Business strategy and climate change
In many respects, the scientific debate is irrelevant. For the business community, climate change represents an impending market shift – one that will both alter existing markets and create new ones. It will not be unlike shifts that have occurred in the past, when consumer needs changed, or technology advanced, and some companies declined while others rose to take their place. In the 1980s alone, computers eliminated the typewriter industry, compact discs replaced phonograph records, and the Bell System’s demise wrought structural changes in telecommunications. New competitive environments produce both risks and opportunities, as well as winners and losers.
This market shift will create new supply and demand for emission-reducing technologies, new financial instruments for emissions trading, new mechanisms for transferring technologies globally (i.e. Joint Implementation and the Clean Development Mechanism), and new pressures to retire historic sources of greenhouse gases (GHG). The shift will affect all companies to varying degrees, and all have a managerial and fiduciary obligation to assess their business exposure and decide whether action is prudent. In short, as the market shift of climate change looms on the business horizon, the argument against action is increasingly harder to make.
For many within the business community, the future is a carbon-constrained world and the time for action is now. Companies with this perspective already have engaged in GHG reductions. Yet other companies (particularly in the United States) continue to resist and deride their proactive competitors with labels such as ‘carbon cartel’ or ‘Kyoto capitalists.’ Such resistance is a very risky strategy, however, in the face of the coming market shift.
The debate is thus strategic (not scientific) and companies taking voluntary climate action are not practicing philanthropy or pure social responsibility (although many couch their activities in the language of ‘doing the right thing’). In fact, many companies are agnostic about the science of climate change. They engage the climate-change issue as a way to protect their strategic investments and to search for business opportunities in a changing market landscape.
This article seeks to explain the current business phenomenon at three different yet closely related levels of response. First, we look at the early warning signs that suggest a market shift is coming. Second, we identify the various business frameworks that can be and are being used to link climate change to business interests. Third, we describe some specific ways in which companies synergistically integrate climate change and business strategy to contribute to the bottom line.
Emergent early warnings: the growing case for climate action
Climate change and consequent policies to reduce GHG emissions create systematic risk across the entire economy, affecting energy prices, national income, health and agriculture. Climate change also creates regulatory, physical and reputational risks at the sector, industry and company levels. As the competitive environment alters, certain companies, industries and sectors will be more at risk than others. Some see the electric utility, steel and aluminum industries as particularly vulnerable. Others warn of impacts to oil and gas, or to automakers. Some see American companies overall as less prepared than their European and Asian counterparts to handle climate-related policy. Regardless of specific vulnerability, very few business sectors are immune to climate change and the inevitable market shift. All of which leads us to ask: Where are the market signals coming from? How are they promoting the business case for action?
The first place to look is the public policy arena, where there are signs that the enactment of a US national climate policy is very near. In much the same way the US Environmental Protection Agency (EPA) was formed in 1970, individual states are increasingly enacting climate-related legislation, creating a spreading patchwork quilt of state and regional regulation. This motivates some corporations to support the idea of a national policy.
The US Senate took a significant step forward in the summer of 2005 when a solid majority supported a resolution that stated, ‘Congress should enact a national mandatory, market-based program to slow, stop, and reverse growth of these GHG emissions.’ The resolution was followed by Energy Committee hearings on a cap-and-trade bill authored by Senator Bingaman (D-NM) and based on the recommendations of the National Committee on Energy Policy (NCEP). In April 2006, the Energy Committee held a full-day climate conference to discuss design elements of potential legislation, corporate governance and international business leadership, a process to which dozens of corporations submitted comments. Finally, a new version of the McCain-Lieberman climate bill will likely be released in 2006, and will share the stage with proposed legislation from several other senators, including Bingaman and Feinstein (D-CA).
In a recent survey by the Pew Center on Global Climate Change, some 31 companies reported that US government policy on climate change is coming. The majority of this sample forecast that a national policy will be established sometime between 2010 and 2015, and that it will set the needed price signals for companies to begin reducing their climate impact. Policy is not the only arena in which movement toward a carbon-constrained world can be observed. On the financial front, mainstream investors are beginning to take notice of climate change. Financial services companies like Goldman-Sachs, Bank of America, JP Morgan, Chase, and Citigroup have adopted guidelines for lending and for asset management aimed at promoting clean energy technologies. The Carbon Disclosure Project is another barometer of this development. When the project began in 2002, 35 institutional investors endorsed a letter requesting disclosure of information on GHG emissions through a questionnaire that was distributed to Fortune 500 companies. In 2003, 95 institutional investors with $10 trillion in assets endorsed the letter. By 2006, those numbers had climbed to 211 institutional investors with $31 trillion in assets.
