Picture above: Chemical Industry pollution in China colours the light of the low-hanging sun. Image: Depositphotos
After the 2015 Paris Climate Conference, Dax corporations and other large companies committed to the goal of limiting man-made global warming to well below two degrees Celsius over pre-industrial levels. But how does a promise become a concrete management question for a company?
Problem: If companies want to align their business to the 1.5 or 2 degree limits, they need climate management. Thus, they must be able to find specific indicators not only for the entire company, but also for individual projects. For this purpose, an economic metric on climate change is eeded whichshows at a glance the extent to which a company is approaching its defined degree target in its economic activities.
Solution: A Frankfurt startup has developed the climate indicator, „X-Degree-Compatibility“ (XDC). It expresses by how many degrees Celsius the earth would warm by 2050 if all companies were to operate as emissions intensivelyas the company under study. This shows how far the business practices of a project, a company or an industry is from the Paris climate target – and what efforts are needed to correct the course.
Bonn, 16 September 2019
Banks, insurance companies and businesses want to better understand the climate crisis: Is their business model compatible with climate protection goals? How can the climate crisis hurt their business model if not sufficiently limited? Is the climate crisis affecting the reputation of a company? How do climate protection measures distress business partners, markets, technological developments and the creditworthiness of customers? „The risk perspective is already driving the demand for economic climate metrics,“ says Ari Pankiewicz, head of Sustainable Finance at the European management consultancy d-fine, in an interview with KlimaSocial.
Karsten Löffler, co-head of the UNEP Collaborating Centre for Climate & Sustainable Energy Finance at Frankfurt School, recently told Börsen-Zeitung that “the various approaches to measuring the impact of companies on climate change are still in their infancy, but their importance in developing a standard should not be underestimated”. In many cases, however, transparency is lacking.
Increasing regulatory requirements
The development is not driven by pure self-interest but also by regulation. Above all, companies are trying to anticipate the expected regulations for non-financial reporting. A European Directive on Corporate Social Responsibility, adopted in 2014 (2014/95/EU), obliges companies with annual sales of more than 40 million euros or with more than 500 employees to publish their non-financial key figures.
This was implemented in Germany by the CSR Directive Implementation Act, which extended the reporting obligations for the non-financial sector. Among other things, Section 289c of the German Commercial Code (HGB) now requires large companies, banks and insurers to declare themselves to be concerned with environmental issues, „whereby the information may relate, for example, to greenhouse gas emissions, water consumption, air pollution, the use of renewable and non-renewable energies or the protection of biological diversity“. Up to now, the business world – with the exception of insurers – has been largely free to decide how it wants to present information. Critics point out that companies, in their own interest, will tend to emphasize those features that make them appear in a good light. By 2020, best practice guidelines are to be developed by European financial supervisors. At present, many companies still follow the recommendations of the TCFD (task force on climate-related financial disclosures) managed by international companies.
The financial sector is widely regarded as the central lever for pushing companies onto the right climate course. Central banks and rating agencies are adjusting to climate risks; activists in the divestment movement are putting pressure on investors to get out of the fossil-fuel business interests. Banks and insurers will have to deal with climate risks at the portfolio level, which will increase the demands placed on companies in the real economy. The risk drivers in individual sectors that can be used to determine a company’s climate course independent of the company’s own data will have to be defined: In the energy sector this will probably be the amount of energy produced, in the transport sector it will be passenger-kilometres, in other sectors gross value added.
There are now various providers such as Four Twenty Seven, Carbon Delta or South Pole that offer approaches for assessing climate and weather risks as well as transformation risks. They employ various valuation models. Ari Pankiewicz says: „In my opinion, the development is at the beginning. There are many very good ideas, but the subject is complex. There are still no providers that have been able to establish themselves with their model or have developed a best-practice standard that customers accept.“
A climate protection protest in Calgary in November 2008: The Rainforest Action Network assigned CO2 footprints to five major Canadian banks. However, the figures refer to the past and say little about which degree Celsius goal a bank is aiming at. Image: ItzaFineDay/Flickr; CC BY 2.0
The Science-Based Targets Initiative (SBTi) is committed to scientifically based CSR reporting. It calls on companies to set their own climate targets consistent with the Paris agreement. These are then to be checked and verified. The initiative’s partner organizations include the CDP (formerly Carbon Disclosure Project), the UN Global Compact and the World Resource Institute. More than 500 companies have now committed to SBTs, in Germany including the software group SAP, the photo service provider Cewe, the automobile manufacturer Daimler, and Deutsche Bahn.
The initiative makes implementation recommendations, with varied medium- and long-term climate targets for individual industries depending on the sector. They relate to emissions that are under the control of the company (called scope 1, for example, for company-owned vehicle fleets or power plants and scope 2 for energy services such as electricity purchased) and to emissions that are caused in the upstream or downstream supply chain not under the direct control of the company (scope 3). This latter also includes emissions generated by suppliers, service providers, employees, or customers during the use phase of the products. If Scope 3 accounts for more than 40 percent of total emissions along the value chain, companies must also make concrete statements about reductions in this area.
