Climate change and corporate governance - a phased approach to smoothing temporal dissonance
Climate change is viewed as a long-term problem by most directors and corporate actors, but the financial impact of climate change is largely misunderstood. Short-termism pervades corporate decision-making, creating a temporal dissonance between the perceived long-term timescales of climate change, and short-term corporate and investment decisions. This dissonance means that climate change is not being factored into today’s corporate decisions or in asset valuations by the market.
Corporate decisions in the near term about infrastructure, asset investment, supply chain decisions and energy choices will have direct and long-term impacts on the climate, but these decisions may also make businesses more or less vulnerable and resilient to the impacts of climate change as well.Climate change impacts are being felt now by businesses, and these impacts are only estimated to increase in the future as we potentially exceed a 1.5°, and possibly even a 2°C, long term temperature threshold. We only have a few years for global emissions to slow and peak, before starting a drastic decline, if the world is to stay within the safe guardrails of 1.5° or well below 2°C temperature increases. Emissions must peak immediately and reach net zero amounts (including negative emissions) by 2050 for a 1.5°C increase to remain feasible. Peaking of emissions after 2030 will mean that the well below 2°C temperature goal will be ‘substantially’ harder to reach. If emissions do not peak and decline drastically, we could be looking at a 3° or even 4°C temperature increase, and there is no certainty that humanity can adapt to such changes given the risks of runaway climate change. Business is an important factor in the transition away from fossil fuels, but short-termism of 3-5 yearly business cycles and quarterly reporting have left directors ill-equipped to embed climate thinking into corporate decision-making. It should also be noted that failures of global and domestic governance to properly regulate greenhouse gas emissions, institute carbon taxes, and provide policy incentives for the transition away from fossil fuels, have led to shrinking windows of time to ensure the safety of human existence in the long-term.
Given this set of circumstances, how can business embed climate smart decision-making? How can this temporal dissonance be dampened? A recent report by the Environmental Audit Committee of the UK House of Commons on Greening Finance on embedding sustainability in financial decision-making has considered the issue, interviewed experts and administered surveys of businesses. Their report, issued in June 2018, states that short-termism is still a pervasive problem in corporate decision making and leaves business ill-equipped to consider and incorporate long term risks and opportunities, such as climate change and environmental sustainability. Legal confusion over the extent that fiduciaries, including pension fund trustees, have to consider environmental and climate risks also prevents institutional actors from taking action on climate. The report recommends first that the Government clarify that pensions schemes and company directors have a fiduciary duty to protect long-term value, and second that climate-related disclosures become mandatory on a ‘comply or explain’ basis for businesses by 2022.
In relation to the first recommendation, corporate governance codes and even the UK Companies Act 2006 have for many years encouraged directors to manage with sustainable long-term value in mind. In 1998 the Combined Code of Corporate Governance stated that good governance should facilitate efficient, effective and entrepreneurial management that can deliver shareholder value over the longer term. The most recent 2016 Corporate Governance Code states that directors should strive to achieve sustainable success of the entity over the longer term. Under s172(1)(a) of the Companies Act 2006, directors are to consider the likely consequences of their decisions in the long-term, although this is subject to the overarching obligation to promote the success of the company for the benefit of its members. As becomes apparent, company law itself does not mandate short-termism – this is a normative phenomenon of corporate governance, albeit a strong one. However, managers are more likely to be less short-term oriented when they have access to more and better information on the trade-offs between long and short-term decisions.
In relation to the Committee’s second recommendation about mandatory climate reporting, the Task Force on Climate-Related Disclosures was established in order to provide a coherent and more standardised approach by businesses to reporting on climate change. Their final report includes the recommendation that directors adopt a scenario analysis approach to incorporating climate-risk into their business strategies. Scenario analysis involves the development of hypothetical futures, which can incorporate uncertainties, and help managers assess the risks of climate change to their business and the opportunities it may present. This tool can help businesses to ‘chunk down’ the large timescales of climate change into firm-specific risks and opportunities. The tool can help businesses carry out supply chain analyses and vulnerabilities, estimate the impact of climate change on their expenditures and capital inflow, as well as assess transition risks of changing global and domestic policies on climate change. Scenario analysis is new, implementation is patchy, and the available data is often global and therefore may only be relevant to large multinational companies. However, the TCFD recommendations are likely to become industry standard, and therefore wise and progressive directors will start developing scenario analyses for their businesses. Better and more accurate information about climate risk using tools such as scenario analysis can help to smooth the temporal dissonance between climate change and corporate short-termism and aid in the global transition away from fossil fuels. Whether this transition is timely enough to avoid catastrophic climate change is less clear.
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