On the corporate side, the intersection of fiduciary responsibility and climate strategy is coming into focus, particularly around the ‘materiality’ of GHG emissions under the Sarbanes-Oxley Act of 2002. Some companies (and their directors) could face lawsuits based on their carbon emissions. Some already do. Eight states and New York City have filed an unprecedented lawsuit against five of America’s largest power companies, demanding that they cut CO2 emissions. Such developments have led some major insurers to express concerns about Directors’ and Officers’ exposure to liability if climate risk is not properly disclosed. Company shareholders are equally concerned. The number of shareholder resolutions requesting financial risk disclosure and plans to reduce GHG emissions increased from 20 in 2004 to 30 in 2005. Energy prices continue to rise, affecting all areas of the economy. This only strengthens the business case for energy efficiency and associated GHG reductions. In 2003, the Pew Center on Global Climate Change conducted a scenario planning exercise involving top global industry, academic, and government experts. In the published results, the worst-case energy price inputs projected out to 2035 were all surpassed by 2006. In the marketplace, consumers are feeling the pinch of rising energy and fuel prices and are searching for new products to lower costs, such as hybrid vehicles and energy-efficient appliances. The Carbon Trust forecasts that climate change could become a mainstream consumer issue by 2010, placing existing corporate brands at risk.
National energy concerns are pushing the frontiers of technology, and US President Bush laid out new priorities for energy research in his 2006 State of the Union address. Future planning for domestic and foreign energy supply increasingly draws attention to the development of various high-efficiency coal combustion options. Beyond coal, clean-energy markets continue to exhibit dramatic growth. Global wind and solar markets reached US$11.8 billion and US$11.2 billion, respectively, in 2005. This was an increase of 47 percent and 55 percent over 2004. Kleiner Perkins Caulfield & Byers, a leading venture capital firm, has announced a set-aside fund of US$100 million for investments in technologies that provide cleaner energy, transportation, air and water. Partner John Doer states, ‘This field of greentech could be the largest economic opportunity of the 21st century. There’s never been a better time than now to start or accelerate a greentech venture.
Also coming into focus are the physical risks of climate change, especially in the wake of recent natural disasters. The insurance industry is understandably concerned about the US$46 billion in losses related to natural catastrophes in 2004. Additionally, Swiss Re estimates that total insured natural catastrophe property and business interruption losses reached US$83 billion for the industry in 2005. Future events will disproportionately affect vulnerable industry sectors, such as agriculture, fisheries, forestry, health care, insurance, real estate, tourism and offshore energy infrastructure (oil rigs and pipelines). Informing all these concerns, the scientific community continues to develop research and data around issues of glacial melts, sea level rise, ocean acidification, and associated impacts on global water currents. In fact, for the vast majority of the scientific community, the issue is not whether climate change is happening, but what can be done to slow its progress and mitigate its effects.
All of these signals present a compelling case for companies to pay attention to climate change. The number of American companies addressing the issue has risen notably since 2003. Indeed, a changing competitive environment is creating the most compelling reasons to address climate change. It impacts companies through partners in the supply chain. (Wal-Mart has recently announced that it will initiate a program to show preference to suppliers who set goals for aggressively reducing GHG emissions.) It impacts companies through competitors in the marketplace. (Toyota has been able to take market share from other automakers in part through its expansion into hybrid drive trains.) In sum, all the signals warn: ‘Businesses that ignore the debate over climate change do so at their peril.’
Linking climate change to business interests
While the strategic benefits of adopting voluntary GHG reductions are as varied as the companies undertaking them, the universal key to financial success is a company’s assessment of its strategic positioning vis-à-vis GHG emissions. As a baseline model, companies have sought strategic benefits from voluntary GHG reductions within seven general frameworks: (1) operational improvement; (2) anticipating and influencing regulations; (3) accessing new sources of capital; (4) improving risk management; (5) elevating corporate reputation; (6) identifying new market opportunities; and (7) enhancing human resource management. Each presents new kinds of questions to help companies ascertain their vulnerability under a climate change protocol.
