By Alan Miller and Vladimir Stenek, from the IFC Climate Business Department.
The IFC is unique among international financial institutions in that it only finances private sector projects. IFC has implemented climate change projects for more than two decades but until recently only tracked and counted investments in mitigation, primarily energy efficiency and renewable energy projects. Along with other MDBs, the IFC announced its agreement on a common definition and reporting system for adaptation projects at the Doha climate negotiations in December 2012. Still more recently, IFC announced its first formally defined adaptation project, an investment in the Turkish paper and packaging company ModernKarton, supporting measures to significantly improve water utilization in an area predicted to face increasing water shortages due to climate change.
Supporting private sector adaptation is very important as much of the response to climate change will have to be accomplished by private entities. Companies are also in a good position to incorporate measures to promote water efficiency, resilience to storms, and other steps to enhance climate resilience as elements of their expansion and modernization plans over time. Some donor supported climate finance including the Pilot Program on Climate Resilience have already recognized these opportunities and included some initial financing for private sector adaptation.
Defining and evaluating successful outcomes from these private sector adaptation projects are thus an emerging issue presenting several challenges. IFC investments are typically for periods of 8 to 12 years, a period too short to allow for most projections of climate change. From a private sector perspective, measures of financial performance are the most important measures of success but in many cases will be difficult to associate with improved climate resilience. (There are exceptions, e.g., when firms surviving extreme weather events achieve exceptional profits due to diminished competition.) Short-term success may also be misleading if overwhelmed by greater future changes (e.g., dikes adequate for a 100 year flood that fail due to the higher level of a 500 year event).
These issues are not merely theoretical as companies will be reluctant to incur the costs for adaptation measures that reduce the value of current assets to the potential benefit of future owners and shareholders, much as current populations undervalue savings and reduced risks to future generations. In the business community, discount rates - interest rates used in financial analyses - are even higher. The consequence is that with the exception of the largest and most sophisticated companies "primarily multinationals based largely in the industrialized countries" one can expect business may pursue adaptation measures based more on reactions to observed variability or market conditions (which, itself, can respond to effects of physical impacts, well illustrated by recent changes in prices of some food staples) rather than structural adaptation that anticipates and prepares for projected change.
These challenges and possible less-than-optimal financial, social and environmental outcomes highlight the need for enabling institutional and market structures that will incentivize incorporation of appropriate climate change information into investment decisions. These structures whether institutional or procedural - already exist to some extent. For example, credit risk rating and reflection of such risks in valuation of assets and share prices needs to recognize that climate change is already a significant risk for some types of companies.
Ski resorts are a noticeable example, as some locations are already experiencing higher temperatures or lower precipitation and it is not difficult to make the link between absence of snow and poor financial performance. Consequently, markets are already responding to the observed variability in snowfall by adjusting home prices in a number of North American ski resorts (Van Butsic, Ellen Hanak and Robert G. Valletta. Climate Change and Housing Prices: Hedonic Estimates for Ski Resorts in Western North America. Land Economics February 2011 87:75-91). However, most price adjustments seem to be result of a backward assessment by buyers and sellers and may not incorporate the expected impacts of the next years.
A number of other real sectors are also likely to be affected by climate impacts. Nevertheless, so far few risk rating agencies are explicitly incorporating forward looking risks of climate riskimpacts into company ratings.
Greater demand for disclosure of such risks may be the most potent source of pressure for corporate recognition, reporting, and response to climate change impacts. The Carbon Disclosure Project, which has so far focused largely on regulatory risks and mitigation efforts, is beginning to focus more on physical risks and climate resilience efforts, an important step in this direction. The corporate social responsibility group Ceres has also called attention to the issue and its relevance to shareholders in several reports. Mercer, a strategic asset advisory firm, also did pioneering work supported by IFC, the UK Carbon Trust, and a dozen pension funds concluding that climate risks for long-term asset management could be in the trillions of dollars.
Another source of risk pricing yet to fully reflect climate change is insurance. Insurance regulators have been slow to allow upward adjustments reflecting changing climate realities, and many insurance companies have so far been surprisingly slow to demand that their clients adopt even modest measures to improve climate resilience. This too will have to change as part of greater market recognition that climate impacts can have enormous consequences for financial performance.
Investment institutions also need to appropriately assess, incorporate - and eventually mitigate - climate risks that are material to their operations. IFC recognized the materiality of potential risks and opportunities, and the sector's need to respond, in its publication Climate Risk and Financial Institutions. As an outcome of this study and of the larger Climate Risk and Adaptation Program, IFC incorporated climate risk considerations and requirements in its Performance Standards on Environmental and Social Sustainability, and is currently developing additional tools to address climate risks in its investments.
Alan Miller is Principal Projects Officer in the IFC Climate Business Department with responsibilities for climate policy and finance. From 1997 to 2003 he was the GEF team leader for climate change and previously directed a center at the University of Maryland and served on the staff of the World Resources Institute.
Vladimir Stenek is Senior Climate Change Specialist in the Climate Business Department. He leads IFC's Climate Risk and Adaptation Program, along with several other initiatives related to climate change and development. Vladimir holds graduate and undergraduate degrees from UC Berkeley, California; PUC, Santiago, Chile; and UNI, Lima, Peru.