Middle East Economic Survey

 

VOL. LI

No 20

19-May-2008

 

GENERAL

 

A Climate Change Risk Assessment For Industry

 

By Paul E Hardisty

 

Prof Hardisty examines the risks and opportunities that industry faces from the rapidly emerging economic and physical effects of climate change. In the context of rapid global change, he discusses risks that businesses  face from operating in a carbon-constrained world, and those associated with adapting to a world increasingly affected by climate change. He shows how companies stand to benefit significantly from early adoption of simple revenue-positive measures to reduce emissions, arguing that operators who fail to act quickly may incur additional costs as regulatory and economic baselines shift. Prof Hardisty is Global Director, Sustainability and EcoNomicsTM, for WorleyParsons, a major engineering services provider to the petroleum and resources industries. He is a Visiting Professor of Environmental Strategy at Imperial College, London, UK, Adjunct Professor of Environmental Engineering at the University of Western Australia, and a Member of the Grantham Institute for Climate Change in London.

 

A Rapidly Changing World

Climate change is only one part of a wider sustainability context that is becoming increasingly relevant for business. That context is underpinned by the fundamentals of a rapidly growing world population, currently at over 6bn, and set to rise to over 9bn by 2050 1, and the legitimate aspirations of billions of people for a life free from poverty and disease. More people, with greater demands, put increasing stress on the natural environment which provides the food, water and raw materials necessary for that prosperity. Recent authoritative surveys of global environmental health2 describe a world challenged by massive forest and biodiversity loss, significantly depleted marine resources, growing atmospheric pollution, and declining and polluted water resources. And now set above all of this, there is clear evidence that climate change is beginning to affect planetary weather systems. Predictions are that these changes will only hasten the decline of our already weakened natural environment 3,4.  

 

The predicted effects of climate change, if emissions continue to grow unchecked over the next 30 years, are global in scale and pervasive in extent3,4. Rising sea levels will lead to increases in the risk and damage associated with storm surges, salination of coastal aquifers, destruction of coastal ecosystems, and the displacement of populations3,4. The majority of the planet’s ecosystems and species are unlikely to be able to adapt quickly enough to the rate of warming predicted for the coming few decades3, undermining our ability to produce food.  It is now clear that the resulting impacts could lead to significant risks to global security, with the prospect of civil unrest and war predicted in a recent study by the Pentagon5. The downside risks of climate change are widely acknowledged to be too frightening to allow 2,3,4,5 .

 

Science Vs Public Opinion

The best available science clearly indicates that climate change is real, is happening, and is starting to impinge on our world now3,4.  That same science is now unequivocal about the fact that we are the cause. Interestingly, however, public opinion still significantly lags behind the science, and many commentators in the public media continue to attempt to discredit the climate change science6. The degree to which public opinion has shifted in recent months, is striking, however. A recent worldwide BBC survey found that 79% of respondents recognised climate change was a serious issue, and wanted governments to take action7. Industry should be mindful of this massive shift in global public opinion, as it will drive higher expectations for corporate environmental performance, manifested through the spending patterns of consumers, the regulations imposed by government, the scrutiny of non-governmental and community organizations, and the expectations of shareholders. If the public wants action on climate change, it clearly wants industry and business to do its part.

 

A New Sense Of Urgency

In recent months, a significant body of research into the impacts of climate change is bringing a new sense of urgency to the issue. The warmest year on record in the arctic has led to hugely accelerated melting of the polar ice cap, and recent studies now predict that if the current trends continue, the arctic will be ice-free in summer by 20158, 50 years ahead of the schedule set out in recent IPCC reports. The implications of such rapid northern melting are significant – accelerated thawing of the permafrost, releasing potentially vast amounts of methane, a potent GHG (greenhouse gas), into the atmosphere. The earth system appears now to be responding much more rapidly to the effects of warming than previously predicted. We may have far less time to tackle the issue than we thought even a couple of years ago. 

 

A Climate Change Risk Assessment

Risk assessment is widely practiced in industry, and is now part of standard operating procedure in most companies. The process attempts to identify possible risks associated with a project or activity, and then assesses them based on the probability of occurrence and the magnitude of the expected effect. Risks with very high probability are deemed unacceptable and are mitigated against. Risks of catastrophic effect (which could put the company out of business or result in significant fatalities), and even very low likelihood, are also typically deemed unacceptable, and are mitigated. Considering climate change from the risk assessment perspective is instructive. Even if we assign climate change a low probability of occurrence (the IPCC states with 95% confidence that we are causing climate change3), the predicted effects are clearly in the “catastrophic” category.  Any corporate or engineering risk assessment done for the planet would classify the risk of climate change as unacceptable, and would call for immediate and comprehensive mitigation.  