So far, the climate scores widely used merely make a statement where a company stands in comparison to other companies by an abstract value. Last year, for example, CDP published a ranking for the world’s 16 largest companies in the consumer goods industry. At first glance, however, the value says nothing about whether a company is acting in accordance with the Paris Climate Agreement. Also there is no external evaluation.
The degree figure as an economic indicator
What is need therefore is an economic indicator on climate change that shows at one glance the extent to which a company is approaching the 1.5 or 2 degree targets in its economic activities. A study carried out in 2017 on behalf of the Swiss Federal Office for the Environment (FOEN) used the so-called PACTA tool to determine a degree value. The investment portfolio of the Swiss pension and insurance funds failed that test. It contains companies that fall well short of the Paris climate target: The portfolio represents the technology mix of a 6-degree Celsius world instead of a 2-degree Celsius world.
The analysis of DAX-30 companies (before the exit of Thyssen-Krupp and the entry of MTU) using the XDC key figures shows a wide dispersion of stocks. Graph: right. based on science
The climate indicator „X-Degree-Compatibility“ (XDC) developed by the start-up „right. based on science“, founded in 2016, also expresses by how many degrees Celsius the earth would warm up if all companies were to operate as emissions-intensively as the company under investigation. The XCD model also generates information on climate-relevant risks, meeting the reporting requirements of Section 289c of the German Commercial Code (HGB). Thus, the model can also serve as a compliance tool for companies. Timo Busch, who researches sustainability in industrial companies at the University of Hamburg, tells KlimaSocial: „I think this is a very promising approach.“ As an orientation tool, the degree target is „very important“ in the financial sector.
Since January 2019, the startup right has been in close exchange with the Potsdam Institute for Climate Impact Research to improve the climate model contained in the XDC calculations. The institute’s founding director John Schellnhuber sees this as „an interesting approach to bridge the gap between climate science and business“. The startup showed, for example, that companies listed on the DAX 30 index were operating in a manner compatible with an average of 4.9 degrees Celsius of warming by 2050, albeit based on highly simplified assumptions. It refers to 2050, since many voluntary commitments, such as the German climate protection plan, also refer to this year.
The XDC index shows by how many degrees Celsius the earth would warm up by 2050 if everyone were as emission-intensive as the economic unit under consideration.
The spectrum of the XDC results runs from 1.26 to 11.23 degrees Celsius. IT and telecommunications companies tend to be at the lower end of the scale. This applies to both German and international groups: Apple, for example, reaches 1.49 degrees Celsius, Deutsche Telekom 1.56 degrees Celsius and Deutsche Börse AG 1.26 degrees Celsius. Those on the higher end are not yet published. They may be energy companies. The Italian energy group Enel S.p.A., for example, reaches 6.08 degrees Celsius.
The degree value illustrates more impressively than any abstract score value where a company stands when it comes to climate protection. „A company’s contribution to climate change as a degree Celsius figure is beautifully concrete and thus has much greater significance and effect than an abstract score,“ explains right-founder Hannah Helmke in an interview with KlimaSocial. The connection between temperature increases and changing living conditions is „very clearly established“. Direct climate consequences could be tied to varying degrees Celsius figures, representing the source of climate-relevant opportunities and risks.
Coal-fired power plant of the Italian energy company Enel S.p.A. in Civitavecchia. The analysis of the standard XDC 2016 has shown that Enel comes to 6.08 degrees Celsius. Image: Depositphotos
„There is a danger that the model will not be accepted everywhere, precisely because it is so impressive and striking,“ says Ari Pankiewicz. The energy sector, for example, could be deterred. Nevertheless, the figure could provide an indication of the long-term inside-out perspective, i.e. the extent to which a company is impacting climate change. For banks and insurers, the XDC number could thus function as a risk indicator that shows how far a company is from the Paris 2-degree threshold. It could also be the starting point for regulation obliging companies to put their own business models on track. In the medium term, however, the outside-in perspective, namely the financial impact of climate change on a company, is more important for the financial sector.
The Degree as a Management Instrument
In its simplest standard form, the XDC model assumes that emissions, companies and the global economy will grow by 3.2 percent annually until 2050. The ratio between emissions and gross value added remains the same until 2050, as it assumes that no climate protection measures will be taken that would change this ratio. To avoid double counting, Scope 1 emissions are counted at 100 percent, Scope 2 and 3 emissions at 50 percent each. Companies can calculate climate targets, growth plans, expansion strategies or the impact of low-emission technologies in the supply chain in various scenarios and also vary the basic assumptions on emissions, gross value added and scope 1 – 3 figures. They can also, for example, assume lower economic growth.
The XDC model can be used to define any target, such as 2 degrees Celsius, and calculate the corresponding emission reduction path. Planned climate protection measures can be evaluated in terms of whether they reduce emissions accordingly. Companies can choose which data to base their target calculation on.
