A Changing Climate for the Extractives Sector

03 April 2013

by Ioannis Chrysostomidis

There is no doubt that managing climate change risk presents real opportunities to improve project economics by identifying and mitigating potential risks early in the project design and implementation schedule.  In the extractives sectors, i.e. mining, oil and gas, climate risk issues are especially important given the challenging environmental conditions the sectors’ operations face from the Arctic Circle to the sub-Saharan desert.

Climate variability is already impacting on the extractives industry in various ways such as production downtime, logistics interruption, staff health and safety and breach of permit conditions (i.e. uncontrolled releases of wastewater) amongst others.   The risk implications of these extremes often merit mitigating actions given the potential loss associated with such events. 

Two areas must be addressed when considering potential risk mitigating techniques due to climate change:

  • Changes in the frequency and/or severity of extreme weather events give rise to one-off cyclical business risks.
  • Changes in climatic and weather conditions result in chronic non-cyclical risks and opportunities

Earth has already experienced, a modest increase in global average temperature of 0.8 °C since pre-industrial times. Nonetheless, even small variations in average conditions can have a big influence on extremes such as droughts and floods, as the world has witnessed over the last decade. As extreme weather events become more frequent, and climate change continues to modify operating environments, risks and opportunities will grow in importance for the sector.

Regulators and investors’ are increasingly demanding from companies full disclosure of climate risks and appropriate strategies in place to deal with them.  CERES’ Investor Network on Climate Risk (INCR), a network of 100 institutional investors with collective assets totalling more than $10 trillion have been concluded in a recent report that while companies in the extractives sector are making extensive capital investments related that carry material financial risks associated with climate change, they are generally failing to adequately disclose them consistent with SEC rules and growing investor expectations. (1)

The extractives sector is considered critical in building a more sustainable global economy.  Capital investments made today, whether into mining, conventional or unconventional oil and gas developments like shale gas and oil sands have the potential to secure the world’s future energy and resource demand for decades to come.  Considering the long timescales and the importance of these investments, it would be negligent not to consider the step necessary to make such projects resilient to future expected climate change related risks.  A simple economic analysis almost always demonstrates substantial pay back on the investment necessary to make a project climate resilient. 

One-off cyclical risks

Climate variability refers to a climatic parameter varying from its long-term mean i.e. some years have below average rainfall, some about average and others above average. The actual rainfall varying from the mean represents drought and flood conditions.

Climate change can cause climate variability to shift and which would be associated with an increase in frequency and severity of such one-off cyclical events such as flooding, extreme temperatures, heat waves and drought, landslides and cyclones.  Basically it loads the dice to make extreme weather more likely or worse, or both.  Consequently, a critical design threshold (e.g. 200mm rain in 24 hours, 160km/hour wind speed) is expected to be breached more often and/or more severely now compared to 20 years ago and in the future compared to now. (Figure 1).

Figure 1. Climate variability and coping ranges

Quantitative methods have been developed to help respond to the need to understand and assess the potential impact of such climate change risks. Quantitative assessments focus on assessing risks that arise from an increasing frequency and severity of extreme weather events using likelihood/consequence based on traditional risk management approaches.

Insurance records, underwriters’ reports, insurer’s catastrophe modelling and historical incidence databases along with climate change projections can be used in conjunction with sensitivity analysis to come up with quantifiable relative changes in risk.  The purpose is to support judgements about typical business interruption delays, or proportion of assets damaged to take account of the specific vulnerability to a given threat. For example, a transport network that has already suffered significant delays from flooding would be considered highly vulnerable. The key calculation combines event frequency, vulnerability, financial consequence and predicted climate change to determine the level of risk to a company’s operations and assets.

Outputs from this exercise can help to identify and quantify potential losses and make the business case for adaptation measures to increase the project’s coping range.

Stress testing can also be very useful exercise here where a “what-if analysis” can be used to assess the resilience of a given operation to hypothetical external shocks. This might assess for example what might happen to a project’s risk register if future climatic extremes are being underestimated by 20%. This process can help identify vulnerabilities and opportunities for “quick wins”.

Treating adaptation as a business decision

Options available to manage preventable risks are evaluated on the basis of their internal rate of return and make the business case for themselves (or not) as is the case with any other type of investment.

Figure 2. An example of a Climate Adaptation Investment Curve in relation to water scarcity

Chronic non-cyclical risks

Aside extreme weather events (i.e. cyclical risks), there is also a set of risks and opportunities that arise from non-cyclical and chronic changes in climatic conditions. For example changes in average temperature conditions could cause a number of things e.g. fundamental change in precipitation patterns and locations, glaciers and the arctic will permanently disappear, sea levels will rise and permafrost will thaw. Such changes, due to their systemic implications, can bring risks and opportunities of a different scale and resilience to risks or positioning to opportunities can be built through taking a more holistic approach.

Climate change as a risk amplifier

Most project developers are undertaking project investments on the basis of a set of technical or non-technical risks.  ERM’s experience is that project developers would be well advised to further consider how climate change might amplify seemingly unrelated project risks or create new opportunities? For example:

  • The existing risk register of a proposed development will be influenced by a changing climate.
  • The proposed resettlement, closure or environmental/biodiversity mitigation banking plan will perform differently 30 years from now.
  • A project’s supply chain and logistics strategy need to take into consideration new transport routes (e.g. arctic) necessary to mitigate climate change event related interruptions

Since everything is connected through an intricate web of risk interdependencies, domino effects can give rise to systemic risks with serious knock-on implications on businesses.

Figure 3. Risk interdependency of “failure of climate change adaptation” and other risk categories

These risks are usually beyond a company’s capacity to influence or control but once identified the management objective is to entertain possibilities and attempt to reduce the impact cost and strengthen resilience where this is needed should they occur.

An approach that companies can use to identify such risks and opportunities in overall strategy and down at project development process is through scenario planning.  Scenario planning recognises that many factors may combine in complex ways to create future scenario stories both plausible and surprising.  Scenarios are developed by starting to categorise into two broad categories things that we consider:

  1. Relatively certain (e.g. demographics) and 
  2. Relatively uncertain (e.g. exact timing and impacts of climate change).

By trying to combine certainty with uncertainty we can start forming future scenarios and their main value is that they can help companies understand how the various components of their complex and interconnected risk landscape is changed if one or more parameters are changed. This approach can be used for decisions at a project level and for complex strategic planning at a corporate level.

Most corporate risk departments already run scenario planning, but there is a need for this analysis to take into account climate change and sustainability aspects as they become material issues to consider when doing businesses.  An opportunity therefore exists for enhancing the risk management process by integrating climate change and sustainability issues into company’s risk management and strategy.

[1] Ceres, An Analysis of SEC Disclosure by Major Oil & Gas Companies on Climate Risk & Deepwater Drilling Risk, August 2012

Figure 1 Source: Willows (2003)

Figure 2 Source: World Economic Forum - Global Risks 2013

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