 

Risks To Industry

The risks to industry posed by climate change, and the wider imperative for environmental sustainability, can be examined from two perspectives:  first, risks of operating in a carbon-constrained world which is responding to the need to mitigate climate change; and second, risks associated with adapting to a world increasingly being changed by the effects of climate change itself.

 

Mitigation risks for industry are driven by increasing pressure from government, stakeholders, regulators, investors and employees, to significantly reduce GHG emissions. The scale of the mitigation challenge is monumental. According to the IPCC, Stern, and others, we need to decarbonize the world’s economy by as much as 60 to 80% by 2050, to give ourselves a reasonable chance of avoiding the worst effects of climate change3,4,9. The scale of this change means that appropriate price signals must be put into place to progressively drive up the cost of carbon, triggering action. Managing the introduction of widespread carbon taxation, in one form or another, is a key business challenge. Carbon-intensive industries will need to make profound changes to avoid large cost increases, and subsequent effects on profitability and competitiveness. Introduction of cap and trade schemes will also mean that emissions will be restricted overall, preventing expansion and growth in emissions.  Companies will have to develop expansion and growth strategies that work within these new limits. Using the carbon markets is one way of managing these risks.  In Europe, companies trade allowances on the flourishing carbon market, which was worth over $24bn in 2006 10. 

 

Even in developing countries of the Middle East and Africa, where there appear now to be no imminent national or regional plans for direct taxation or capping of emissions, industry will face rapidly increasing pressure from stakeholders to reduce clearly damaging practices such as venting of CO2 from natural gas production, and flaring of natural gas. In 2007, it is estimated that over 170bn cu ms of natural gas, worth over $30bn, was flared or vented worldwide, creating over 400mn tons of CO2e of greenhouse gases11. The Middle East region was responsible for over 50bn cu ms of the total, enough to provide continuous feedstock for a 20mn tons/year LNG (liquefied natural gas) plant11. This is but one example of the huge opportunities available to industry. Efforts to reduce gas-related emissions can be profitable because recovered gas is a valuable commodity, and because access to the world’s carbon markets may bring additional revenue to help pay for the emissions reductions. The Clean Development Mechanism (CDM), established under Kyoto, allows companies operating in developed nations to reduce their emissions by implementing emission reduction projects in developing countries. In 2006, over 500mn tonnes of CO2 equivalent, worth over $15bn, were traded through the CDM 10. But here also, there is a procrastination penalty. CDM requires that emission reductions meet the “additionality” test – in other words they must represent reductions which would not otherwise have occurred under business-as-usual in that country. As local regulations become more stringent, what is eligible for CDM credits today may become ineligible with time.

 

Understanding the fast-moving nature of carbon pricing is critical to climate change risk management for industry. There is a fundamental difference between current market or tax-based carbon prices, voluntary market prices, and the real value of carbon. The true cost of carbon, or the social cost of carbon (SCC), reflects the value of the damage caused by each additional tonne of GHG put into the atmosphere. The SCC is thus directly related to the total amount of GHG in the atmosphere – so the longer it takes to stabilize concentrations of GHG, the higher the SCC will be. The economic costs and benefits of actions taken by businesses to reduce emissions need to be carefully considered as the marginal cost of carbon (now in the order of $5 to 25/tCO2e) climbs inexorably towards the social cost, which Stern today estimates at around $85/tCO2e4.

 

One area where many businesses can achieve significant revenue-positive reductions in GHG emissions, and thus carbon costs, is in energy and heat efficiency. Many energy and heat efficiency opportunities available to industry are revenue positive12. But many firms require that modifications to achieve reductions in energy consumption meet financial hurdle rates which are actually much higher than for new capital projects. In many instances, energy efficiency projects examined without carbon costs cannot meet these hurdle rates, and are therefore rejected. The result is that many environmentally worthwhile projects are not pursued because they are marginally NPV (net present value) negative – they are profitable, but not profitable enough to meet internal rate of return (IRR) targets. These calculations almost always exclude any accounting for environmental or social externalities, which might make the overall economics look starkly different, especially if future trends are considered. This “NPV-IRR trap” is a major barrier to improving sustainability in industry. Revenue positive sustainability can and should be considered in the light of the predicted progressive internalization of the marginal cost of carbon, and its trajectory towards the SCC, along with a significant real rise in the cost of energy. These considerations alone could significantly alter the perceived economics of many worthwhile projects. In this way, profits from efficiency and energy savings in the near term can help to defray the costs of further, more difficult emissions reductions in the medium-term.