In this framework, the links between climate change and business interests are forged when reductions in GHG emissions expose opportunities for process optimization (such as lower energy costs, reduced material utilization rates, minimized emissions, and decreased costs of transportation. Energy efficiency is the first and central issue for any assessment of the economics of GHG reductions. In conjunction with their GHG reduction programs, some companies have begun to ask, ‘How energy efficient are our operations? Is our company at the limits of efficiency?’ These companies have found economic gains waiting in energy-use reductions both as complex as plant alterations and as simple as lighting upgrades.
Going further, an assessment of GHG emissions and reduction opportunities often reveals new insights into taken-for-granted or under-studied operational parameters. Not all operational improvements lie within the operating plant. Some companies have found more benefit in focusing on improvements in transportation or distribution.
Anticipating and influencing climate change regulations
While regulatory compliance is typically viewed as a cost of doing business, the regulatory terrain of climate change is complex and emerging on many levels. In order to think strategically about climate change regulations, business managers must adopt a multi-pronged approach. Managers must be aware of developments in policy standards at the international, national and regional levels. They must be prepared to respond, if and when those standards emerge. And, they must be able to assess whether they can have an influence on the shape those standards will take. If a company can influence the final form of climate programs to align with their own internal plan, they will deflect the need for operational change in order to comply. Their competitors, on the other hand, will have to adapt existing operations. Companies that can anticipate and influence regulations are, in effect, setting their own programs as the regulatory standard. For example, BP’s expertise in cap-and-trade earned the company an advisory role in designing the United Kingdom GHG Emissions Trading System. Similarly, Shell’s experience with their own emissions trading desk won them an advisory role in developing the European Union’s (EU) Trading Directive. These national and international programs incorporate distinct elements reflecting the companies’ special experience and expertise in GHG trading.
Accessing new sources of capital
The availability of capital is directly related to the issue of GHG trading. In many cases, governments are introducing financial incentives to reduce GHGs. At the outset, the dividends are likely to come from government subsidies. Going forward, they will come more and more from inter-firm trading as trading directives (like that in the EU and UK) go into effect. How much money is at stake? Richard Sandor, chairman of the Chicago Climate Exchange, estimates the market could be as large as the existing US$5 billion annual market for sulfur dioxide. The World Bank foresees a US$10 billion market in GHG emissions by 2006. CO2e.com estimates the range from US$10 billion to US$3 trillion by 2010. Others estimate it could be as large as US$100 billion per year after the Kyoto Treaty goes into effect.
Of course, these estimates include contingencies that must be weighed into the calculation of any climate change strategy. One such contingency is the inclusion of carbon sinks and the exclusion of trade ceilings, which sends conflicting signals through the market. Other contingencies depend on who participates. According to the research group Climate Strategies, the market will be about US$9 billion if the EU, Japan, Canada, Australia and New Zealand are potential buyers. This market figure would increase substantially if the United States were to join the group.
Improving risk management
In the strategic framework of risk management, greenhouse gas reductions can reduce financial risks. According to the Coalition for Environmentally Responsible Economies (CERES), US$7.4 trillion in corporate assets today potentially are threatened by climate change. This leads the Coalition to conclude that corporate board members, senior executives, and institutional investors can no longer ignore such costs, and would be negligent in their fiscal responsibilities should they do so. The risks are enormous. They are both physical (the results of droughts, floods and hurricanes) and financial (the effects of GHG liabilities on share price and asset valuation).
Elevating corporate reputation
Greenhouse gas reductions also present an opportunity to enhance a corporation’s reputation. This can have an impact on a variety of important constituencies, including, but not limited to, voters who influence future policy, jurors who sit in judgment on legal cases, investors who consider environmental investment strategies, communities that influence corporate expansion and new construction, reporters who write about a company’s initiatives, activists who protest a company’s operations, employees who produce goods and services, and the consumers who purchase those goods and services.
Identifying new market opportunities
Greenhouse gas reductions can expose important information and insights for guiding new strategic directions. Companies can exit increasingly risky business areas in favor of more secure options by measuring environmental costs and risks associated with product or process lines. New market opportunities also emerge when a company remains alert to changes in consumer preference, media attention, community concerns, and regulatory program trends.
Enhancing human resource management
At the core of all these strategies lies an often overlooked and under-rated initiative: the engagement of the workforce. Technological and economic activity may be direct causes of climate change, but it is the culture of an organization that guides the development of solutions.
