Managing risks

Net zero decision making: a least regrets pathway

The focus on net zero continues to sharpen and companies are developing plans, metrics and budgets as they map their pathways forward. However, the world within which these decisions are being taken is changing continuously, making it increasingly challenging to work out what the “right” decision is. We propose that the right decision is one that drives action without limiting future options.

In this article we start with an overview of climate-related risks, before considering the responses we are seeing from boards – and the shift in thinking that we recommend to help decision makers navigate uncertainty.

TCFD: A framework for unpacking risks

The framework laid out by the Taskforce for Climate-related Financial Disclosures (TCFD) is the clear point to start. It is increasingly forming the basis of voluntary disclosure of climate risk. The TCFD identifies transition risks and physical risks as the two main classes of climate risk to assess for transparent disclosure. APRA and ASIC both cite TCFD as best practice for disclosing the financial implications of climate risk. TCFD has also been mandated as a disclosure requirement in the UK and New Zealand, and steps are afoot in the US to introduce TCFD style reporting. We expect TCFD to form the basis of mandatory climate disclosure in Australia in the near term.

The other framework people consider for assessing and reporting their progress on addressing climate change is the Science Based Targets Initiative (SBTi). The SBTi is best used to frame the metrics and performance measures required by the TCFD.

Transition risks are becoming clearer

Transition risks are those related to the path to net zero. They relate to emissions reduction, the policy changes that will direct attention and effort, and the associated changes in costs. Companies typically explore these risks across a number of categories including energy price changes, carbon price changes and the rate of reduction in emissions required.

The scenarios that companies can use to explore these risks typically relate to the pathway taken to net zero. They can be articulated in the context of a temperature increase associated with the warming that will result if globally that emissions reduction trajectory was adopted.

Companies talk about a net zero pathway that aligns with 1.5^oC of warming, this will require the majority of companies globally to eliminate their scope 1 and scope 2 greenhouse gas emissions entirely by 2050. Companies also talk about reducing their emissions in line with 2^oC of warming or 3^oC of warming. These different transition scenarios highlight the future that the company is willing to accept for themselves and their society.

Physical risks are increasing

Physical risks arise from a changed natural environment. These risks are going to occur whether companies reduce their greenhouse gas emissions or not. We have already locked warming into our global weather systems. Reducing emissions going forward will limit this change, however it will not take this change away. Addressing physical risks is usually achieved through resilience and adaptation planning.

The scenarios used to explore how a changed climate will impact a company are typically aligned to 1.5^oC of warming, 2^oC of warming, and sometimes 3^oC of warming. The impacts of 4^oC of warming are so extreme it is difficult for models to converge to a point where you can assess the impact of climate on assets.

A note about scenarios

Companies should take care when deciding the scenarios that they will explore for both transition risks and physical risks. Deciding that emissions reductions will occur in line with 3^oC of warming because of the perceived cost of reducing emissions any faster, and then only assessing the impact of 1.5^oC of warming on the operations of the company, is at least disingenuous.

A pragmatic response

Companies are exploring the breadth of these risks, and using scenarios to unpack the outcomes of different strategic decisions, for example buying or building new assets. Typically when companies try to assess best outcomes, they look for an optimal or win-win option. However, when two different sets of scenarios relating to a future global state are overlaid onto the decisions, it is extremely unlikely that one option will be best in all cases. It is much more likely that different options are preferred as a function of which scenario is being explored at that point.

The uncertainty and complexity could result in companies or boards deciding not to take a decision, to wait and see what happens, to delay until uncertainty is resolved. However, the only thing that is certain about physical climate risk is that uncertainty will increase. For transition risks, while some will resolve, others might increase in magnitude.

However, it is no longer possible to define a right decision, or a best decision. We are unlikely to be able to optimise a decision outcome. However, what we can do is assess how likely an option is to be wrong. We can assess how options rank as we explore the different scenarios being assessed. As a minimum, it is possible to work out the option which is least likely to be wrong.

This will require boards and companies to become more risk and variance tolerant in their decision taking and might require adjustment of control points.

The only wrong decision is the decision not to act.

In Energetics’ work with clients we help them to address this uncertainty head on. We work through options and processes to enable them to reach decisions and move forward. We always come at decisions from the perspective that if you stand still you will lose, and endeavour to help our clients to take the most robust decisions in uncertain times.

Given the urgency to deliver net zero, to reduce emissions so that we have a chance of limiting global warming to 1.5^oC and thus ensure that life on earth is not changed beyond imagination, we have to act now.