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Sustainability and Catastrophic Risk: What Business Leaders Can Learn from BP

Words by 3p Contributor
Investment & Markets

By Jay Apt

It is natural for our optimistic and energetic MBA students to look at the upside of decisions, and to maximize the returns on their firm’s investment in the minimum time. But that isn’t always a strategy for sustainability, either for the firm or for the planet.

Imagine that you are the leader of the largest railway signal-and-control company in the world’s fastest-growing economy. Your firm supplies its technology to more than 20 countries. Your market share in those countries far eclipses your competitors’ shares combined, and your investment of profits into reducing manufacturing costs will keep it that way. Life is good, and you are happy that you have balanced profit maximizing with mitigating business risks by investing in meeting the needs of your customers. You are grooming your daughter to take over the business, and look forward to the third generation coming along shortly.

Then a low-probability event of enormous consequence happens. Lightning strikes a high-speed rail line, and wrong signals are flashed. One high-speed train crashes into the rear of another on a bridge. Forty people are killed and 191 injured. A Cabinet investigation receives worldwide coverage. The investigation finds flawed development of the signaling equipment, poor quality and slipshod inspections by safety professionals. Your dreams of a generations-long business lie with the wreckage of the ruined trains.

Catastrophic risk can end corporate life. Catastrophic risks are unanticipated losses or damage that cripple an organization and often lead to a survival mode. BP systematically underestimated physical risks, costing the company $20 billion and the CEO his job. Physical risk management failures forced the Johns-Manville company into Chapter 11 bankruptcy for five years. A toxic gas leak at a Union Carbide plant killed 14,000 people in India, and the company nearly repeated the disaster in West Virginia within a year; it was forced to sell off profitable subsidiaries to survive a hostile-takeover attempt when the disasters drove down its stock price. On the other hand, one man in China turned around that nation’s once-dismal airline safety record.

Since 2007, I’ve been teaching our Tepper MBA students a course in Catastrophic Risk Analysis and Management. What is the connection between sustainability and catastrophic risk? The core concept is understanding, analyzing and managing high-consequence events (that may be of low probability) in the presence of irreducible uncertainty.

These uncertainties can be about the types of events or about modes of the failure chain. But the largest uncertainty is one internal to the firm and to its leaders. It is a question of time scale. Potentially catastrophic events can be ignored for a while, but if the firm plans to be in business for a long time, managing these sorts of events must be considered.

It is this very question of time scale that is critical to the question of sustainability, whether of the firm or of our planet.

While only one of the course modules is on a topic that is explicitly related to “sustainability," greenhouse gas emissions, every module deals with developing a culture that considers long-term risks. Those are the low-probability events that can rock a company to its foundations.

The Tepper School of Business attracts very quantitatively-inclined students. Our MBA students leave the course with five core lessons:

  1. Students learn how to identify and quantify physical risks in real-world problems.

  2. They are trained to structure their thinking about physical risks.

  3. They are familiarized with risk models and tools that include stock-and-flow analysis, toxicology and epidemiology (and the good and bad points of each), probabilistic risk analysis including Monte Carlo analysis, event trees and fault trees, benefit-cost analysis, and decision analysis.

  4. Students are exposed to practical examples of risk perception and risk communication.

  5. We leave the students with examples of both excellent and poor leadership in physical risk management.

Graphically, the course structure looks something like this:

One of the first class of models introduced in the course are stock-and-flow models. The MBA students readily understand that if income exceeds expenses (both are flows of cash) that the bank balance (a stock) will increase. The initial example used is the buildup of Radon gas in homes constructed in certain regions of the U.S. The flows are the leakage of Radon into and out of the home, and the stock is the concentration in the living spaces.

You could be invited to that home for a dinner party and not appreciably increase your risk of lung cancer. But if you lived there for 40 years and the concentration was high enough, it would be a different story. Time scales matter.

Similarly, the risk to firms due to greenhouse gas concentration depends on time scale and concentration. The flows here are the emissions of CO2 and other greenhouse gases and their natural absorption sinks, while the stock is the concentration in the atmosphere. Like a bathtub with more water flowing in than is leaving through the drain, the level of greenhouse gases in the air will rise if emissions exceed the natural sinks.

Time scales in this problem are of two types. First, CO2 and most other greenhouse gases are not like conventional pollutants that leave the air in days or weeks. Most of a ton of CO2 that is emitted today will be in the air in our great-grandchildren’s day. Second, there is very little harm to those of us living today from the greenhouse. Controlling emissions requires short-term discipline today so that people living well after we are gone can benefit. Some firms understand this well. Bloomberg News reported in December 2013 that Exxon Mobil, Royal Dutch Shell, BP, and Total are all basing plans for future capital investments on the assumption that they will have to pay for carbon dioxide emissions at a rate of up to $60 per metric ton.

The idea that a firm must take the long view has been largely out of favor in recent years. While my course acknowledges the arguments for short-term profit maximization, I also want the students to leave with an understanding that ignoring the low-probability, high-consequence events has been catastrophic for firms. True sustainability requires the discipline of putting resources into mitigating the chances of catastrophic events even at the risk of lower short-term profit. There are no correct answers, but by giving tomorrow’s business leaders examples of both good and poor decisions this course has been successful in making sustainability part of the conversation.

Image credit: Flickr/Green Fire Productions

Jay Apt is a Professor of Technology at the Carnegie Mellon Tepper School of Business and director of the Carnegie Mellon Electricity Industry Center.