The organizational implications of climate change involve both quantifiable and nonquantifiable benefits. First, implementing strategies for GHG reductions requires substantive changes, in both the structure and the culture of an organization. Such changes include, among others, reward systems, training programs, management philosophy, employee involvement, reporting requirements, data collection, and analysis. In all of these and more, companies must engage workers as partners in identifying and enacting strategies for – and reaping the benefits of – reducing GHG emissions.
Second, the adoption of greenhouse emissions strategies can improve a company’s morale and consequently increase the retention rates of its skilled workers. Lower recruiting and training costs notwithstanding, a strong company morale contributes significantly to the attraction and retention of a high calibre workforce. Such organizational benefits may be difficult to quantify, but they are real.
We mentioned at the beginning of this section that addressing climate change and the coming market shift require a company to ask new types of questions about new types of issues. Here are some key questions that require attention within the frameworks outlined above.
Questions for developing a climate strategy
- What is the energy efficiency of your operations, and can you improve it?
- Do you know how to measure your company’s production of carbon dioxide and other greenhouse gases (methane, nitrous oxide, hydrofluorocarbons, perfluorcarbons, and sulfur hexafluoride)?
- Do you know the available technologies or alternatives for reducing emissions and the cost/benefit trade-offs associated with each?
Anticipating and influencing climate change regulations
- Do you know how to monitor and forecast the development of GHG regulations at the state, federal and international levels?
- Can you influence the form of those regulations?
Accessing new sources of capital
- Do you know how to conduct commodity trading of GHG emissions and are
- you aware of government subsidies for efforts to reduce GHG emissions?
Improving risk management
- Are any of your operations at risk due to the natural consequences of climate change and do you know the financial implications of that exposure?
- Do you know how to quantify your emissions and the financial liabilities that may incur should a GHG disclosure scheme go into force?
Elevating corporate reputation
- How is your company’s market reputation improved or harmed by its posture towards GHG reductions?
- Do you have good relations with key constituencies that care about that posture?
Identifying new market opportunities
- Are there alternative product or process lines that you could be exploring that will become more attractive as GHG reduction programs proliferate?
- Are there products or services (including GHG credits) that your company can sell to other companies who have decided to embark on voluntary GHG reduction programs?
Enhancing human resource management
- Are your employees concerned about GHG emissions?
- Would voluntary reduction initiatives improve morale, increase the retention rates of skilled workers, lower the costs of recruiting and training new ones, or attract and retain higher calibre applicants?
Integrating climate change and business strategy
In today’s business world, several companies already have a history of experience in working with climate-change issues. These are the companies now trying to shift their climate-related strategy from one focused on risk management and bottom-line protection to one that emphasizes business opportunity and top-line enhancements. While this does not mean that all such initiatives are singularly driven by the issue of climate change, nonetheless, climate change is a market shift that further enhances the value proposition of the initiative. Goldman Sachs, for example, identifies three climate-related ways to add value to the company portfolio: protect reputation, enhance competitive position, and develop new products.
Some companies have focused their efforts on fundamental technology shifts. DuPont, for example, has identified the most promising growth markets in the use of biomass feedstocks. These can be used to create new bio-based materials such as polymers, fuels and chemicals, applied biosurfaces, and biomedical materials. The company’s goal is to have 25 percent of its revenue come from such non-depletable resources, and today is two-thirds of the way toward meeting that goal. One promising development is the Sorona® polymer, a result of the joint venture between DuPont and Tate & Lyle plc. In 2006, DuPont will produce 1,3-propanediol, the key building block for the new polymer, using a proprietary fermentation and purification process based on corn sugar. This bio-based method consumes less energy, reduces emissions, and employs renewable resources instead of traditional petrochemical processes.
Another promising development is the 2006 creation of a partnership between DuPont and BP to develop, produce and market a next generation of biofuels. The two companies have been working together since 2003 to develop materials that will overcome the limitations of existing biofuels. The first product to market will be biobutanol, which is targeted for introduction in 2007 in the UK as a gasoline bio-component. This biofuel offers better fuel economy than gasoline-ethanol blends and has a higher tolerance of water contamination. Both of these developments represent a significant change in product lines and research focus for DuPont, and one that dramatically reduces the company’s environmental footprint. DuPont’s R&D leadership predicts that over 60 percent of DuPont’s future business will come from the use of biology to reduce the use of fossil fuels.
