In September 2015, then Bank of England Governor Mark Carney gave a landmark speech on the “Tragedy of the Horizon.” The concept was simple: climate change creates tremendous risk for financial markets, but these mounting risks are ignored by investors due to the market’s tendency towards myopia. The speech marked a significant turning point in […]
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In September 2015, then Bank of England Governor Mark Carney gave a landmark speech on the “Tragedy of the Horizon.” The concept was simple: climate change creates tremendous risk for financial markets, but these mounting risks are ignored by investors due to the market’s tendency towards myopia. The speech marked a significant turning point in finance: the starting gun in the race to internalize climate-related financial risks.
Eight years later, the “tragedy of the horizon” 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 – or the now-inevitable early shockwaves of physical climate impacts – 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.
Consistent with the core recommendation of this blog, the Federal Reserve should be praised for focusing its recent transition risk scenario exercise on a 10-year time horizon. But the actual scenarios employed in the risk oversight project, borrowed from the Network of Central Banks and Supervisors for Greening the Financial System (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 “medium-term” climate risks. In particular, the economic assumptions embedded in firms’ current capital plans and financials must be scrutinized and updated for the transition that is now indisputably underway.
Getting markets to look out
Two years after Carney’s speech the Taskforce on Climate-Related Financial Disclosure (TCFD) 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’s recommendations have served as a framework for many financial regulators around the globe as they work to upgrade climate risk oversight and disclosure rules.
Chief among the TCFD’s recommendations to overcome one aspect of the tragedy of the horizon—paralysis in the face of uncertainty—firms are encouraged to use scenario analysis. The TCFD’s initial discussion encouraged firms simply to develop narratives of different possible futures and their business implications – 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 scenarios are used for financial supervision and have also been widely adopted by non-financial firms for their own analysis of climate risks and opportunities.
How far the horizon?
Transformative as it was, Carney’s metaphor left out a key detail for firms seeking to navigate the rough seas of climate disruption: how far out is the horizon?
A natural answer emerged from the climate science and policy communities. Global mean temperature change caused by rising atmospheric GHG levels is conventionally measured out to 2100. 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 converged on a global mean temperature threshold of 1.5oC by 2100 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 1.5oC change by 2100 also implies net zero carbon dioxide emissions by 2050 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.
This assumption is mistaken. It is, of course, terrifyingly probable that extreme climate-related impacts and potential tipping points loom in the second half of this century (and over that horizon, into the next century), but some extreme climate-related impacts are already evident. 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.
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: “The transition may be happening, but it’s less directly relevant to business today.”
Perhaps also implicit, risks that crystalize mid-century and beyond are also well beyond the careers of senior management in today’s market: “The transition may be happening, but it’s not on my watch.”
This ignores the presence of climate risks entirely material to the balance sheets of today’s 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 “tragedy of the horizon” is more like a decade out. The “tragedy of the tragedy of the horizon” 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.
Where today’s decisions touch climate discontinuity
Capital plans are where corporate decisions meet climate change in the real economy. Firms in the “real economy” serve the core function of determining how and when to develop or maintain real assets – 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 “baked in” to the future—many physical risks in the near to medium term are now impossible to avoid, the inevitable consequence of historical emissions.
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’ll call this the “medium-term”, While today’s 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.
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 attributed with saying: “We 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.”So too with climate change.
Take the US economy as an example. Congress has just poured an unprecedented amount of public spending into the green economy under the Inflation Reduction Act (IRA). The IRA comprises an enormous public investment, anywhere from $367 billion to $1.2 trillion. 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 all the more likely 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 policies like the IRA drive substitution and erode the projected revenues that underpin the valuations of incumbents.
Transition, physical, and climate risks in the medium term have bearing on the decisions made by companies today. For instance:
- The operating life of real assets being planned in a firm’s capital plans today: Capital-intensive firms in the real economy typically make and disclose capital investment plans on a three-to-five-year time horizon for real assets that often operate for 10 or more years.
- The term of debt financing those capital plans: Banks can be quick to dismiss the risks associated with climate change in the second half of the century as immaterial to credit risk because loans are relatively short-term. But it’s not uncommon for mid- or long-term bond maturities, or project financing loans, to run 10 or more years.
- The career risk of management making company capital plans or financing decisions about those companies (the average age of an S&P 500 CEO is 57.5 years).
The impacts of climate risk, while theoretically smaller than risks that are further off, are felt by both companies and the individuals operating within them with respect to the decisions being made right now.
Revealing the blindspot: implications for climate risk analytics and disclosure
Firms are very good at looking several quarters out, understanding trends affecting their business, and how to plan for them. They are increasingly capable of describing their place in the hypothetical, stylized distant futures of climate economic models. They remain blind to the disorderly, divergent, and rapid social, economic, and policy changes just beyond the corporate horizon.
Shorter-term target-setting improves this problem, but only partially. A firm’s target for 2030 should, in principle, imply something about how it will achieve that target in the interim. But even short-term targets are insufficient. They are still disclosures about where a company expects it will be in seven years and about the future condition of the company. Reporting on targets can, and usually does, remain circumspect about what a company is and should be doing today to anticipate the economy in which it expects to operate in 10 years. The medium-term is important because it already matters to the financial condition and decisions of companies today. The discounted cash flow of planned real assets, the terminal values of its existing ones, are all expressly assumptions about revenue from those assets in the medium term.
Where a company does have a 2030 target, these should be very clearly tied back to disclosure of any current capital planning, or any financial assumptions, affected by that target. Even in the absence of a target, though, any financial disclosure that is informed by assumptions about the medium-term, and especially capital planning, should reflect express disclosure of climate risks.
Perhaps the strongest illustration of this is how most carbon-intensive publicly listed firms have scored on the Climate Action 100+ Net Zero Company Benchmark. They have, by and large, shown progress on developing and disclosing net-zero targets, mostly around 2050, but occasionally for 2030. They have failed, almost to a company, to reflect any such change in their capital plans or the economic assumptions baked into their financials.
Focusing on the medium term means real economy firms, and their investors and lenders, should understand how financial decisions now would fare under different scenarios that have bearing on today’s investment decisions, including those of a rapidly decarbonizing and warming world. The following are some suggested changes to approach that might help overcome the tragedy of this “medium-term” horizon:
- Less focus on the strength of model outputs later in the century, and more focus on insights within a 10-15 year period.
- Less use of scenarios that work backward from end-century temperature assumptions, and more driven by plausible or even credible techno-economic, policy, and market dynamics.
- Less modeling of cost-optimizing policy and techno-economic pathways, and better capturing of the potential disruption associated with divergent “disorderly” policies (like the IRA).
- Less modeling of the extreme poles of climate outcomes, whether high atmospheric GHG concentrations or idealized decarbonization pathways, and more modeling of the highly plausible and thus financially relevant area between these extremes.
- Less attention on the adequacy of disclosure and design of corporate targets and commitments, and more attention on how contemplated scenarios affect the economic assumptions in firms’ capital plans and financials today.
Improving our ability to “see” this medium term only begins when the attention is on it. Climate-related financial risk is less about the mid-century and beyond, and much more about the financial and climate implications of capital investments taking place today.
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