{"id":17468,"date":"2023-05-04T11:01:00","date_gmt":"2023-05-04T16:01:00","guid":{"rendered":"https:\/\/blogs.law.columbia.edu\/climatechange\/?p=17468"},"modified":"2023-05-17T12:27:54","modified_gmt":"2023-05-17T17:27:54","slug":"the-tragedy-on-the-financial-horizon-is-closer-than-you-think","status":"publish","type":"post","link":"https:\/\/blogs.law.columbia.edu\/climatechange\/2023\/05\/04\/the-tragedy-on-the-financial-horizon-is-closer-than-you-think\/","title":{"rendered":"The Tragedy on the Financial Horizon is Closer Than You Think"},"content":{"rendered":"
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Credit: Ilmi Granoff<\/figcaption><\/figure>\n

In September 2015, then Bank of England Governor Mark Carney gave a landmark speech on the \u201c<\/span>Tragedy of the Horizon<\/span><\/a>.\u201d The concept was simple: climate change creates tremendous risk for financial markets, but these mounting risks are ignored by investors due to the market\u2019s tendency towards <\/span>myopia<\/span><\/a>. The speech marked a significant turning point in finance: the starting gun in the race to internalize climate-related financial risks.\u00a0<\/span><\/p>\n

Eight years later, the \u201ctragedy of the horizon\u201d has become a central concept of much climate risk discourse. Efforts to incorporate climate risk through activities like scenario analysis and target-setting have tended to focus on long-term time horizons, focusing on emissions trajectories and climate impacts that resolve later in the century. But the horizon most relevant to the markets is much nearer. Climate risks like abrupt responses to policy and consumer demands \u2013 or the now-inevitable early shockwaves of physical climate impacts \u2013 are far more relevant to the economics of business decisions today than what happens in 2050. Capital decisions made now create and maintain real assets that will exist in a vastly different world a decade hence. Despite the progress made since 2015 to prepare companies for climate risks, the corporate decisions are underpinned by economic and financial assumptions that still poorly reflect both predictable physical risks and the zero-carbon transition. Under efficient markets theory, the medium term is reflected in asset prices and company valuations, but in practice it is not.\u00a0<\/span><\/p>\n

Consistent with the core recommendation of this blog, the Federal Reserve should be praised for focusing its recent <\/span>transition risk scenario exercise<\/span><\/a> on a 10-year time horizon. But the actual scenarios employed in the risk oversight project, borrowed from the <\/span>Network of Central Banks and Supervisors for Greening the Financial System<\/span><\/a> (NGFS), are not appropriate for illuminating this decade-long period. The scenarios approach the transition through stylized GHG concentration reductions over time. They are not tied to any particular policies, even existing and predictable ones. Efforts must shift to helping regulators and financial actors appreciate \u201cmedium-term\u201d climate risks. In particular, the economic assumptions embedded in firms\u2019 current capital plans and financials must be scrutinized and updated for the transition that is now indisputably underway.\u00a0<\/span><\/p>\n

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Getting markets to look out<\/span><\/h2>\n

Two years after Carney\u2019s speech the <\/span>Taskforce on Climate-Related Financial Disclosure (TCFD)<\/span><\/a> developed the now widely adopted recommendations for the analysis, management, and disclosure of climate-related financial risks. While introduced as a market-led and voluntary framework, the TCFD\u2019s recommendations have served as a framework for many financial regulators around the globe as they work to upgrade climate risk oversight and disclosure rules.\u00a0<\/span><\/p>\n

Chief among the TCFD\u2019s recommendations to overcome one aspect of the tragedy of the horizon\u2014paralysis in the face of uncertainty\u2014firms are encouraged to use <\/span>scenario analysis<\/span><\/a>. The TCFD\u2019s initial discussion encouraged firms simply to develop narratives of different possible futures and their business implications \u2013 scenario analysis at its most basic level. Discussion of climate-related scenario analysis has evolved to imply the application of complex, data-intensive climate economic modeling (modeling of climate-related economic change rather than modeling solely of the behavior of greenhouse gases or their effect on natural systems) that allows for more information-rich quantitative analysis to accompany those narratives. For example, the NGFS-commissioned integrated assessment model <\/span>scenarios<\/span><\/a> are used for financial supervision and have also been widely adopted by non-financial firms for their own analysis of climate risks and opportunities.<\/span><\/p>\n

How far the horizon?<\/span><\/h2>\n

Transformative as it was, Carney\u2019s metaphor left out a key detail for firms seeking to navigate the rough seas of climate disruption: how far out is the horizon?\u00a0<\/span><\/p>\n

