The Atlantic hurricane season, which begins in June and lasts throughout November, is upon us. Coastal owners have reason to be concerned. The shareholders too.
Until recently, reinsurers and banks bore most of the market risk associated with climate change. Now things are changing. Individual companies are explicitly held responsible for the risks of global warming. A court in The Hague has ordered Royal Dutch Shell to cut emissions. The International Energy Agency has said energy groups must halt new oil and gas projects in order to achieve net zero emissions by 2050.
Indeed, market sanctions for companies making bad decisions about climate risk are broader than you might think. A Pentland Analytics report, “Risk, Reputation and Accountability,” examined several episodes of extreme disaster, including the 2017 hurricane season, which was the most expensive in US history.
Deborah Pretty, the author, examined companies listed in the United States with annual revenues exceeding $ 5 billion and which revealed the financial damage caused by Hurricanes Harvey, Irma and Maria. By modeling the reaction of the stock price over the year, she found an average reduction of 5% from the S&P 500 Index, or the equivalent of $ 18 billion of loss in value for shareholders.
Pretty also studied companies that had more than 10% of the global value of their insured property in an affected area, to see what precautions, such as flood or wind protection, they had taken. Among the companies that reported financial damage, less than half of the recommended actions had been implemented. On the other hand, among those who did not report any material financial damage, almost two-thirds of the recommendations were completed.
At the end of the line ? Market perceptions of the negative consequences of such natural disasters have “shifted from bad luck to mismanagement,” says Pretty. Stock prices now reflect whether or not the C-suite takes the risk of climate change seriously. Indeed, Pretty’s research shows that the best performing companies are those that consider resilience more important than a good balance sheet deal. In other words, they take all possible steps to mitigate this risk, even if the models show that the risk is low.
It may confuse economists, but as one engineer interviewed for the study put it, “Look, if you have four holes in your boat and you plug three, you’re still going to sink!” This is part of the argument for resilience rather than economic ‘efficiency’, which influences not only climate disaster preparedness, but also supply chains (companies are starting to shorten them) and cyber risk. Pretty notes that between 2010 and 2020, ill-prepared companies that fell victim to a cyber attack underperformed the market by 20% in the year following the attack.
If regulators do what they want, these risks will become more explicit, especially when it comes to the climate. G7 leaders last week announced their commitment to mandatory climate-related financial reporting, modeled on that recommended by the G20 Working Group on Climate-Related Financial Reporting. This provides a roadmap on how to integrate climate risk measures into corporate governance and strategy.
Europe has made more progress than the United States in forcing companies to disclose this risk. In Washington, the body best placed to create and enforce such regulation would be the Securities and Exchange Commission. But under President Donald Trump, the SEC relaxed regulations generally and didn’t mention the climate at all. The US government still subsidizes coastal flood insurance, even as cities like Miami are considering building multibillion-dollar walls to hold back rising tides.
If the Biden administration is successful, that will change. The SEC, now headed by ambitious regulator Gary Gensler, has just finished collecting public comments on ESG reporting rules. Gensler says he wants to bring “consistency and comparability” to what companies report. This could mean specific industry standards for reporting emissions as well as information on the amount of riparian properties owned by a company or prevention measures taken around flood-prone areas.
Some activists are pushing for extremely granular disclosures about water insecurity, heat stress and the extent to which businesses could be affected by disease, political unrest and migration. A February Center for American Progress report, co-authored by Andy Green (now the US Department of Agriculture’s senior advisor on fair and competitive markets) outlines the potential range of future reporting requirements.
If companies are forced to quantify their ESG footprint in a way that makes it easier to compare sectors and individual company efforts, it’s hard to overstate what the impact on the market might be. Exposure, for example, of a clothing manufacturer to agricultural production (and the subsequent potential for crop damage by drought, heat or plague) could significantly affect shareholder value. A price on carbon could change the math for some exporters, making activities such as long-haul heavy machinery transportation much more expensive. Asset managers with too many investments in high carbon sectors could find themselves in breach of their fiduciary duties.
As the hurricane season begins, we may see a dramatic shift in the markets as well as in the weather.