From the July-August 2009 issue of Treasury & Risk magazine

Perils of Climate Change

Two years ago, executives at Levi Strauss & Co. analyzed the effects of climate change on their business and realized the consequences could be dire. Declining water supplies and increasing temperatures in India, Pakistan and other countries that produce cotton--the company's core ingredient--could spell disaster for the San Francisco-based clothing manufacturer. "We needed to be sensitive to risks that would influence the price, yield and quality of that vital material," says Anna Walker, senior manager of worldwide government affairs and public policy at Levi Strauss. What was needed, Walker and her colleagues figured, was a way to improve the efficiency of agricultural water use.

So the company launched an ambitious effort to teach farmers in those areas more water-efficient techniques, teaming up with a nonprofit group, Better Cotton Initiative, that works on such efforts. Products made from this cotton haven't hit the market yet, but the company is hoping to have 5% of its clothing made using these methods by 2015. Eventually, it wants all its merchandise to be sourced in this way.

Levi Strauss is one of a relatively small number of companies engaged in systematic efforts to address the potential risks caused by climate change. As of now, the most prevalent reaction by companies to the threats posed by the warming of the Earth's temperature has been to try cutting their emissions of carbon, methane and other greenhouse gases. But because carbon dioxide remains in the atmosphere for decades, and oceans store heat for even longer, previous emissions will continue to warm the Earth for many years to come. As a result, some businesses are taking steps to strengthen their resilience against the impact of past emissions and protect themselves from those risks.

At this point, much of the scientific community agrees that higher temperatures caused by climate change have already begun wreaking havoc around the world. As greenhouse gases trap the energy emitted by the Earth, and its atmosphere and oceans grow hotter, we're seeing a wide range of potentially calamitous effects, from melting glaciers and rising sea levels to more severe hurricanes, wildfires and droughts. As of 2006, 11 of the previous 12 years were warmer than any others since 1850, according to the Intergovernmental Panel on Climate Change (IPCC). Now, researchers are predicting a likely rise in the average global surface temperature of anywhere from 3 degrees to 7 degrees Fahrenheit by the end of the century.

There is still some disagreement over the damage that climate change has produced so far and will bring about in the future, as well as its causes. Some researchers, for example, say they see no correlation between climate change and the frequency and severity of hurricanes. Others contend that there are many reasons for these changes and global warming is just one. "Is increasing storm activity from climate change or natural cycles?" says Robert Muir-Wood, chief research officer of RMS, a Newark, Calif.-based company that models catastrophic risks. "I'd say it's 50-50." And few experts would be willing to connect a specific weather event to the effects of global warming.

Whether instigated by nature or man-made, climate change poses a host of serious risks for businesses. The most critical seem to fall into three categories. There's the potential for physical damage from events like hurricanes or wildfires and their effects on business operations. Second, links in a company's supply chain may be vulnerable. Finally, suits from shareholders or other parties could increase as stakeholders experience damage from climate-change related events.

Generally, most businesses have been slow in addressing how to adapt to these risks. "This isn't top of mind at any companies I study," says Yossi Sheffi, a professor at the Massachusetts Institute of Technology and director of the MIT Center for Transportation and Logistics, who works with retailers and manufacturers. At the same time, some forward-thinking companies have started to see the need to incorporate climate change risks into their business planning. And a profusion of research suggests other steps businesses can take to protect themselves. Here's a look at some of them:

Physical Damage Risk

The problem: As global temperatures rise, so will sea levels, making coastal areas more likely to experience storm surges and flooding. Thanks to warmer oceans, many scientists predict increased heavy rainfall and more powerful hurricanes. And snowy regions will have more rain than before, dumping large amounts of water at one time, according to Business for Innovative Climate and Energy Policy, an industry group. Other regions, such as the western United States, will experience less summer runoff and reduced water supplies, along with an increase in wildfires.

The result: Facilities, especially those
located near coastal regions, are likely to face flooding, while areas experiencing higher temperatures could have less snow and a depleted water supply--effects likely to impact a wide range of industries. Agricultural businesses could find that changes in temperature and rainfall impair their ability to grow crops. Ski resorts might lack enough snow to support a viable business. Electric utilities might be unable to meet demand. Seaside hotels--or for that matter, any business near a coast--might face crippling floods.

What to do: The most obvious response is for companies to build new facilities in locations that are not near a coast or an area predicted to experience rising water levels. According to Byron Stigge, associate principal with Buro Happold, a New York City-based engineering firm, some real estate developers are already considering climate change in their plans. He points to a developer in New York City, one of 10 cities worldwide at greatest risk of flooding, who decided recently not to purchase property in downtown Manhattan, because "New York has clearly defined areas that will be underwater with one meter of sea level change," Stigge says.

