Q&A: Stanford advisors to the state of California on climate risk disclosure explain their recommendations

The State of California should translate specific risks associated with climate change into financial terms and use that information in deciding how to spend its $260 billion annual budget and manage over $1 trillion in state pension fund investments, according to a group of advisors appointed by Gov. Gavin Newsom.

The group, which was co-chaired by Alicia Seiger, the managing director of the Precourt Institute for Energy’s Sustainable Finance Initiative at Stanford University, issued its report with 45 recommendations on Sept. 20. Among the recommendations: California should require entities that do business with the state to disclose climate risks and plans to transition to carbon neutrality, especially for large infrastructure and procurement expenditures.

Furthermore, the group recommends that pension funds for state employees, California public school teachers and University of California employees should pressure companies they invest in to make climate risk part of their regular financial reporting and to move toward decarbonization. These funds can use climate risk metrics to better evaluate investments under increasingly strict climate regulation and the costs of climate impacts, including heat, drought, fires and floods. Disclosure can also be used to help drive investment in companies whose products reduce climate change and its impacts.

Dan Iancu, an associate professor at Stanford’s Graduate School of Business in the Operations, Information & Technology area, and Thomas Heller, emeritus professor at Stanford Law School, were also members of the state’s 20-person Climate-Related Risk Disclosure Advisory Group. Here, Seiger and Iancu explain the importance of climate risk assessment and reporting, the justifications for their recommendations and the road to implementation.

 

What are the climate risks to California’s state spending?

Alicia Seiger: Every sector of the economy will be impacted by climate change, but the industries with the greatest exposure overlap a lot with state spending, like infrastructure. Construction projects near the coast can be delayed by flooding amid rising sea levels. Should those projects be moved inland? Are there alternative solutions to the same infrastructure need? If not, do the state’s counterparties have the ability to manage the costs of potential delays or rebuilds? Should the state pay an upfront premium to ensure more resilient infrastructure over the long term?

Or take energy. State agencies buy a lot of electricity from power companies. If that power comes from hydroelectric dams, what are the risks of insufficient production due to increasingly common draughts? And with more wildfires, what if the power is there but it can’t be delivered due to major transmission lines being damaged or taken out of service as a prevention? Does the company have the ability to deliver and who pays for cost overruns and damages? On the other hand, the transition to a low-carbon economy could be great for electric generating companies. The state has an interest in helping counterparties envision how their businesses can thrive in a carbon-constrained world. In an electric vehicle-dominated world, for example, electric utilities could make a lot more money if they manage the transition well.

California state entities need to collect climate information so that they can better safeguard public dollars in the face of increasing climate risk and build an equitable future. Every dollar spent mitigating risks saves at least six dollars in disaster response.

 

Is calculating financial risks associated with climate change something people know how to do?

Dan Iancu: Assessing climate risk is fairly new, dynamic and – like most financial risk assessments – very complicated. Let’s say the state is taking bids for the lighting of a new highway. LED systems are more expensive upfront than fluorescent, but LED bulbs have lower operating costs because they use less electricity and last a long time. The financial assessment of whether the higher upfront investment is wise depends on the outlook for electricity prices. Maybe lower hydropower supplies throughout the western U.S. drive up electricity prices in California for years or decades. That would bolster the argument for LED.

But, maybe climate policies encourage so much building of solar, wind and other renewable generation that electricity becomes quite cheap for a long time. In that case, maybe LED wouldn’t pay off. This isn’t about just the physical climate risks, but also uncertainty about the impacts of transitioning to a low-carbon economy.

The state and its suppliers need to make these climate risk assessments, which are far from a perfect science. Standards are being developed, led by the G20’s Financial Stability Board. It has developed standards that organizations across all sectors can adopt and apply for measuring and disclosing climate-related financial risks. Our report starts there and charts new territory for specificity and ambition. Several California agencies, including the pension funds CalPERS (California Public Employees’ Retirement System) and CalSTRS (California State Teachers’ Retirement System, are already disclosing climate risk using internationally recognized standards.

