Managing carbon emissions and providing answers about cost and risk is not easy. Carbon impact, and with it, carbon cost and carbon risk, stretches across the entire business portfolio. So a company’s plan for net zero must cover the entire portfolio as well. The first step is to measure the emissions of each business in the portfolio across the value chain. This assessment forms the basis for evaluating the portfolio according to a key metric – Value at Carbon Risk (VaCR). Once the assessment has been developed and applied across multiple scenarios, businesses can then develop a frame for strategic decisions about the portfolio.
After a decade of climate deliberations, hard action toward net zero emissions is underway by governments, leading multinationals, and large institutional investors. Corporate leaders (CEOs, CFOs, boards and strategic planners) need to be ready to respond with a strategic plan for emissions reduction, regulatory reporting, and metrics that account for risk and financial impact. But how? And what metrics?
There’s no questioning the urgency. Momentum is building, the result of pressure from consumers, industry peers, value chain partners and investors. In May, activist investors won board seats at ExxonMobil to push the company faster toward net zero targets. Equinor and Shell have announced plans to achieve net zero emissions by 2050. The Bank of England recently warned banks and businesses to start assessing their risk exposures to future climate change. In November, the United Nations Climate Change Conference of the Parties (COP26) met in Glasgow — the start of concerted global action to limit the earth’s average temperature increase to 1.5°C compared to pre-industrial levels, the threshold for catastrophic climate damage.
Responding — by managing carbon emissions and by providing answers about cost and risk — is not easy. Carbon impact, and with it, carbon cost and carbon risk, stretches across the entire business portfolio. So any plan to address it must cover the entire portfolio as well.
Measure emissions across the value chain.
The first step is to measure the emissions of each business in the portfolio across the value chain. This requires reaching beyond the organization into supplier relationships. A single product or subsystem, like an aircraft or a jet engine, may involve several components, subcontractors, manufacturing steps and transportation episodes before it arrives at final assembly. Each generates carbon emissions and costs. All must be factored in.
Accurate modeling of cost and risk will be needed. To diagnose the portfolio, start by assessing the sensitivity of earnings and free cashflows of each business under different carbon-pricing scenarios. That provides an assessment of how exposed the portfolio is to the risk of tighter environmental regulations.
Value at Carbon Risk (VaCR) is the key metric.
The assessment forms the basis for evaluating the portfolio according to a key metric I introduce here – Value at Carbon Risk (VaCR). Different from “Carbon Value at Risk” or “Carbon VaR,” VaCR is based on the current business investments, existing business models, and operations. Specifically, the Value at Carbon Risk (VaCR) for a portfolio is the probability-weighted change in the value of the portfolio, taking into account the emissions across the value chains of businesses in the portfolio and various scenarios and outcomes with respect to carbon regulations (and pricing) and their respective probabilities.
Benchmarking the performance of each business may reveal only part of the story. The assessment may show that certain operations, business processes, and/or supply-chain designs are not viable under stricter carbon regulations or higher carbon prices. In that situation, it’s necessary to make a decision to either sell the business or invest in reducing its emissions.
Strategically managing a corporate portfolio in an evolving regulatory environment, a rapidly changing technology landscape, and in view of mounting pressure from stakeholders is highly dynamic – which means that evaluation and re-evaluation must be constant.
Frame the strategic decisions and develop the portfolio strategy.
Once the assessment has been developed and applied across multiple scenarios, you can develop a framework for strategic decisions about the portfolio:
- Where to transform: Identify investment opportunities for reducing the carbon intensity of various core businesses and their supporting business models.
- Where to expand: Identify opportunities for M&A and investments in new businesses and business models.
- Where to divest: Determine which businesses or assets should be under consideration for divestment.
The development of the roadmap is, of course, not a quick process. It requires rigorous evaluation of the investment opportunities, both standalone and in the context of the organization’s overall portfolio strategy.
Look beyond financial metrics – and maintain the effort for the long haul.
Financial metrics shouldn’t be the only ones in the mix. Special consideration should also be given to some or all of the following: Residual emissions; metrics governing portfolio balancing across time, geographies and markets; exposure to regulatory and technology risks, and measurements of the novelty vs. maturity of business models.
The work does not end with the initial planning. During implementation, and on a periodic basis, corporate leaders will need to manage carbon budgets and residual emissions allocations by business unit, just as capital allocations are currently managed.
The accelerated timelines for net zero are without a doubt a strategic challenge for decision-makers. But the situation presents strategic opportunities as well. By starting with a thorough understanding of your corporate portfolio’s exposure to carbon risks, you will be in a position to identify the strategic moves that will enable your company to limit the downside and capture value creation opportunities.