As for existing facilities, Stigge suggests companies consider retrofitting them to better withstand storms. Case in point: About 500 commercial clients of FM Global had about 85% less damage from Hurricane Katrina than similarly situated properties, a reduction in damage directly attributable to hurricane loss prevention and preparedness measures. That's according to a recent study by the Heinz Center, an environmental think tank, and Ceres, a coalition of investors and environmental groups. (FM Global's position is that there's no correlation between hurricane activity and climate change.)

The most important step companies can take is to introduce a systematic method for analyzing the likely impact of climate change on business operations, says Muir-Wood. "Companies need to set up an internal process to review the degree to which they may be sensitive to issues around climate change."

Not surprisingly, companies that have done the most work in this area are in particularly vulnerable industries or locations. Consider Entergy, the New Orleans utility that suffered $2 billion in losses from Hurricanes Katrina and Rita. While the company doesn't say that the storms were specifically caused by climate change, "They were, at the least, a foreshadowing of things to come," says Brent Dorsey, Entergy's director of corporate environmental programs.

The experience prompted CEO Wayne Leonard and other executives to embark on a comprehensive plan for dealing with other storms. A group of in-house experts and consultants developed a multi-phase analysis. The first step was to identify risk drivers--key short- and long-term climate-change-related risks likely to affect both Entergy's service area and business operations, including everything from damage to power plants and increased insurance costs to disruption to transportation systems. Then they mapped potential effects, focusing on Entergy's service area and other locations where the company had major investments, and evaluated the level of risk for each of Entergy's assets, to prioritize their efforts. That meant deciding where to build new plants and how to fortify existing operations. At the same time, the company took steps to improve its emergency response systems, relocating such vital functions as transmission and the corporate data center to less flood-prone areas.

Still, according to Dorsey, the company has a long way to go. First, assessing the likelihood of risk has been complex. "As we've worked on this strategy, we've seen that sea levels and temperatures are rising far faster than was expected just a few years ago," he says. What's more, the long time frame Entergy is dealing with--most power plants are meant to last 50 years--has made formulating accurate projections more difficult and the ability to determine the best sites a moving target. "You have to start somewhere," says Dorsey.

Supply Chain Risk

The problem: The typical supply chain includes multiple links and many, if not most, may be vulnerable to climate-change effects. Manufacturing facilities may be located in flood-prone areas. Transportation routes could be incapacitated by storms. Then there's the matter of too much or too little water and the shrinking availability of arable land. According to the IPCC, food production in regions near the equator will decline as even small rises in temperature impede crop growth. And in regions such as Northern Europe and North America, average temperature increases of 1 to 3 degrees Celsius are likely to create increased flooding. For businesses that depend on agricultural raw materials, from food companies to apparel manufacturers, it means "you simply may not be able to get the supplies you depend on," says Alex Hammer, an analyst with SustainAbility, a London-based sustainability and corporate social responsibility consulting firm. "Certain companies may not grow their crops in the traditional regions."

What to do: Experts recommend that companies analyze the components of their supply chain to see which areas are most likely to be hurt and then come up with alternate plans. One tack is to conduct what's known as a life-cycle analysis of a particular product, to study what goes into the production and distribution process from initial raw material to final sale.

That's what happened at Levi Strauss. In 2007, Walker and her colleagues conducted an analysis of a pair of Levi's jeans and a pair of Dockers khakis. Through that study, they came to realize that a particularly problematic point in the supply chain was the growing of cotton, which makes up 95% of the company's products. Producers in India, China, Pakistan and the U.S., who contribute 70% of the company's cotton supply, were starting to experience the effects of climate change in the form of a reduced water supply. The inevitable result: declining quality and, potentially, a decrease in the availability of arable land for growing cotton. "We didn't know if growers would face a situation where they had to choose between using land for fiber or food production," says Walker.

As a result, the company decided to take steps to increase the sustainability of cotton. The plan they developed was to work with the Better Cotton Initiative, an organization funded by a number of international groups that trains farmers in less water-intensive techniques. Walker is also working with the mills that produce the fabric to help them integrate the new cotton into their production line.

At the same time, Levi Strauss plans a slow introduction of the cotton into the supply chain, probably at the beginning of next year, to avoid "excessive demand," says Walker. Because a number of other companies, such as H&M and the Gap, are participating in the initiative, "Our collective demand will outstrip supply, so we need to slowly integrate Better Cotton so as not to crush the system before it has an opportunity to blossom," she says. Ultimately, the goal is to produce all cotton using these methods.