Both pension funds have pledged to have zero greenhouse gas emissions by 2050. The measuring of emissions is part of risk disclosure and also very complicated. The report recommends that the state invest more in climate risk data, climate models and other tools the private and public sectors need to assess their risks. If related companies or projects use common data and analytical approaches, that would give the state and investors better insights for making decisions.

 

Should the state government use its enormous purchasing power to get businesses to commit to reducing their carbon footprints?

Seiger: To a degree, yes. At a minimum, suppliers to California agencies should disclose their governance of climate risk, their strategy for assessing risks – which should include a low-carbon transition plan – and metrics, which include emissions and reduction targets and timelines. Making all that public will provide pressure to operate more sustainably.

At the same time, many of our recommendations address equity issues facing the government, like the need to balance disclosure requirements to avoid disinvestment in vulnerable communities. The state also may need to provide some technical assistance to avoid undue reporting burdens on small companies.

As a matter of public policy, this isn’t new. The state uses procurement to advance its public mission, like support for women- and minority-owned businesses, as well as small businesses. California has been a leader in setting minimum ethical standards for parties that receive its taxpayer dollars. For example, it restricts non-essential state-funded travel to states that discriminate against lesbian, gay, bisexual and transgender people.

Companies and other organizations that have robust climate risk management programs and are actively transitioning their business in line with science-based targets should be prioritized. Under state law, California’s economy is to reduce greenhouse gas emissions to 40 percent below 1990 levels by 2030. The state should avoid doing business with counterparties that are wholly opposed to its climate goals.

 

And the state’s three large retirement investment funds should push for disclosure, too, invest accordingly and encourage companies in which they invest to change course when needed?

Seiger: Absolutely. In fact, we think all investment funds should do this and many are. Last year, the University of California Retirement System announced that its holdings were fossil free and that it had invested $1 billion in clean energy projects. This past spring, CalSTRS drove the shareholder vote to place three climate experts on ExxonMobil’s board of directors. And both CalPERS and CalSTRS have set targets for their portfolios to achieve net-zero greenhouse gas emissions by 2050.

This isn’t just advancing public policy. Pension funds’ top priority is to maintain investment returns. The impacts of climate change – the heat, drought, fires and floods already seen in the state ­– can threaten that. So, they’re acting on their fiduciary responsibility.

 

Now that your report has been submitted, what must happen for your 45 recommendations to be implemented?

Seiger: On the investment side, we call for a phased-in approach that builds on what the pension funds have already started doing. Risk assessments are time and resource intensive, and the data, models and best practices are still being developed. We believe the field will move forward faster through a process of learning by doing. Case in point: The granularity of physical risk data and the specification of transition pathways have both advanced a lot, even in the past six months. To manage implementation, funds can prioritize the economic sectors with the greatest potential exposure to climate risk. Beyond energy, these sectors include transportation, construction and agriculture.

Iancu: On the spending side, the state has so many agencies that implementation will take time, but efforts are already underway to build expertise and coordinate policies across state, regional and local agencies. California’s Integrated Climate Adaptation & Resiliency Program has developed a vision for a resilient California, as well as principles for state implementation efforts.

At the same time, this is an urgent issue. Gov. Brown issued an executive order that targets statewide carbon neutrality as soon as possible and no later than 2045. Gov. Newsom’s executive order, under which he created our advisory group, directed the state pension funds to advance California’s climate policies. The order also instructed the Department of General Services to leverage the management of its buildings, which total almost 20 million square feet, its 50,000 vehicles, and other assets and goods to minimize the state’s carbon footprint effective immediately. So, implementation will take time, but it is already happening.

Our hope, ultimately, is that other investment funds and other states use our recommendations, too. Large funds follow what CalPERS and CalSTRS do. Meanwhile, the U.S. Securities & Exchange Commission is developing climate risk disclosure rules, as are the White House and other federal offices.