Ron Dembo is the founder and CEO of RiskThinking.ai.
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We are living in a time characterized by unprecedented uncertainty in our environment. Business leaders are paying attention to the risks of climate change and asking important questions more often in boardrooms, leadership summits and conference calls:
• How can we measure the future financial impact of climate change?
• How will factors such as rising temperatures or fuel costs affect our businesses?
• What do we need to know to make good decisions in the future?
It’s impossible to answer these questions with certainty—not just because the future is inherently uncertain but because climate change is an extremely complex problem governed by dynamic and interconnected systems. We know the climate is changing, but we can't predict with certainty what this means for the planet and its people or how it will affect our businesses.
Climate change affects the physical and financial assets of businesses. If your company has a dozen data centers in England, and heat waves force you to temporarily reduce your output or shut down centers, you may take a big financial hit. If you have offices throughout the U.S., and several locations are flooded because of storms in the northeast, you may experience serious economic losses.
I believe the traditional ways people manage uncertainty are fundamentally misguided. Forecasting is the norm in risk management, but it often falls short. Unknown factors can disrupt our plans and predictions, so we must rethink our approach to managing risk.
It is critical to use forward-looking data—aggregating a multitude of perspectives about future outcomes into probability distributions—to better prepare for climate risks and develop a data-based strategy. When there is deep uncertainty, the “form of a solution” should involve taking action but simultaneously including mitigation strategies or hedges. I recommend taking the following steps to cope with risks in an uncertain future.
1. Measure your exposure and risk using forward-looking data.
Without measuring potential risks and impacts, it's hard to plan for the future. Gather as much forward-looking data as possible from various expert sources and weigh their significance. Consider a range of possibilities, not a single forecast. This systematic, future-focused approach can help you deal with unpredictable changes.
For example, in a more carbon-constrained world, the prices of goods and services your company relies on may fluctuate. Investigate potential scenarios that could occur if the cost of raw materials, manufacturing or shipping suddenly rise.
2. Plan for mitigating risks.
Mitigation strategies can vary depending on your business context. For instance, if you run an airline, exploring hydrogen fuel or other alternative sources for planes may help mitigate future risks associated with carbon pricing and environmental concerns. Or if you're in the oil and gas industry, and your company is facing increased pressure as electric vehicles become more popular, diversifying into electric power stations could help hedge against the decline in traditional gas stations.
The key is to think beyond standard risk measurement and explore different scenarios and alternatives. Scenario thinking, or risk thinking, involves considering all possible outcomes and building a strategy that makes sense in an uncertain world. By considering various viewpoints and aggregating them into an actionable plan, you can navigate risks more effectively.
3. Set aside capital.
Setting aside capital is similar to buying insurance against potential losses. A financial buffer can provide your business with a safety net when unexpected events occur.
Perform a cost-benefit analysis to determine how much capital you need, aligning the amount with the level of risk your business is willing to bear. The more you want to eliminate risk, the more expensive this becomes—and you have to balance this tradeoff. Setting aside too much capital can be financially inefficient, just as overinsuring a low-risk event can be costly.
We need to learn to adapt our risk thinking strategies to be effective in an uncertain world. We can't predict the future with 100% accuracy, but we can develop solutions that combine action and mitigation.
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