Climate Risk, Political Shifts and ESG

With climate change and geopolitical shifts can come uncertainty, where firms must decide whether to bank on the status quo or invest in a more resilient, future-proofed strategy. When capital investments take years to develop, how can a firm ensure its strategy remains relevant across shifting political and environmental landscapes?

In this interview, Paul Calluzzo, associate professor and Toller Family Fellow of Finance, delves into climate change-related transition risk and its interplay with physical risk, from both a firm and policy-specific perspective. He also explores how firms and nations navigate uncertainty during shifting political winds and highlights the importance of creating a resilient investment strategy that treats environmental factors as fundamental risks.

Drawing on research, Calluzzo also compares the investment behaviours of divergent nations like Norway and Saudi Arabia, demonstrating how their sovereign wealth funds are being used to diversify against climate-related transition risks for future generations.

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Paul Calluzzo

00:08 How does climate risk impact firms?

One way that we can think about climate risk is that there's physical risks. So, when there was Hurricane Sandy, my grandparents' house flooded, right. There was a storm surge. They flooded. They had to leave their house for a few years. That's physical risk.

Transition risks are that as the world shifts in response to climate change, how is your firm going to be affected by that risk? So, for example, when there was a carbon tax in Canada, if you produce fossil fuels, you're exposed to transition risk of that regulation. And similarly, if it's cut then you get a benefit. But basically, your cash flows are going to be sensitive to regulation associated with climate change. So, if you're a fossil fuel producer, you have a lot of transition risk. If you're an IT firm, you're not going to have as much transition risk.

As firms consider managing climate risk, I almost think there's two scenarios that can unfold. So, on the one hand, maybe transition risks lowered if there's a global decrease in regulation that would lower transition risk, but I would argue increases physical risk.

But then if there's increases in regulation, an increase in awareness, then there might be an increase in transition risk but a decrease in long-term physical risk.

And I also think to some extent there's a balancing act there that as a lot of the physical risks of climate change show up, I think it's harder to ignore from a policy perspective, government policies that just say, let's continue with the status quo.

01:37 How are firms responding to political transition risks in the ESG space?

So, I think that we're seeing that firms are treating these ESG issues, and especially environmental issues, as fundamental risks to the firm. And obviously, there's been a big shift in the political winds. And this is in the US context.

The most recent election definitely has changed the calculus, but I think we have to separately consider how it's changed the calculus for social issues and how it's changed the calculus for environmental issues. But with the environmental issues, there has been a shift, but not to the same magnitude that we've seen the shift in social issues. And when we look at how the firms are treating those environmental issues, we haven't seen as big of a pivot.

02:15 How do firms navigate this uncertainty?

I think on the one hand, there's an element that just because the winds blow one way, that they could also blow the other way so that you almost, as a firm, want to create a resilient investment strategy.

So, if you're an electric car company, it's not like just because there's an administration in power that doesn't like electric cars, that you should just completely scrap that strategy because that's a multiyear strategy and a huge investment went into that. And there's no saying when there's another election, which way the winds are going to blow then. So, you want to create a resilient investment strategy in order to hedge against what our future political situations.

This quote by Wayne Gretzky about skating not where the puck is now, but where the puck is going. And it's this idea that you basically want to form an investment strategy, trying to time where the puck is going to be when you start producing your goods.

The political situation right now is favouring fossil fuels, but when you make a big investment, it's going to take three or four years to develop an oil field or something. But what is the political climate going to be in three or four years. It's not necessarily going to be what it is today. So you almost want to shoot for the average. Really, firms are making decisions at a really long horizon when they make their capital investments. 

The other thing that you have to consider, the political situation in the U.S. can dominate our orbit, but when we think about a firm, we want to think about all the stakeholders. We still live in a world where there's a group of people that really like one thing and another group of people that really like another thing. And I think it's easy to forget there's also a big group in the middle that might change how they vote election to election, but they either aren't as polarized or one kind of a middle solution. So I think as a firm, ultimately you have to manage all your stakeholders vertically in the sense of your shareholders, your community, your government.

04:08 How do countries utilize sovereign wealth funds to hedge against transition risks? 

There are countries all around the world that see themselves in a good situation that I think we wish Canada was in and any country would want to be in, which is that you have a lot of more money than you know what to do with. 

The classic example of this is Norway, which had a huge windfall from oil development in the North Sea. So, you have this huge amount of money and what they want to do is spread that money to future generations. So, they've taken the oil wealth and have actually invested into the public markets. That's what a sovereign wealth fund is.

When we think about the different countries that have sovereign wealth funds, we have Norway and then we have Saudi Arabia. I think that it’s really hard politically to think of two countries that are more divergent on both social issues, but also on really how their governments are structured. But they actually have the same concern of what's going to happen when the oil runs out.

What we do in a paper I'm working on is look at how they're investing. And what we see is that they're investing in a way that diversifies against this transition risk. So, instead of buying oil and gas companies, they're buying companies in other industries that are more resilient to transition risk. So that come two or three generations down the line, they're going to be in a position where they're still resilient with their source of wealth, because they've invested it in industries that are not tied to those climate risks.