Similarly, 10 years ago, Unilever, the food, home care and personal products manufacturer, analyzed its end-to-end water use to determine how best to address the problem of scarcity, looking at everything from producers of raw materials and manufacturing plants to consumers. Its finding: for food products, most water was used at the beginning of the chain, by farmers. For that reason, the company launched an effort to help growers reduce their use of water, employing such techniques as building trenches to store rainwater for later use and irrigation systems that minimize over-watering. It also addressed manufacturers' water use through recycling, collecting reusable water and other changes. In 2008 alone the company reduced water use by 3%. "Unilever is committed to sustainable agriculture because without it, a time will come when there simply aren't enough crops available for the products Unilever makes," Jan Kees Vis, director of sustainable agriculture at the London-based company, said in an e-mail.

Liability Risk

The problem: Failure to address climate-change risks adequately could also draw the ire of shareholders, politicians and the public, with the potential not just for shareholder actions, but litigation, as well.

For one thing, there's the possibility of legal claims against large users of energy. Already, electric utilities and energy companies have become the targets of various suits. "They're on the front line of carbon-related action," says Beth Young, senior research associate at the Corporate Library.

In 2004, a group of eight state attorney generals and the city of New York sued five utilities, alleging the companies' emissions had caused environmental damage. The case was dismissed by the Southern District Court of New York in September of 2005 and is on appeal in the U.S. Court of Appeals for the Second Circuit. In 2007, New York State Attorney General Andrew Cuomo subpoenaed five large energy companies demanding they disclose the financial risks of their greenhouse gas emissions to shareholders. Xcel Energy and Dynegy both settled last year, agreeing to disclose risks in their 10K filings, while the inquiry on the three other companies is still ongoing, according to the New York attorney general's office.

And, in a closely watched lawsuit in February 2008, residents of the Alaskan village of Kivalina sued five oil companies, 14 electric utilities and one coal company for contributing to global warming and threatening their community. The village's lawsuits are still pending.

So far, shareholder activism has focused on forcing better disclosure of how companies are managing climate-change-related risk, not on real litigation. According to a study conducted by Ceres of more than 6,000 Securities and Exchange Commission (SEC) filings from S&P 500 companies from 1995 to 2008, a mere 5% of annual reports included a strategy for managing climate-change-related risk. Almost 80% didn't mention the topic at all. A record 64 climate-related shareholder resolutions were filed with U.S. companies for the 2008 proxy season, according to RiskMetrics.

As for shareholder litigation, while none has happened yet, it's only a matter of time, according to Young. When it does occur, it's likely to take the form of a securities law claim for inadequate disclosure if shareholders experience financial damage caused by anything from the closing of a plant to measures required by new cap-and-trade legislation. Or it could be a breach of fiduciary risk. That would arise if shareholders could prove financial damage resulted from the board's "willfully refusing to consider the impact of climate risks on company results," says Young.

What to do: The place to start, according to Young, is with a company's disclosure of climate-change risks. That means warding off shareholder actions by disclosing any risks in SEC filings. Another useful step: participating in the annual questionnaire from the Carbon Disclosure Project, a London-based group that surveys companies' climate-change policies and activities, addressing such issues as risks and opportunities created by changes in weather patterns and legislation. Just 56% of S&P 500 companies responded to the survey in 2007, compared with 77% of the world's largest publicly traded companies, according to RiskMetrics.

At the same time, such disclosure requires instituting a new process, one that probably involves both sustainability officers and employees in charge of SEC filings. "Without that, people will just assume the risks for the current year are the same as the ones from last year," says Young. As important is board oversight of issues related to disclosure and climate-change-related liability and, says Doug Cogan, director of client risk management for RiskMetrics, "a robust enterprise risk management process that accounts for climate change."

These actions can be a double-edged sword, however. If a company discloses its risks and doesn't take appropriate action, the business could also become vulnerable to lawsuits from disgruntled shareholders or public officials. Still, like other climate-change-related risks, it's an issue that can't be ignored. "The growing evidence pointing to the effects of climate change, combined with regulatory measures to address them, will compel businesses to adopt a higher level of disclosure," says Cogan. "Companies will have no choice but to comply."

U.S. Insurers Just Starting to Introduce Innovations

Of all the industries most directly impacted by climate change, insurance may be at the top of the list. After all, it's insurers that must cover damage caused to property by storms or wildfire or, potentially, claims against boards through directors and officers (D&O) insurance. In fact, from 2010 to 2019, the industry's average worldwide losses related to climate change could total $41 billion a year, according to a report from insurer Allianz.