A natural answer emerged from the climate science and policy communities. Global mean temperature change caused by rising atmospheric GHG levels is <\/span>conventionally measured out to 2100<\/span><\/a>.\u00a0 There is already a tremendous amount of modeling to develop stylized emissions scenarios as they resolve over the course of this century as a guide to policy-makers on both the transition and physical impacts of climate change. For example, efforts to stabilize atmospheric GHGs have <\/span>converged on a global mean temperature threshold of 1.5<\/span><\/a>\u00b0C by 2100<\/span><\/a> as an optimal societal goal. Thus, so it seemed, transition risk could be captured by working backward from achieving this end-of-century outcome and understanding how firms fair if society were to emulate modeled outputs. For example, a 1.5<\/span>\u00b0C change by 2100 also implies <\/span>net zero carbon dioxide emissions by 2050<\/span><\/a> leading to somewhat nearer-term implications. It has been natural to assume that these time horizons were the most important ones to draw into financial decision-making.<\/span><\/p>\n

This assumption is mistaken. It is, of course, terrifyingly probable that <\/span>extreme climate-related impacts and potential tipping points<\/span><\/a> loom in the second half of this century (and over that horizon, into the next century), but some extreme climate-related impacts are already <\/span>evident<\/span><\/a>. Tangible-yet-neglected financial risks are beginning to accumulate, right now, and in the near future. These nearer-term risks are increasingly priceable by the market, and yet not being priced.\u00a0<\/span><\/p>\n

Too much focus on the very long term has provided easy excuses for corporate inaction. For example, the greater uncertainty of the distant future, 30, 50, or 75 years on provides a handy defense for firms seeking to justify business as usual. Firms in the real economy can avoid course correction now by imagining technological rescue in the distant future. Financial institutions, in turn, can claim that their investment and financing portfolios will shift dynamically as the real economy changes and thus avoid any risk. Each is effectively saying: <\/span>\u201cThe transition may be happening, but it\u2019s less directly relevant to business today.\u201d<\/span><\/i>\u00a0<\/span><\/p>\n

Perhaps also implicit, risks that crystalize mid-century and beyond are also well beyond the careers of senior management in today\u2019s market: <\/span>\u201cThe transition may be happening, but it’s not on my watch.\u201d<\/span><\/i><\/p>\n

This ignores the presence of climate risks entirely material to the balance sheets of today\u2019s firms in the real economy, portfolios of financial institutions, and careers of those who manage each. If the economy is decarbonizing, as it appears to be doing, it is well within the lifetime of assets being planned now and the career risk of those planning it. The market \u201ctragedy of the horizon\u201d is more like a decade out. The \u201c<\/span>tragedy of the tragedy of the horizon<\/span><\/a>\u201d is that, between the short-termism of the market, and the long-termism of climate modeling, entirely priceable risks of the medium-term remain poorly scrutinized.<\/span><\/p>\n

Where today\u2019s decisions touch climate discontinuity<\/span><\/h2>\n

Capital plans are where corporate decisions meet climate change in the real economy. Firms in the \u201creal economy\u201d serve the core function of determining how and when to develop or maintain real assets \u2013 durable capital assets like oil fields, refineries, power plants, steel mills, manufacturing facilities, and buildings. These long-lived assets also emit greenhouse gasses or produce goods that do. They are also exposed to the impending physical risks that are now \u201cbaked in\u201d to the future\u2014many physical risks in the near to medium term are now impossible to avoid, the inevitable consequence of historical emissions.\u00a0\u00a0<\/span><\/p>\n

It takes time to plan, permit, finance, and develop these types of assets. They then operate over decades to produce goods and services and generate revenue to pay out shareholders and pay back lenders. Capital investment today is therefore a financial decision the economics of which are predicated upon forecasts about a decade or so out. For the sake of simplicity, we\u2019ll call this the \u201cmedium-term\u201d, While today\u2019s capital investment decisions are shaped by the medium-term, there is far less scrutiny of the assumptions that underpin those plans and whether they reflect the implications of the transition adequately.\u00a0<\/span><\/p>\n

In periods with some degree of economic continuity, we can rely on historical trends to make some decent if crude assumptions about the future. But climate, and the low-carbon transition, is a discontinuity, one that diminishes the reliability of the assumptions underpinning empirical data. The default response to uncertainty about the future is that past performance is our best guess: with climate, we have every reason to assume that this is incorrect. Bill Gates is <\/span>attributed<\/span><\/a> with saying: \u201cWe always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.\u201dSo too with climate change.\u00a0<\/span><\/p>\n

Take the US economy as an example. Congress has just poured an unprecedented amount of public spending into the green economy under the <\/span>Inflation Reduction Act<\/span><\/a> (IRA). The IRA comprises an enormous public investment, anywhere from <\/span>$367 billion to $1.2 trillion<\/span><\/a>. Those investments are also specifically targeted at mobilizing private investment, and at restructuring the US economy to substitute zero-carbon technologies for high-carbon ones. To begin to consider transition risk, one need not even conjecture about future policies (which new policies become <\/span>all the more likely<\/span><\/a> as public and private investment in the green economy begins flowing in) to begin evaluating the implications, opportunities, and risks as climate policy and technology reshape demand. At a minimum, investors need to price in how <\/span>policies like the IRA drive substitution<\/span><\/a> and erode the projected revenues that underpin the valuations of incumbents.<\/span><\/p>\n

Transition, physical, and climate risks in the medium term have bearing on the decisions made by companies today. For instance:<\/span><\/p>\n