Climate change

James Dunn outlines the growing threats posed by climate change risk and explains why directors must make it an integral part of their duty of care.

While the responsibility of directors for ensuring that organisations manage risk for long-term success is well established and well understood, climate change risk and its impact on markets and organisations has not historically appeared to be a front-of-mind issue for Australian directors.

This is despite Australia’s corporate sector’s particular vulnerability to climate risk, given the amount of business activity with connections to natural resources. But following the publication of a legal opinion last October by the Centre for Policy Development, things could soon change.

The opinion, written by barristers Noel Hutley SC and junior counsel Sebastian Hartford-Davis, concludes that Australian company directors who fail to consider climate change risks could be found liable for breaching their duty of care and diligence.

The major elements of the opinion include:

• Climate change risks may be regarded as foreseeable by courts, and relevant to a director’s duty of care and diligence to the extent that those risks intersect with the interests of the company (for example, by presenting corporate opportunity or risks to the company or its business model).
• Directors are not legally restricted from taking into account climate change and related economic, environmental and social sustainability risks, where those risks are, or may be, material to the interests of the company.
• Directors certainly can consider, and in some cases should be considering, the impact of climate change risks on their business – and directors who fail to do so now could be found liable for breaching their duty of care and diligence in the future.

After the release of the opinion, Hutley commented that it was “likely to be only a matter of time” before we see litigation against a director who had “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.”

In February 2017, financial institutions were then put on notice by a speech by Australian Prudential Regulation Authority (APRA) executive board member, and former chief executive officer (CEO) of Suncorp Life, Geoff Summerhayes MAICD. Summerhayes warned banks, insurers and superannuation funds that the regulator considers it their [the institutions’] duty to calculate the financial risks associated with climate change, stating that these risks were an “important and explicit part” of the agency’s thinking.

While climate risks have been broadly recognised, they have often been seen as a future problem or a non-financial problem, said Summerhayes, but no more: he told the Insurance Council of Australia’s 2016 Annual Forum that the regulator now views climate risks as “foreseeable and material” to financial institutions, and expects businesses to systematically monitor, disclose and discuss the risks.

Moreover, climate change could threaten the entire financial system, something to which APRA and other regulators were “paying much closer attention.”

“To be blunt, 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,” Summerhayes said. “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,” he added.

Summerhayes’ statement addressed the risks identified by Bank of England Governor Mark Carney in 2015 in a landmark speech, which highlighted:

• Physical risk around the effects of climate change.
• Transition risk from the shift toward a net-zero emissions economy.
• Liability risk for company directors, trustees and insurers.

It followed the Paris Climate Agreement’s entry into force in 2016, and the release of the Financial Stability Board’s recommendations on climate-related risk disclosure.

Ignorance is not bliss

The prospect of litigation against company directors is a “salient reminder that climate change risks cannot be ignored,” says Will Heath, partner at King & Wood Mallesons.

Heath highlights the success that Australian Securities and Investments Commission (ASIC) has had over the past five years against directors who breached their statutory duty of reasonable care and diligence. Such actions can bring financial penalties and/or disqualification from acting as a director. “These cases have created valuable precedents for ASIC and others – including, potentially, climate change litigators – to sue company directors in the future,” says Heath.

He says there are three things in particular that should worry directors in respect of their companies’ climate change risks.

The first is the “low bar” that ASIC has to clear in prosecutions under the civil penalties regime. “ASIC can go after directors and say they were negligent or failed to consider the risk and seek a fine of $200,000 against each director. They [ASIC] only have to prove the offence ‘on the balance of probabilities’, not ‘beyond reasonable doubt’. It’s not a jury case, even though the actual punishment for breach of directors’ duties is akin to a criminal offence.”

The second is ASIC’s track record. “If ASIC brings an action against you as a company director, you’re in deep trouble. It’s a relatively low bar and they have a good track record. They’ve successfully won 22 cases of 26 brought against company directors for civil penalties in the past five years. If you’re a football team, and you’ve won 22 out of 26 games, nobody wants to go up against you. There were only three successful appeals by directors, and two by ASIC,” he says.

The third is that climate change is a very high-profile issue with elements of all three of the environmental, social and governance (ESG) trinity. In an increasingly litigious society, “it’s likely that at some point we’ll see a high-profile ‘test’ case,” says Heath. “ASIC has shown before that it is willing to pursue high-profile cases – think of its case against the Centro directors, a high-profile case that came out of the GFC and the James Hardie directors, a high-profile negligence case.”

But in light of what has been seen in the US, he says an action is more likely to emerge from a well-funded activist group. “In the US, youth activists have already launched a climate change lawsuit for failing to protect them from the harmful effects of climate change. It’s possible here that an activist group could sue – or agitate for ASIC to sue – a company board for negligence because it failed to take steps to address carbon dioxide emissions,” says Heath.

ASIC’s precedent cases against company directors establish the following general principles:

• For a director’s act or omission to be capable of constituting a breach of the duty of care, there must be actual damage caused to the company by reason of the breach; or it must otherwise have been reasonably foreseeable that the relevant conduct might harm the company’s interests.
• Relevant to the question of breach of duty is:
  • Whether a reasonable person in the director’s position would have foreseen that the conduct in question involved a risk of harm to the company.