At the same time, it's mostly been such reinsurers as Munich Re and Swiss Re and European-based insurers like Allianz that have been sounding the alarm. On the whole, U.S.-based insurers have been slow to address the potential risks that climate change poses to their customers and themselves. "In this country, the work is just beginning to happen," says Sharlene Leurig, manager of the insurance program at Ceres, a coalition of environmental groups and investors.

One of the problems, of course, has been the reluctance on the part of government, until recently, to embrace the issue of climate change. In addition, some insurers dispute the connection between climate change and some weather trends. "Climate change has not been shown to directly cause an increase in the severity or frequency of natural catastrophes, and it is not clear that it will in the future," says Louis Gritzo, vice president and manager of research for FM Global.

There's something else: difficulty in building effective predictive models. Traditionally, insurers have determined their underwriting through historically based models used to forecast one to five years in the future, according to Mark Way, director of sustainable development in the Americas for Swiss Re. But models that take into account climate change must include a plethora of unpredictable and fast-changing variables that also have no historical precedent. Companies such as RMS, a Newark, Calif.-based modeling firm, are developing the capacity to assess future risks for coastal areas, but they're far from complete.

Efforts by insurers to assess their risks--and act on them--should get a big push from a new initiative from the National Association of Insurance Commissioners (NAIC). Recently, the organization mandated that all insurance companies with annual premiums over $500 million must complete a climate-risk disclosure survey by May 2010. Those with premiums over $300 million have another year.

The questionnaire asks insurers to report on the financial risks they face from climate change, how they're changing their risk management and catastrophe-risk modeling, and steps they're taking to educate policyholders about climate-change risks, among other points. According to Pennsylvania Insurance Commissioner Joel Ario, who chairs the NAIC climate change and global warming task force, the effort should help regulators--and insurers--better understand their risks. "We feel that if the survey shows significant risk, then insurers are going to take steps to address those risks," Ario says.

The primary response among insurers so far to more storms and other severe weather events has been to increase premiums, in some cases as much as 400%, or pull coverage of property located in coastal areas likely to experience storm surges and high winds. A few years ago, for example, such insurers as State Farm, Allstate and Nationwide stopped writing wind policies in Florida. As a result, the state expanded its own program, Citizens Property Insurance Corp., to cover wind as well as other perils.

Recently, some insurers have started to introduce innovations. For example, some are issuing so-called cat (for catastrophe) bonds. These floating-rate bonds pay principal and interest to investors, depending on the occurrence of a triggering event like a hurricane. If there are significant losses, the principal is used to pay those losses. If there's no triggering event, the bonds pay principal and interest payments as they become due. The cat bond market is expected to reach $3 billion this year in additional underwriting capacity, according to David Kodama, director of policy analysis for the Property Casualty Insurers Association of America.

Other companies have been testing pay-as-you-drive insurance, in which the cost of a policy is related to the number of miles a customer drives. And a handful of insurers have started offering green policies. St. Paul, Minn.-based Travelers, for example, provides incentives for homeowners who install shutters and other storm-protection materials, and discounts on insurance for owners of hybrid vehicles. CEO Jay Fishman has called for the creation of a hurricane wind zone, in which the government would regulate most aspects of wind insurance underwriting, but would have no financial role, thereby helping to provide property insurance to residents living along the Atlantic and Gulf coasts.

These steps are a far cry from efforts by European-based insurers and reinsurers, however. For example, for the past 20 years, Swiss Re has had an ambitious climate-change strategy that includes ongoing scientific research to understand the effects of climate change and a vigorous advocacy campaign, as well as a slew of innovative practices. For instance, when writing new D&O policies or renewing old ones, underwriters take into account whether companies that have identified potential greenhouse gas-emission risks have responded to questionnaires from the Carbon Disclosure Project (CDP), a group that asks large corporations to answer annual surveys about their efforts to reduce emissions or disclose risks.

As for Allianz, in 2007 the company launched a subsidiary, Allianz Climate Change Solutions, to advise businesses on how to address climate-change risks. In Austria, Allianz Elementar offers customers a 10% discount on their annual premium if they've bought a public transit pass. In. Russia, it's using weather-index-based derivatives that protect farmers against the possibility their harvests will be destroyed by heavy rain. As a result, farmers can get a loan on future harvests and buy necessary equipment, because lenders know the farmer will have access to a fixed income. Perhaps in another few years, U.S. companies will be offering such products, too. -- ANNE FIELD