given that the cost of being effectively preparing for the pandemic might have been as low as $2-3 per capita globally, perhaps the global business community should have banded together to ensure that the world’s governments prioritized the problem and allocated the necessary funds. Enormous business losses might have been avoided. Arguably, climate change systemic risks pose a similar challenge and opportunity for collective action.

Assumption 8: Disclosing climate risk, e.g. through the TCFD scenario planning process, will provide investors and others with the objective information needed to help decarbonize the economy.

Auditing the Assumption: It is clearly a good practice for companies to better understand their climate risks and risk management options. What is less clear is whether disclosing climate risk information necessarily serves the interests of the companies themselves, or even of the investors as the intended consumers of that information.

First, strategic planning and scenario planning is often a proprietary exercise given its competitive implications. Scenario planning specifically for public release could easily turn into a “check off the box” exercise that serves no one’s interests particularly well. Second, the assessment of climate risk is far from an objective or standardized exercise. The longer-term the risk assessment, the more comprehensive its coverage of 1^st, 2^nd, and 3^rd order effects of climate change and climate policies, and the more risk-averse its framing, the more material the perception of climate risks is likely to be. By implication the reverse is also true. The first major climate risk assessment in the U.S., carried out by a major coal utility, concluded that climate policy did not pose a material risk to the company. How could that be? Well, it assumed slow and limited climate policy and an infinite supply of carbon offsets at $4/ton. In that context the “no materiality” conclusion is easy to understand, even if it might seem silly today. But even today climate risk variables can be interpreted in all kinds of plausible ways to arrive at very different climate risk conclusions. To make risk disclosures comparable, all companies might need to use the same underlying scenario, but that poses complications of its own.