Managing through climate change legislation

Randy Wilson, Ken Hooper, KPMG LLP, Houston

Legislation and industry guidance on climate change and greenhouse gas (GHG) emissions could significantly impact business operations for energy companies, but many of these firms are struggling to understand and assess the potential impact of legislation that is still being debated. Companies should develop a systematic and reliable approach to managing climate change as a material business risk, and the tools available through a company's enterprise risk management (ERM) framework can be used to manage this risk.

ERM is an organizational commitment to govern, assess, measure, monitor, mitigate, and optimize enterprise risks proactively. The ERM process is designed to identify and manage potential risks that may affect the achievement of objectives. Energy companies can leverage existing investments in ERM committees, systems, performance metrics, and reporting channels to support their response to climate change legislation.

Addressing climate change within an ERM framework can make this issue a regular agenda item within existing risk management committee meetings. In addition, financial, compliance, and reputation effects from climate change can be addressed through existing regulatory compliance, trading and insurance, communication, and financial planning efforts.

A six-part framework that leans heavily on processes and structures already in place at most energy companies can be useful in structuring a corporate response to climate change legislation.

A carbon ERM framework

1) Assigning responsibility: Companies should assign a manager to manage carbon related initiatives. The scale and potential impact of carbon legislation makes it important to have a single point of contact that can assess the risk of climate change legislation across the enterprise and develop appropriate cross-functional responses. This manager should be senior, have broad contacts across the company, be a trusted advisor of senior executives, understand the quantitative aspects of risk management, have deep experience in business operations, understand financial reporting and key financial metrics, and have a passion about remaining current with legislative developments and how these developments could affect the business. Some key activities that need to be considered in the short term include:

Creating an inventory of issues that impact the company
Developing ranking criteria for identified risks (e.g., financial, compliance, reputation)
Defining issues as current, near-term, or emerging
Assigning ownership for specific climate change risks
Assessing the connection among risks, opportunities, and strategies
Evaluating existing risk mitigation plans that could impact a company's response to climate change
Designing a tracking system for compliance, current activities, and new opportunities, templates, and tools.

2) Conducting preliminary measurement of carbon footprint: At a minimum, energy companies should understand the methodologies available to measure and report GHG emissions, and they should perform an initial assessment of total emissions. For certain companies, the U.S. Environmental Protection Agency's proposed rule under the Clean Air Act requires GHG emissions reporting for calendar year 2010.

The initial carbon inventory or footprint does not have to be overly precise, but it should allow analyses at the specific asset level. Eventually, the GHG inventory will have to be accurate, auditable, and repeatable, as GHG data will likely have to be made available to regulators and other key stakeholders when climate change legislation is passed.

3) Understanding a company's natural carbon position: After a company has a good estimate of its overall carbon footprint, it should determine how its natural carbon position depends on its assets, how it contracts around those assets, and whether its natural carbon position can be easily altered. This should include a robust discussion at the board level to help ensure that strategic climate change initiatives are being considered.

Furthermore, a company has to identify areas where it has natural carbon offsets. For example, the total carbon position for power and utilities companies can be offset by investments in renewable technologies.

Finally, a company has to determine whether it really has better capabilities than its peers in order to manage its overall carbon risk.

4) Assessing financial impact: The next step involves assessing the impact of climate change legislation on a company's financial performance. By combining advanced financial modeling techniques and scenario analyses, companies can develop a distribution of possible outcomes around key financial metrics under varying economic, commodity price, and carbon price scenarios. Many organizations are also creating a carbon balance sheet to assess the broader impact of how an optimized emissions inventory can influence not only financial statements, but overall financial performance.

The impact of varying levels of future carbon prices needs to be considered in the assessment of asset valuation models, forecasting and planning tools, operational optimization tools, and other decision support methodologies. When developing carbon-specific scenarios, it is important to consider factors such as regulatory changes, variability in carbon prices, variability in the supply of regulatory credits, the impact on valuation of financial contracts, and the related accounting effects. The impact on a company's overall financial performance could be dramatic. Understanding the full impact on the company requires that detailed scenario analyses be performed at the plant level across the organization.

Companies also want to make sure they consider a balanced approach to assessing the impact of climate legislation on financial performance. In addition to measures of profitability, companies should consider the impact on cash flow, liquidity, and capital allocation. For many energy companies, some longer term growth initiatives will have a much different return on capital once carbon is priced into the model. For example, investments in Canadian oil sands projects may not be as profitable once carbon has been factored into the decision.

5) Developing a strategy: For many energy companies, a financial strategy based solely on the management of its emission credit position may seem like the best way to manage the impact of climate change legislation. However, this may not be sustainable over time. Companies should look across the enterprise for asset-based solutions that may mitigate carbon risk. In advance of climate change legislation, companies should consider other forms of approved offsets, like renewable energy certificates (REC) and certified emissions reduction certificates (CER), energy efficiency improvements, and partnerships with companies that have a comparative carbon advantage.

There are several questions that companies should ask about their carbon strategy. Is managing carbon risk—broadly defined—part of the normal way the company does business? Is managing climate change a priority part of what the company is known for by its peers and customers? How is the company identifying new business opportunities arising from its climate change program? How are these programs helping the company contribute to the communities where it does business? Is carbon risk management an aspect of capital investment decision making, market expansion opportunities, and product and service redefinition in the marketplace? Has the company considered the impact of climate change across its supply chain?

6) Designing and implementing governance structures around carbon: The primary governance activities related to climate change programs include processes for developing, supporting, and embedding the strategy and accountabilities into the organization. Key program governance elements include:

Executive ownership and sponsorship
Climate change policy and procedures
Board and executive committee operations
Organizational structure
Scope of oversight and review activities
Roles, responsibilities, and accountability.

The governance activities should be consistent with the organization's objectives, regulatory guidance, or industry leading practices. Formal documentation should address a wide range of information including, but not limited to, climate change strategy, roles and responsibilities, approved activities and investments, and policies and operational procedures. In addition, climate change business objectives, governance, policies, and performance metrics should be clearly linked.

Climate change is potentially a material business risk, but where there are risks there are also opportunities. Companies that respond to risks by taking early action are likely to gain a competitive advantage.

About the authors