Factoring Climate Change Risk into Financial Valuation: Strategy valuation is best suited to adaptation and resilience

Roland Mader, Strategic Advisor; Linus Adler, Associate; Leila d’Heurle, Associate; and Karl Schultz, Principal

Adaptation Leader LLC

This commentary is part of a series on emerging issues from Adaptation Leader LLC

The capital markets must acknowledge that there is no such thing as “not deciding” relative to climate risk – deciding to ignore climate risk is effectively a decision to select for the status quo (i.e., business as usual), whereas incorporating climate risk into financial valuation is adaptive management that will limit future beta/risk (Economist 2015).

 

Introduction

The Intact Centre on Climate Adaptation at the University of Waterloo, Canada, is pioneering the application of corporate valuation methods in conjunction with climate risk matrices on climate change risks.  Their report published in March 2020 showcased five valuation methods: Ratio Analysis, Discounted Cash Flow, Rules of Thumb Valuation, Economic Value Added (EVA) and Option Pricing Models (OPM).  All these methods are valid and well defined, but when factoring climate change risk into financial valuation, we believe that another approach, Strategy Valuation, is missing from this list. 

Strategy Valuation explicitly takes into account the specific, individual risks which the valued company faces. The Strategy Valuation method is, in our opinion, best suited to take climate change risks into account.  As applied to adaptation and resilience challenges in our practice, we refer to this as Adaptation Strategy Valuation or “ASV.”   

 

Strategy Valuation in the Context of Corporate Valuation Methods

The most common corporate valuation method is the Discounted Cash Flow (DCF) method, as outlined in the referenced UOW paper. The DCF method is based on the Capital Asset Pricing Model (CAPM), where the projected after-tax cash flows are discounted with the CAPM discount rate. This can be the weighted average cost of capital to calculate the gross value of the company or the equity rate to calculate the net value. As outlined in the referenced UOW article, the CAPM discount rate is the sum of the risk-free rate and the market risk premium multiplied with the so-called beta factor, which is a dimensionless number, representing the unsystematic risk of the valued company, the risks that the company cannot diversify away. Climate change risks are unsystematic in nature and hence should be reflected in the beta factor. UOW translates the occurrence of extreme weather on cash flows into an upward adjustment of the beta factor of 7.5%. As the beta factor is based on historical company and market returns, climate risks, such as extreme weather adjustments should therefore, theoretically, already be reflected in the market returns. We argue, just like UOW, that this is unlikely to be the case.  Furthermore, the CAPM model itself has always been criticised; the model assumes a perfect market, full transparency, no transaction costs, information immediately available to all market participants – which clearly is far from reality.   

The fact is that market-based approaches and risk measures make it very difficult to quantify the specific climate related risks a company faces. While climate risks are by nature unsystematic, the impact of these risks are very different from company to company, for some the impacts are negative, for some they are positive.

The Strategy Valuation method is, in our opinion, best suited to take climate change risks into account. Strategy Valuation is in effect a DCF method as forecast of the after-tax cash flows is needed. The discount rate however, unlike the CAPM rate, is determined via risk aggregation using Monte Carlo Simulation, yielding the expected cash flows and their standard deviations, which in turn are used to calculate the discount rate in each particular year. It should be noted that the more uncertain the cash flows are, the higher is the standard deviation, hence the higher the discount rate and the lower the company value. Also, the Strategy Valuation method allows for different discount rates in different years which makes it even more suitable for valuing the impacts of climate change risks as these risks are not static. Strategy valuation can be applied to all strategic and/or entrepreneurial decisions. Typical applications include large investments, acquisitions or material changes in the strategy.

 

From Strategy Valuation to Adaptation Strategy Valuation

In essence, Strategy Valuation is a comparison of risk-return profiles of alternative (strategic) options for action, recorded by a risk-adequate future decision value, unlike the “traditional” capital market-oriented company valuation where historical and current stock market data and/or peer group comparisons are used. Hence, Strategy Valuation requires a process of structured identification, quantification and aggregation of risks.

Adaptation Leader LLC has created a strategy valuation cycle, called Adaptation Strategy Valuation. It values the exposure of a company to climate change risks and the value of adaptation.

 

As with every method used to value the impact of climate change risks, the translation of climate change risks into tangible uncertainties in the company statements is key. Caution must be applied when modelling the uncertainties, especially their correlations with each other in order to not amplify risks, resulting in unrealistically high results.

We believe that, for practitioners, it is preferable to assess climate change uncertainties on a company’s bottom line individually, instead of relying on the market to price in climate change risk. Also, the Strategy Valuation method can be applied to all sectors, even for cyclical industries as the risks are aggregated on an individual basis.

Option Pricing Models, as also referenced in the UOW article will play an important role in valuing climate change risk impacts for longer time frames (2050-2100) while Strategy Valuation is, in our view, better suited for shorter time frames within the financial planning horizon of most corporates (2021-2050).

 

 

The Road Ahead

Corporate valuation methods have been well defined and applied. When valuing climate change risks however, much work has still to be done. We certainly need further attention to translating climate change into climate impacts and further into corporate valuations than mere risk analysis. More and more investors demand climate change readiness from their investments, as currently partly addressed in the emerging ES&G ratings. But the key question is and remains, how to translate climate models into uncertainties on a corporate level. At Adaptation Leader, the ASV approach translates climate models by means of quantitative and qualitative analysis and expert judgement.

 

Conclusion

Valuation is a powerful tool for investment decision-making, allocation decisions, and for climate change vulnerability and adaptation planning. We applaud the work of the Intact Centre on Climate Adaptation, to translate traditional corporate valuation methods for climate change risks.

 

Extending this work, Adaptation Leader proposes that the Strategy Valuation method is especially relevant for business and public sector valuation where climate impacts are already happening or are expected in the short to medium term. This method considers how climate and adaptations impact revenues and profitability/solvency and pinpoints and justifies optimal  investments — for finance, operations, supply chain, human resources and markets.

 

Climate change is happening. We need to develop and deploy the best available tools to both mitigate and adapt to the new reality.