Climate Change in Corporate Investment Decisions: How Are We Integrating It in Our Capital Budgeting Decisions?

Climate change has been gaining traction in the financial system, with a predominant focus on how external financiers, policymakers, and regulators can nudge companies to behave responsibly. The push by these critical players in the financial ecosystem has been reasonably successful so far, but far from what is desired. One of the key reasons why companies’ climate actions have not been encouraging enough is the internalisation of climate change costs in corporate investment decision-making. Failing to address these may make corporations vulnerable to climate change risks. Since the financial market’s reaction to any risks, including climate change, often dictates investment decisions of corporations, the latter frequently ignores the risk if the former doesn’t consider it. Over the last 12 months, the financial market and corporations have been largely indifferent to climate change risks, partly due to a shift in the socio-economic atmosphere (e.g., climate denial, despite not being backed by science). But corporations’ lives, sometimes assets, are at stake, and the investment horizon is longer than any policy and regulatory regime. The change in policy landscape will bring climate change back into the realm of policy decision-making, resulting in adverse or favorable corporations’ financial performance and valuations.

Climate change and capital budgeting are closely intertwined.

One of the major corporate investment decision-making is capital budgeting, where return (Net Present Value (NPV) or Internal Rate of Return (IRR)) depends on the realisation of cash flows over the life of the asset. Climate change risk or opportunity has a material impact on the project’s NPV or IRR – the longer the asset’s (project’s) life, the more likely the impact of climate change.  For example, the carbon price (categorised as transition risk) is expected to increase significantly over time, which has a substantial effect on capital-intensive industries with long asset lives. Similarly, climate-induced extreme weather events (categorised as physical risk), such as floods, storms, and heatwaves, will become more intense and frequent over time, resulting in a more adverse impact on the assets’ value.

Internalisation of the future to make corporate investment resilient

As per accounting standards, only expenses (cash or non-cash) are a part of financial statements. However, the future cost is not considered in financial statements unless allowed by regulators and accounting standards. For example, loan loss provisions are permitted, even if real losses occur in the future, to enable banks to avoid unexpected credit losses that could potentially create instability. However, the cost of sustainability (for example, carbon pricing and water costs) is not allowed to be included in the financial statements, even if the costs of carbon and water are expected to increase in the future. It is crucial to incorporate carbon pricing or related costs into capital budgeting, as it is widely acknowledged that carbon policy will become increasingly stringent in the future in most countries. Although carbon pricing is not meaningful in several countries, including India, there is a policy signal from policymakers and regulators that the cost of carbon will increase. Sometimes, carbon pricing policies are only applicable in a few industries due to economic and social constraints, but expand over time.

For example, all energy-producing and consuming industries are likely to face a significant increase in carbon costs, regardless of their operations and markets. Some energy-intensive companies include carbon cost in their capital budgeting decisions; however, pricing is not meaningful enough for them to accelerate their decarbonization journey. The fear of including meaningful pricing may lead to the rejection of several budgets, resulting in incorrect decisions in later years when the pricing takes effect.

Impact of carbon cost on profitability: Transmission Channel

For example, many energy-intensive industries (e.g. steel, cement) have a long asset life. Corporations can only make meaningful returns if assets are functional for a long duration (15 to 30 years). If the carbon cost increases significantly over time, the asset could become stranded if the cost of carbon exceeds the profitability of companies. The regulated/utility industries may be able to pass on this cost to consumers, but not all energy-intensive industries. The cost of carbon is not limited to carbon prices, but may also impact a company’s topline, R&D, and capital expenditures. In a competitive industry, if a company is unable to pass on the increase in carbon cost to consumers, its product may become less competitive than its peers, and consequently, the company’s top line would be affected. Besides, the company must invest additional capital in R&D and capex on low-carbon technologies, which can also erode its profit margin. Additionally, the high carbon cost also affects the company’s cost of capital during the refinancing stage of the project. All these costs will negatively impact the NPV and IRR of the projects, potentially making these financing metrics too low compared to the estimates.

Integrating carbon or other climate-related costs likely to materialise in the future will make capital budgeting more robust and bring stability to future cash flow generation from various projects.

Adaptation – More important in climate-vulnerable regions

Similarly, several sectors, particularly infrastructure (e.g. roads and ports) and properties where shifting location is not feasible or extremely expensive, are exposed to climate-induced extreme weather events. The value of the assets depends solely on location, and it takes a considerable amount of time to recover the massive initial investment. Integrating climate adaptation into capital budgeting is critical to make these assets resilient to these physical risks. A study by the Boston Consulting Group (BCG) suggests that the benefit-to-cost ratios of climate adaptation infrastructure to withstand flooding are ~2x 7x:1x globally, but 4x 7x:1x in emerging markets and developing economies. Several insurance companies have increased insurance premiums or have withdrawn insurance coverage from markets which are prone to climate-induced weather events (e.g., the Real estate market in Miami). Insurance coverage may be withdrawn if the corporation hasn’t invested adequately in climate adaptation, for example, green and grey infrastructure to mitigate the effects of flooding, storms, and cyclones. Integration of climate adaptation costs during the capital budgeting stage will not only protect assets, supply chains, and operations but also enable the company to continue its much-needed insurance coverage, making informed decisions.

Views are personal and do not represent that of the authors’ employers.

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”