FinLogic FinLogic Quantitative Think Tank Center|Wildfires, Climate Policies Start to Shift Corporate Views on Risk

For Southern California Edison,FinLogic FinLogic Quantitative Think Tank Center a U.S. power company with 15 million customers, the risks of climate change are already in its backyard.

Edison’s electrical wires sparked two deadly wildfires in 2017 and 2018, and the company recently set aside a $4.7 billion reserve fund for possible liabilities related to the fires. 

Now it has embarked on a costly program to upgrade its electrical lines and make its grid less likely to spark fires. 

“We are seeing the early manifestations of climate change in our state,” said Chief Executive Pedro Pizarro. “Beginning in 2017 and with the fires in northern California, those were at a scale that no one had ever imagined.” 

In response, he said, the company was replacing 6,000 miles of bare electrical wire to reduce fire risk, installing thousands of micro weather stations that monitor wind speeds, and swapping the oil in its transformers with a less flammable alternative. 

For Edison International, the listed company that owns Southern California Edison, the financial impact of the fires has been serious. The company reached a $360 million settlement agreement with the public entities that were damaged by the Thomas and Woolsey fires, and multiple other legal cases will determine damages to other parties. 

PG&E, another California utility, started bankruptcy proceedings in 2019 after a series of catastrophic wildfires left it on the hook for as much as $30 billion in possible liabilities. 

Owing to the severe risk, PG&E had to shut off power to nearly 3 million customers this past autumn to prevent its electrical wires from sparking another fire. Edison also used blackouts in areas of high risk, leaving about 200,000 customers without power.

The California wildfires and their impact on power companies are one of the most visible examples of how climate-related risks are starting to affect businesses, sometimes at a speed and scale that is unexpected. 

Over the past year, a growing number of companies and investors have been focusing on the physical risks of climate change, which include not just wildfires but also changing weather patterns, storms and increased flood risks. 

In his January 2020 annual letter to chief executives of major companies, BlackRock CEO Larry Fink, head of the world’s largest asset management company, described climate change as “a defining factor in companies’ long-term prospects” and said “the evidence on climate risk is compelling investors to reassess core assumptions about modern finance.”

BlackRock has been criticized in the past by environmental activists for its investments and accused of not doing enough about climate risk, but Fink wrote that it was putting sustainability at the center of its investment approach, including exiting investments in thermal coal producers. He also wrote that BlackRock would be “increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”

“We will see changes in capital allocation more quickly than we see changes to the climate itself,” he wrote.

Paul Polman, the former chief executive of Unilever, said there had been a big shift in the way companies viewed climate-related risks. 

He pointed to a recent survey that asked board members whether climate change was relevant to their business: In 2017, 40 percent of respondents said it was not relevant, but in 2018 that figure dropped to 14 percent. 

“You see things moving faster than anyone ever imagined,” he said, referring to how businesses consider climate risk. “Companies need to have climate-competent boards.” 

Regulators Add Climate Stress Tests

The physical risks are only part of the picture—businesses also face risks from abrupt policy shifts, as governments try to reduce carbon dioxide emissions. Over the past year, several major economies, including the UK and France, have adopted targets to cut emissions to net zero by 2050, which will mean a radical restructuring of the economy in coming decades. 

As companies try to plan for these changes and quantify their impact, regulators have also taken note. 

In December, the Bank of England outlined a climate stress test for the largest UK banks and insurers, saying it would be the toughest such test in the world. The test will scrutinize how institutions are prepared for more frequent severe weather events, and examine whether they could withstand a sudden fire sale of “brown” assets (those considered detrimental to the environment).

“Climate change will affect the value of virtually every financial asset; the [test] will help ensure the core of our financial system is resilient to those changes,” said Bank of England Governor Mark Carney.

The test includes three future scenarios, the most severe of which envisions 4 degrees Celsius of warming by the year 2080, which would bring major weather changes including more extreme heat waves and flash floods. 

Jon Williams, partner for sustainability and climate change at PwC, said companies and institutions needed to carry out their own checks, even before the mandatory tests begin. “Firms need to think about how their businesses, operations and clients are exposed to physical, transition and liability-related risks,” he said. 

However, quantifying the exact costs of the changing weather that results from climate change is still a difficult undertaking. Some sectors, such as real estate, have developed sophisticated risk assessment models that take rising sea levels and storm risks into account. But for many sectors, the effects of climate change are more diffuse.

A study by the non-profit climate assessment group CDP, which tallied the climate risks reported by 500 of the world’s largest companies, found that they reported nearly $1 trillion in climate risks to their business. Of these, around $250 billion were related to write-offs or impairments due to policy changes and physical risk. 

‘Climate Change Brings Significant Volatility’

For the California power companies, the wildfires are only one example of the physical risks that companies face due to climate change. 

“It is not just drought, but we have also had floods,” Pizarro said. “Climate change brings significant volatility and changing patterns.”

While some parts of the world will see more frequent heat waves and drought due to global warming, others could see increased rain and flooding as global temperatures rise. 

The power companies also have to plan for how to address rising sea levels and the challenge of coastal erosion. One thing under consideration is “to what extent will we need to harden our grid there in response to sea level rise,” Pizarro said. “Will you see adaptation as moving inland from the coast, or will the homes on the coast be [protected]?” 

The uncertain physical risks are compounded by big policy shifts under way. California aims to be carbon neutral by 2045, which will mean a complete reshaping of the utilities business.

Electricity demand is expected to rise by 60 percent by 2045 compared with today, according to calculations by Edison, as the state works to cut emissions by introducing more electric vehicles. At the same time, California will also boost its wind and solar power and add more energy storage. 

“The investment requirement across the economy for added renewable storage and wires is around $250 billion between now and 2045,” Pizarro said. That figure does not include the new electric vehicles, heating and appliances that will also be needed to reach the target.

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