Because it can also be used to evaluate individual projects or company divisions, the indicator is also suitable for flexible climate management. Fund and investment companies can also use the metrics for their financial products, as the data necessary can be obtained and applied independently of the companies examined from data providers. German users already include Zalando, the fund managers of Salm & Salm Partner and GLS Bank.
The XDC ratio as an investment tool
Alexander El Alaoui, Director of Sustainable Investments at Salm & Salm Partner, was looking for a key figure which, unlike the CO2 footprint, is not related to the past but can reflect future development. His guiding question is: „Will this company still be listed on the stock exchange in 30 years?“ He was also looking for a climate metric that could be determined on a scientific basis largely independent of the company’s own data. Two and a half years ago he set up a new fund with 2-degree compatibility, the target value of the included companies is still „below 1.5 degrees“. He then got into contact with right to reevaluate the fund using the XDC model, which he now considers „the best available instrument“.
„If one were to invest in our fund today, the earth would warm up by 1.38 degrees,“ says El Alaoui in an interview with KlimaSocial. For him, one thing is clear: „Any fund manager who wants to invest climate sensitively must actively intervene in the stock selection process. If a company with a good financial ratio is not „climate compatible“, El Alaoui will not include it in the fund.
The graph shows which data sources are included in the XDC model and which values are generated from them. Graph: right. based on science
The Salm & Salm Partner fund invests in every sector where other funds also invest. However, it selects the „Climate Leaders“ for each sector. The fund also takes into account other sustainability indicators such as the eco-social balance sheet, the quality of corporate management or the carbon footprint. However, the climate rating is the factor that ultimately decides whether an otherwise acceptable company is included or excluded. As a result, the fund outperformed the market. After costs, it has been 2.5 percent higher than the MSCI World Global Index since the beginning of the year.
Management tool for bank portfolios
GLS Bank intends to present its 2018 figures calculated using the XDC model before the end of this year. The entire loan and investment portfolio will be evaluated and referenced to individual loans. „You can always compare yourself with other banks,“ says Laura Mervelskemper, responsible for impact transparency and sustainability at GLS Bank, „but with regard to ecological limits we have had no meaningful figures so far“. The bank opted for the XDC model because it was „the most scientifically sound and practicable to implement,“ she explains. Above all, it goes beyond just reporting CO2 emissions. Mervelskemper tells KlimaSocial that the model makes it possible to say to what extent a product or project is compatible with the Paris climate targets.
For the GLS bank it is important to live up to its social-ecological promise, says Mervelskemper: „We want to know if we are as good as we want to be.“ Only on the basis of transparency would it be possible to align banking business even better with long-term social goals.
The Bank finances many projects in the environmental field and even slightly more projects in the social field, for which there have been no environmental indicators so far. „CO2 emissions are not at the forefront of a nursing home loan decision. Here we could then see which renovation measures would be possible,“ says Mervelskemper.
Many customers cannot provide CO2 data. With the Wuppertal Institute for Climate, Environment and Energy, GLS Bank is therefore developing a method that will allow statements to be made on the emissions of individual projects that are „as accurate as possible“. The work on it is intensive: Every week the partners connect to compile and evaluate the results of their work.
XDC goes Open Source
In May, the startup right released the source code for its XCD model written in Python under an open-source license as part of the „right.open“ project. GLS Bank continues to use the software and adapts it for individual scenarios. In the end, Mervelskemper says, the bank wants to know „what social impact we achieve with our customers“ and to what extent these fit in with the industry-specific visions of the future that the bank has developed.
Right has been motivated to the release by the findings of the IPCC Special Report in 2018. It noted that the course to limiting global warming must be firmly implemented by 2030. 45 percent of CO2 emissions have to be reduced by then, and complete decarbonization achieved by 2050. „We must therefore work quickly, precisely and collaboratively,“ emphasizes Hannah Helmke. The source code of the XDC model is to be made available to academic chairs, their scientific staff and graduate students in order to research practice-relevant questions.
Speed through cooperation and standardization
By making the model open-source, right not only wants to create more transparency, but also make it available to all. By giving both users and consultants a tool, the startup moves away from the consulting business at the same time. It sees itself more as a standard setter if experts from all disciplines can work with the model on a consistent basis.
For this reason, management consultant Ari Pankiewicz considers the open-source strategy to be the right approach, as it offers the transparency that is required for a uniform method accepted by the community. Moreover, the disclosure now makes it possible to further develop the model cooperatively and to create a certain confidence in modelling results and that the associated uncertainties, for example with regard to socio-economic developments or climate-related financial impacts, are sufficiently covered by the model. Ari Pankiewicz says: „It is not helpful to bring a model onto the market and to simulate a fake accuracy without depicting the inherent uncertainties and making them transparent.“
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This article is published in the project KlimaSocial on the platform Riffreporter.de. KlimaSocial stands for a change of perspective. The climate research we are writing about does not focus on physics or technology, but on social processes. You can read more about us and our topic here.