Climate change risk must now be on the board agenda

It is likely to be only a matter of time before we see litigation against a director who has failed to perceive, disclose or take steps in relation to a foreseeable climate-related risk that can be demonstrated to have caused harm to a company (including, perhaps, reputational harm)¹.

Last month, the Australian Securities and Investments Commission (ASIC) told a Senate committee hearing on climate change risk disclosure that it agrees with the view that directors must consider and disclose climate risks to fulfil their duties under the Corporations Act 2001 (Act). This communication followed a significant speech by APRA’s Executive Board Member Geoff Summerhayes in February,  in which he said “The days of viewing climate change within a purely ethical, environmental or long-term frame have passed.”

Prior to this speech, a seminal legal opinion was produced by Noel Hutley SC which concluded that directors who fail to consider climate change risks now could be found liable for breaching their duty of care and diligence in the future. Against this backdrop, climate change disclosure recommendations have recently been published by the Task Force on Climate–related Financial Disclosures. 

This legal update provides an overview of these recent developments and reinforces that now is the time for Boards and senior management to be giving proper consideration to the risks (which include both transitional and reputational, as well as physical) posed by climate change, with a view to ensuring that these risks are incorporated into strategic decision making, and appropriate consideration is given to the need for disclosure of relevant financial-related risks.

On 2 February 2016, the Senate referred an inquiry into carbon risk disclosure to the Senate Economics References Committee for inquiry and report. The inquiry lapsed at the end of the last Parliament but was re-established in October last year. The Committee was initially due to report by 31 March 2017, but has been given an extension to 21 April 2017. The Committee recently held public hearings, at which ASIC, amongst others, made statements. 

In ASIC’s oral statement, joint senior executive Kate O’Rourke referenced section 180 of the Act which requires directors to act with care and diligence. Importantly, section 180(2) provides that directors will fulfil this duty if they inform themselves about the relevant subject matter and believe their judgment is in the best interests of the corporation (known as the “business judgement” rule). O’Rourke recommended that further guidance was needed to assist companies disclose climate risks within the existing reporting framework.

At the same time that ASIC affirmed that directors have a duty to consider and disclose climate risks, Emma Herd, CEO of the Investor Group on Climate Change told the Senate inquiry hearing, that most of the top 200 ASX listed companies have significant gaps in their carbon disclosure. For example most companies do not report on their strategies to address climate related risks. This gap between the growing consensus that directors have a duty to consider climate risks on the one hand, and the current lack of disclosure on climate risks on the other, will likely be a key focus of the Senate inquiry committee’s final report.

Not long before ASIC’s statement, APRA’s Executive Board Member Geoff Summerhayes delivered a speech on the need for carbon risk disclosure and announced that APRA will increasingly examine how banks, super funds and insurers respond to climate risks. In his speech, Mr Summerhayes referred to three recent developments as justification for the need to take action: the Paris Agreement, the Hutley Opinion and the report by the Task Force on Climate-Related Financial Disclosures.

Mr Summerhayes emphasised that there were two primary risks arising from climate change: physical risks and transition risks. He noted that the transition now in train to a lower emissions economy could potentially lead to significant repricing of carbon-intensive resources and activities and reallocation of capital, and that it is the transition risks which are likely to be particularly relevant to financial institutions. He also painted scenario analysis, particularly around a 2 degrees transition scenario, as the “new normal”. 

As Mr Summerhayes bluntly put it “if entities’ internal risk management processes are not starting to include climate risk as something that has to be considered – even if risks are ultimately judged to be minimal or manageable – that seems a pretty reasonable indicator there might be something wrong with the process. Similarly, if you’re an investor and you’re not already asking questions about how the companies you invest in approach these issues – perhaps you should be.”

In a recent legal opinion, barristers Mr Noel Hutley SC and Sebastian Hartford-Davis were commissioned by The Centre for Policy Development and the Future Business Council to consider the extent to which Australian company directors are currently required to respond to ‘climate change risks’ (Hutley Opinion).

The Hutley Opinion argues that climate change risks are capable of representing risks of harm to the interests of Australian companies, and would be considered by a court to be foreseeable risks at the present time. In other words, they would not be considered ‘far-fetched or fanciful’.  Further, a director’s lack of belief in climate change, or whether it was human-induced, would not provide sufficient protection. “The Court will ask whether the director should have known of the danger”².

As such, Hutley and Hartford-Davis concluded that directors who fail to consider climate change risks now could be found liable for breaching their duty of care and diligence in the future. They also concluded that there is no legal obstacle to Australian directors taking into account climate change risk where those risks are, or may be, material to the interests of the company and arguably the ASX Listing Rules already mandate this.

Recognising the need for greater disclosure of climate related risks, in April 2015, the G20 asked the Financial Stability Board (FSB) to “convene public- and private-sector participants to review how the financial sector can take account of climate-related issues”. The FSB is an international body that aims to promote international financial stability by coordinating national financial authorities and international standard-setting bodies.

