The link between long-term value and climate change

December 22, 2022
The ESG App
The traditional finance approach to a company's valuation involves a probability-weighted estimation of the "material" events that could impact the company's business.

The traditional finance approach to a company's valuation involves a probability-weighted estimation of the "material" events that could impact the company's business. The approach is also time-weighted, meaning that events closer to today carry a higher financial valuation than events that may occur further into the future. To help manage the potential downside risks, the valuations are estimated based on a full assessment of a company's " material " risks. These may include the disproportionate influence of a key supplier or distributor, hard-to-predict geo-political events, or sudden unpredictable events like a global pandemic.

What about climate change? Is it a risk that should be considered in a company's valuation? The business risks of climate change are increasingly becoming recognized as tangible risks that should be factored into the valuation of a company, and the magnitude of the effect differs by the nature of the company's business.

Climate change is a broad term that describes shifting conditions in the natural world, many of which are consequences of man-made activities such as mass-scale industrialization, mining and processing of natural deposits, and various unintended consequences of man's ingenuity. Although the natural world is highly adaptable, its ability to cope with these activities is now strained, as shown by metrics such as the exponential growth of certain gases in the atmosphere and the planet's warming. The accumulation of scientific evidence pointing to an escalating level of climate risk is increasingly indisputable, leading mainstream businesses to seriously contemplate the effect of climate change on their operations.

What are some of these effects on business operations? Supply chain disruption usually comes first to mind. The supply chain of any global business relies on a predictable network of trading partners operating across the globe to bring efficiency and minimize disruptions. When there is a disruption in the supply chain, the downstream consequences could be multiple times more substantial than the initial disruption. A case in point is the disruption of the Covid-19 pandemic on the global supply chain. Because of factory closures and other containment measures, the manufacturing and distribution value chain of many products was disrupted, leading to an initial crisis in product shortages. This, in turn, led companies to re-evaluate their current supply chain network in order to minimize the possibility of this type of disruption in the future.

Climate change brings with it a higher frequency of unpredictable weather events, such as droughts, heat waves, and extreme weather events. These events can cause business disruptions, such as emergencies and closures, that lead to disruptions in business operations. It is these risks and potential consequences that businesses are becoming increasingly aware of, and are being factored into the risk profiles of the business's operations. Ultimately, this affects the financial value of the businesses and the attractiveness of the business to its investors.

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