Climate change and sustainability disputes: Banking and finance sector perspectives

Overview

Climate change and sustainability issues are now high priority issues for governments, regulators, investors, businesses, boards and individuals. These issues present significant opportunities for the banking and finance sector, particularly in relation to financing the energy and all industries transitions. But they also present a complex myriad of legal, financial and reputational risk. In the face of a strong push globally for more stringent reporting and disclosure requirements, as well as rising levels of climate-related litigation and regulatory action, the risk that banks will face related disputes is on the rise. Recent years have seen a significant number of strategic claims targeting not only governments, but also a wider range of corporate entities as well as individuals, including company directors, corporate decision-makers, trustees and professional advisors. Banks and financial institutions have not been immune, with some already facing claims in various different legal and domestic fora. More claims are predicted to come in the near future. In addition, banks are exposed to risks associated with climate-related disputes through their portfolios, investments and the wider market. 

Financial institutions are accustomed to assessing and managing complex risks, and are well-equipped to adapt when new risks arise. To manage risk, however, first requires an understanding of the nature and breadth of exposure. Much has been written about the physical and transition risks for banks, so this article focusses on analysing the legal and regulatory risks for banks associated with climate change and sustainability disputes.

Climate change and sustainability risks

Central banks and financial regulators globally have for years been noting the significance of climate-related risks, both to financial institutions and to the stability of global financial markets. Banks need to manage these financial and non-financial risks in respect of their operations and financial exposures as well as through the effects of the wider economy and market. In parallel, they are looking to exploit opportunities, such as financing the rapid and deep transitions underway in the energy sector and in various different industries as they move to a lower-carbon economy and climate-resilient operations.

Climate-related risks can be broadly grouped into three main categories: 

• physical risks; 
• transition risks; and 
• legal and regulatory risks.

Physical risks are those which arise from the changing climactic conditions and more frequent and severe weather-related events associated with climate change (such as rising sea levels, flooding, cyclones, heatwaves, droughts and wildfires). These risks can impact banks’ operations. But more significantly, they could cause reductions in asset values and reduce the creditworthiness of borrowers, which could result in significant financial losses to banks. For example, property in low lying areas used as collateral for bank loans may be at risk of flood damage or rising sea levels and therefore decrease in value, even potentially losing value entirely. Denmark’s central bank recently warned that more than DKK 40 billion (€ 5.4 billion) of loans are currently exposed to flood risk and that could increase to DKK 198 billion (€ 26.6 billion) by the end of the century. The bank noted that this may present a risk for individual credit institutions as well as the Danish financial system. Food and agricultural businesses are especially vulnerable to changing climactic conditions and extreme weather events as these impact living and working conditions, affect health, labour productivity, and animal and agriculture productivity and indeed overall viability. In recognition of such risks, many central banks and regulators are now ramping up not only their warnings but also their activities to assess and implement policy to mitigate such risks. For example, the Bank of England recently launched a program (the 2021 Climate Biennial Exploratory Scenario, CBES) to assess the resilience of the UK’s largest banks and insurers as well as the UK financial system more generally, to withstand physical risks associated with climate change as well as transition risks. 

Transition risks arise from the political, social and market adjustment towards a low-carbon (or net-zero) economy. Financial institutions could, for example, face credit exposures where changes to policy and regulation (such as new carbon taxes or tariffs, or changes to subsidy regimes), the phase out of fossil fuels, or the introduction of new technologies, processes and business models prompt a reassessment of the value of assets and investments. Another key risk associated with the transition is the impact of commodity markets, for example, the effect of the transition on the demand, cost of extraction, volumes and prices of fossil fuels. This could potentially impact not only private companies but state-owned enterprises, with a knock-on effect on the security of sovereign lending and borrowing. Banks also face more nebulous transition risks, such as the impact on banks’ businesses of changing sentiment around investment in certain asset classes.

Legal and regulatory risks encompass a wide array of potential disputes, which are explored in detail in the following sections.

What are climate change & sustainability disputes?

Climate change and sustainability disputes are now a global phenomenon. Legal issues traverse multiple fields of law and various causes of action, and involve a wide range of claimants and defendants from multiple sectors. To date, governments and major emitters (in particular, oil and gas companies) have been the primary targets for such claims. However, claimants are increasingly targeting a broader range of private sector and financial actors, and the grounds for claims are broadening to focus on fiduciary duties and corporate due diligence and governance. There have already been claims involving banks, pension funds, import-export banks, central banks, as well as government agencies that invest in or financially support banks or bank sponsored projects.

It is also worth highlighting at the outset that disputes risks for banks are both direct as well as indirect. Legal and regulatory proceedings against banks expose them to defence costs, damages, reputational harm, shareholder discontent or activism, and potential disruptions to operations. However, banks are also exposed to indirect litigation risk such as where banks are financiers of or investors in a company facing climate-related claims or which is impacted by a claim against a government (whether in respect of claims to challenge authorisations or to drive broader governmental policy) which might lead to a reduction in value of the investment or a decrease in the credit-worthiness of the client.

Any assessment of legal and regulatory risk to the banking sector must reflect the full risk landscape. A good starting point is the UK’s Prudential Regulatory Authority (PRA) assessment – it identified three primary potential climate-related causes of action against financial institutions: failure to disclose climate-related financial risks; failure to adapt to the foreseeable nature of those risks; and failure to take action required to mitigate future financial risks. Banks and financial institutions have already faced claims on each of these grounds, and with the push for greater regulation and investor focus on these areas, more claims are likely to arise.

We would add to the PRA’s list, the risk of contractual disputes arising out of the banking and finance sector’s involvement in financing transition, mitigation and adaptation activities. Another potentially significant category we would add, is the risk of disputes between banks (as investors) and host-states.

It is also worth briefly noting ‘climate change damages’ claims which seek financial redress for direct or indirect effects of climate change on the claimant’s property or investments, often in conjunction with other relief (such as injunctions).

Concluding thoughts

The risk profile of climate change and sustainability disputes is not only complex but in a state of flux. Any assessment of climate change and sustainability disputes risk also needs to be an ongoing, organic process. This is partly due to the ongoing evolution of climate-related policy and regulation on both the national and international stage, as states and regulators grapple with how to address climate change and who should shoulder the fiscal burden of transition, adaptation and mitigation measures. It is also partly due to innovative claims being brought by claimants. Assessment of climate-related risks for banks should be viewed as the start of an ongoing conversation.

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