 

Adaptation Risks

The second category of risks to business is adaptation. Changes in the earth system, rising population, dwindling natural resources, and our responses to these issues are already starting to have effects on the global economy. Food prices rose substantially in 2007, due to a combination of increasing demand, crop failures in many parts of the world (including Australia), and the diversion of food crops to produce bio-fuels. Energy prices are rising worldwide, and water scarcity is driving up water costs. Businesses will need to adapt to ensure security of supply of key commodities and resources which may be affected by changing weather and climate. The physical risks are also considerable. Businesses with significant coastal or marine assets, including port facilities and offshore structures, will need to carefully consider the implications of climate change for design and operations, including accounting for rising sea levels and increased wave and storm surge energy. Industry should also be aware of the possibility that turbine and other system efficiencies may decline as marine cooling water sources warm. Even access to insurance may be affected, with premiums rising for climate-exposed businesses.

 

Business Response

Business can deal with the issue of sustainability by examining a hierarchy of possible responses. Companies can react on a philanthropic level, as many already do, by implementing over-arching corporate social responsibility (CSR) policies, engaging with local communities and stakeholders, and by taking actions that allow them to be perceived as being part of the solution and not the problem. Furthermore, companies can develop specific risk-management strategies designed to adapt to the changes that are coming, including carbon pricing and resource security. At the pinnacle of the hierarchy is a strategic approach, where businesses seek to redefine themselves to take advantage of the considerable opportunities associated with sustainability, and seek to achieve competitive advantage by positioning themselves to not only withstand the shocks that climate change will bring, but also to provide the goods, services, ideas and commodities that the world will need to achieve a sustainable society. 

 

Conclusion

Sustainability is emerging as one of the defining issues of the 21st century. How business responds to these challenges, and the increasing regulatory, stakeholder, investor and shareholder pressures that they bring, will be a key factor in achieving a sustainable society on the planet, and will also play an important part in determining how successful individual companies and business sectors will be in the future. In both mitigation and adaptation, the risks of inaction far outweigh the costs of well-considered, economically viable action using all of the tools, expertise and market mechanisms currently available to industry. Climate change carries with it a clear procrastination penalty for industry and the planet. Companies that wait to take action run increasing risks of higher costs, disrupted operations, and stakeholder scrutiny. The world’s scientific community is unequivocal about the dangers of inaction. This extends to industry and businesses in developed and less-developed parts of the world alike. We must act now to preserve the planet’s environment, and businesses will benefit from taking a prominent role in this endeavor. 

 

References

 

1.         US Census Bureau, 2008. World Population Statistics.

 

2.         UNEP, 2007.  Global Environmental Outlook 4:  Environment for Development (GEO-4). United Nations Environment Program, Nairobi, Kenya.

 

3.         Intergovernmental Panel on Climate Change (IPCC), 2007.  Fourth Assessment Report.  Complete Report.  Cambridge University Press.

 

4.         Stern, N 2006.  The Economics of Climate Change – The Stern Review.  Cambridge University Press.

 

5.         Schwartz, P and D Randall, 2003.  An Abrupt Climate Change Scenario and its Implications for United States National Security.  Report to the US Department of Defence, Washington, DC.

 

6.         Boykoff, J, and M Boykoff, 2004.  Journalistic Balance as Global Warming Balance. Creating Controversy  where Science Finds Consensus.  Fairness and Accuracy in Reporting. www.fair.org

 

7.         BBC, 2007.  BBC climate change poll.  www.bbc.com

 

8.         Maslowski, W 2006.  Cause of Change in Arctic Sea Ice, AMS ESSS Seminar, May 2006.

 

9.         DEFRA, 2003.  The Scientific Case for Setting a Long Term Emissions Reduction Target. United Kingdon Department for Environment, Food and Regional Affairs.  www.defra.gov.uk/environment/climatechange/pubs

 

10.      World Bank, 2007.  State of the World’s Carbon markets.  Washington, DC.

 

11.      World Bank, 2008.  Global Gas Flaring reduction Partnership, www.worldbank.com, Washington, DC

 

12.      McKinsey, 2007.  A Cost Curve for Greenhouse Gas Reduction.  McKinsey On-line services.