In response, the Task Force on Climate-related Financial Disclosures (Task Force) was launched to develop recommendations for voluntary climate-related financial disclosures. It is chaired by Michael Bloomberg, and is made up of 32 members drawn from the private sector across G20 economies, including major companies, accounting firms, banks and insurers. Australia’s member is Dr Fiona Wild, Vice President, Climate Change and Sustainability at BHP Billiton.

In December 2016, the Task Force published a set of draft recommendations which aim to assist businesses to analyse and disclose climate change risks. Following a consultation period, the Task Force’s final report will go to the G20 in May 2017. The Task Force recommendations represent a strong push by an influential body of stakeholders to propel climate related risk reporting from the periphery to the core of public financial reporting. The clear hope is that, despite the challenges this poses because of the complexity of the issue, the area will develop and standardise rapidly and the Task Force are hopeful that a five year time horizon is achievable.

The Task Force provides broad insight into what will be required for disclosure of climate change risk to be effective. Key takeaways for companies include:

• Financial impact assessment will require senior management engagement. The Task Force considers the scenario testing recommended³ will lead to the need to assess impacts on core financial metrics such as cash flow analysis and asset valuation. As such, the expectation is that CFOs will need to be involved in the evaluation of climate-related risks and opportunities.
• Disclosure needs to be useful. The Task Force is pushing the mantra of “forward looking, decision-useful information” as the basis for disclosure. It recognises concerns around scenario testing revealing commercially sensitive business strategies or being used as fodder for climate litigation, but considers these should be able to be managed rather than used as a basis for making limited disclosure.
• Waiting for better data tools is not good enough. The Task Force is pushing for disclosure to work with the data and methodologies available and suggests that gaps and limitations are highlighted (rather than those gaps being used as the reason for not disclosing). In particular, the Task Force considers that asset owners and asset managers should engage with reporting metrics on GHG emissions associated with their investments.

In addition, the Task Force developed seven principles to assist in the achievement of high-quality and decision-useful disclosures. Disclosures should:

1. represent relevant information
2. be specific and complete
3. be clear, balanced and understandable
4. be consistent over time
5. be comparable among companies within a sector, industry or portfolio
6. be reliable, verifiable and objective
7. be provided on a timely basis

The Task Force has set out a framework for disclosure, which aims to identify the information needed by investors, lenders, and insurance underwriters to appropriately assess climate change and price climate-related risks and opportunities. Recommended disclosure requirements are structured around 4 themes as set out below. 

Governance: Who should be responsible for assessing and reporting on climate-related risks and opportunities?

It is recommended that climate-related financial disclosures are subject to appropriate internal governance processes. For companies with publicly traded debt or equity securities, the Task Force suggests that internal governance for climate-related disclosures should be similar to existing public financial disclosure. This may involve review by the chief financial officer and audit committee. For other companies, climate related disclosures should follow similar review and approval protocols currently used for similar communications. Utilising existing governance systems will help companies to integrate climate-related financial disclosures. The Task Force recommends both disclosure of the board’s oversight of climate-related risks and opportunities and management’s role in assessing and managing those risks and opportunities.

Strategy: What are the actual and potential impacts of climate change?

Investors need to understand how climate change may affect company strategy. The Task Force recommends that companies analyse and disclose:

• the climate-related risks and opportunities that the company has identified over the short, medium and long term;
• the impact of climate-related risks and opportunities on business, strategy and financial planning; and
• the potential impact of different climate scenarios, including a 2⁰C-compatible scenario. 
  

Risk management: What processes are used to address these impacts?

The Task Force recommends that companies disclose their processes for identifying, assessing and managing risk, and how these fit into the company’s overall risk management strategy to allow investors and other stakeholders to assess the company’s overall risk profile and risk management activities. 

Metrics and targets: What data sources and methodologies can be used to measure these impacts?

It is necessary that companies disclose the metrics and targets that have been used in assessing risk to allow investors to analyse any disclosures made, and allow companies to be compared within a sector or industry.

In addition, the Task Force has developed specific guidance for the financial sector as well as certain non-financial sectors that are considered to be most affected by climate change – energy, transportation, materials and buildings, and agriculture, food and forest products. Companies operating in these sectors should consider the Task Force’s recommendations in formulating a disclosure framework that best fits their business.

The Task Force’s recommendations and the Hutley Opinion demonstrate it is clearly time for the Australian business community to elevate climate change considerations to the board room to ensure that all companies and directors are aware of, and prepared for, its short- and long-term impacts.

In the Task Force’s view, the success of its recommendations depends on near-term, widespread adoption by organizations in the financial and non-financial sectors. Only then will climate change risk analysis become ingrained in business risk management and strategic planning processes.

Adopting the Task Force’s recommendations may be a practical measure to help Australian companies adequately disclose climate-related financial risks, and assist directors to fulfil their duty of care and diligence. Such steps should ensure that the following does not come to pass: “It is likely to be only a matter of time before we see litigation against a director who has failed to perceive, disclose or take steps in relation to a foreseeable climate-related risk that can be demonstrated to have caused harm to a company (including, perhaps, reputational harm)⁴.

Norton Rose Fulbright, in conjunction with the Future Business Council and Point Advisory, will be providing Climate Risk Training for directors and senior management. These training sessions will commence in May, and further details can be found here.