Alcoa is another experienced corporation that believes future climate policies will create market opportunities, in their case by expanding aluminum recycling. Recognizing that aluminum produced from recycled materials requires only five percent of the energy needed to make primary aluminum, and that energy prices probably will continue to rise, the company has pledged that 50 percent of its products (excluding raw ingot sold to others) will come from recycled aluminum by 2020. Alcoa views increased recycling as one of the company’s more significant long-term strategic opportunities. Another one is the expected boost in demand for aluminum as a material for lighter weight vehicles. Alcoa has developed ‘Dura Bright’ commercial truck wheels that are lower in mass than conventional wheels, and do not require polish or scrubbing. Current Alcoa data indicate that a ten percent reduction in vehicle weight typically yields a seven percent reduction in GHG emissions.
The insurance underwriter, Swiss Re, also is looking at ways in which to augment existing climate change activities and create new business opportunities. Insurance is perhaps the one industry most directly affected by the physical impacts of climate change because it underwrites natural catastrophes and property loss. Since climate change directly affects Swiss Re’s core business, with or without regulation, the company is integrating related concerns into its underwriting practices. Notable in this regard are insurance packages for Directors & Officers (D&O) and Business Interruption (BI). Moreover, the company now channels considerable investments into a number of environmentally impacted sectors, including alternative energy, water, and waste management/recycling. Specifically, Swiss Re seeks opportunities representing medium to high risk-return investment profiles: infrastructure (wind farm, biomass, solar); publicly quoted, small- to medium-capitalized growth companies; and cleantech venture capital (the highest risk-return profile). Tightening policy frameworks increase the demand for such projects, and the company’s investment strategy is beginning to pay off. The value of Swiss Re’s market portfolio rose substantially in 2005, thanks to both a strong share performance and new investments.
Yet another example of climate change/business strategy integration is found among the oil companies. The Shell Group has discovered that their operations, and more importantly their products, are squarely in the middle of the climate controversy. This is an issue the company cannot ignore. In 2005, Shell’s operations emitted 105 million metric tons of CO2, while downstream combustion of its fossil fuels generated an additional 763 million metric tons. Together, these emissions account for some 3.6 percent of global CO2 emissions from fossil fuel combustion.
A primary source of GHG emissions is the flaring of methane gas in exploration and refining operations. Shell is working to end the flaring practice and now captures the gas, either pumping it back underground to enhance well production or feeding it to nearby facilities for power production. When the economics are right, methane can be converted into liquid natural gas (LNG), a major area for potential growth. Looking ahead, the 2005 edition of Shell’s Global Scenarios to 2025 articulates a vision of how worldwide forces may shape markets over the next two decades. The conclusion is that the world and its business enterprise eventually will face a price for carbon. This conclusion justifies Shell’s efforts to increase natural gas production (especially LNG), and the company’s investments in wind, solar, biofuel, coal gasification, and experimental hydrogen delivery systems – all of this while still working to make its core fossil fuel business succeed in a carbon-constrained world.
Early warning signals, identifiable business interests, and integrated business strategy all inform us that inaction is not a viable option with regard to the impending market shift caused by climate change. As a start, companies should understand their vulnerability by developing a clear understanding of their emissions profile and of the risks and opportunities this profile creates. Next, companies should understand the possible policy options of future regulation. Finally, companies that have experience with GHG reductions should try to influence policy formation so as to reduce the uncertainty of the market shift.
Companies that are now taking action view those that do nothing as not only missing out on a myriad of near-term financial opportunities, but also setting themselves up for long-term political and financial challenges. Advancing climate regulation, rising energy prices, and the investment community’s increasing attention on climate change all bring a fluid business environment into stark relief. The rules of the game are changing in ways that cannot be ignored. In the near term, companies need to be prepared for a carbon-constrained world that will alter existing business models. In the long term, they need to be prepared for a carbon-constrained world in which they will be transformed.
In the end, sustainable climate-related strategies cannot be an add-on to business as usual. Instead, climate-related strategies must be integrated into a company’s overall business strategy for success. Linda Fisher, DuPont’s Vice President and Chief Sustainability Officer, has articulated this mandate for the entire business community: ‘We need to understand, measure, and assess market opportunities. How do you know and communicate which products will be successful in a GHG-constrained world? How should we target our research? Can we find creative ways to use renewables? Can we change societal behavior through products and technologies? The company that answers these questions successfully will be the winner.'
This article was adapted from: Hoffman, A., 2007. The coming market shift: Climate change and business strategy," in K. Tang and R. Yoeh (eds.) Cut Carbon, Grow Profits: Business Strategies for Managing Climate Change and Sustainability. Middlesex University Press, London, pp. 101-118.
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