If a risk of harm was reasonably foreseeable, what a reasonable person in the director’s position would have done by way of response to the risk, taking into account the magnitude and degree of probability of the risk, along with the expense, difficulty and inconvenience of taking alleviating action.

“The risk of harm to the company is not confined to financial harm. It includes harm to all interests of the company, including its reputation and its compliance with law,” says Heath. “In this context, it is possible that a director who takes or fails to take action without adequate regard to climate change risks may be exposing the company to a risk of harm and, in turn, a breach of duty.”

Ongoing impact

The Hon Nick Sherry GAICD, principal at superannuation and pensions consultancy Sherry & Associates International and independent director of Spotless Group Limited, says the carbon dioxide emissions/climate change issue is “conceptually no different” to the waste management issue that companies in developed countries were forced to face over the last century.

“For many years, waste was dumped into the broader community, but governments began to impose regimes of infrastructure and collection, and eventually the cost (of waste handling and disposal) was passed back to the producer,” says Sherry.

The carbon dioxide emissions/climate change issue is the same, he says. “Any industry sector – whether public or private – that has an external impact on the broader environment as a consequence of its activities will at some point have to bear the cost of ‘capture’ of the externality, and in turn that cost of capture will eventually be passed back on to the producer. Eventually it will become an additional cost and expense to the business. In a market against competitors providing a different solution, that will impact on the direction and possible survival of the business,” says Sherry.

The second element to this issue, he says, is the question of energy source. “All governments, to differing degrees, with perhaps different policy designs and different time frames, are encouraging, incentivising, subsidising or mandating renewable energy sources – that is, solar, wind or hydro. Governments, rationally or reasonably – or not – are responding to growing community concern. The convergence of these approaches means a director must consider the likely impacts, positive or negative, on the business for which they have responsibility,” says Sherry.

But businesses face considerable uncertainty over the issue, he argues. “The risk to business is in the complexity of impact and its time frame. In all jurisdictions there is highly contested debate about whether there is a problem and, if there is, what the solutions are. Given the level of contestability of policy and politics, there is considerable lack of clarity or consistency, which adds to business uncertainty,” says Sherry.

“Determining any necessary shift in the business therefore carries an onus of deep analysis and making a considered judgment on strategy. To add to the complexity, the business shift and timing may vary depending on the country in which the business operates – if a business is operating in a number of countries then timing and solutions will vary.”

Director responsibility

Sherry argues that it is wisest for directors to assume their company is affected by these issues. “The whole carbon dioxide emissions/climate change issue impacts all business to varying degrees. Even if not directly impacted, the indirect impact such as the price of energy and reducing it via an energy audit with reduction solutions, is important,” says Sherry.

Directors bear a responsibility for understanding the risks their companies face. “Directors have to understand policy and political risks. They have to have a good understanding of the basic features of the legislation. They should read widely and ask to be specifically briefed at a board level on any likely impacts – both challenges and opportunities – on the current business, any areas of existing business to exit, and new areas to enter,” says Sherry.

In addition, there is a communications imperative attendant on this. “Some stakeholders and shareholders may not agree with your decisions so you need effective oversight and communications. But companies can take it that the customer and shareholder base is increasingly interested and a ‘ticking-the-box’ approach is insufficient,” says Sherry.

Larger investors are certainly watching. “Our board has long held the view that climate change is a material ESG investment risk that can impact the long-term value of our members’ investments,” says Angela Emslie, chair at superannuation fund HESTA. “That’s why the HESTA board approved a specific climate change policy, outlining how we incorporate climate change considerations into investment processes .”

As a fiduciary, says Emslie, HESTA’s directors see it as part of the fund’s responsibility to its members to ensure that ESG factors are considered when investment decisions are made. “Similarly, we see it as a responsibility for the directors and boards of the companies we invest in to consider ESG risks and transparently report to owners and the market how they are identifying, managing and mitigating these risks,” she says. “When it comes to climate change, our engagement with companies is often focused on understanding how boards and senior management plan to transition their businesses for a low-carbon future.”

While HESTA doesn’t tell “managers or directors of companies how to manage their businesses,” the fund and its investment managers will certainly want to understand how companies are managing climate change risks, says Emslie – but this focus is also aimed at finding opportunities.

“The more we understand about a company, the better we can price in both risk and the potential for improved performance that could increase the value of our investment. This also allows us to better understand our own exposure to climate change risk through our investments,” she says. “We know that well-run companies perform better over time, and inevitably, these businesses will attract more capital from investors.”

Conversely, in the climate change context “tick-the-box” compliance will not cut the mustard if a company wants investors like HESTA and its fund managers on its register. “We think that companies that have a lax compliance culture, whether it is around climate change or other issues, will eventually face an issue that impacts the value of the company,” says Emslie.

Growing risks

Michael du Plessis, director of sustainability and innovation management consultancy Greenice, says businesses face a wide range of risks from climate change. “It could be reputational risk from changing consumer behaviour and expectations; loss of corporate customers who demand action on climate change; having stranded assets – having to write down the value of assets that have a high carbon intensity; having products made obsolete; the threat of technological change, and the need to adapt; through to the potential financial impact on assets from severe weather events, such as storms, flooding and bushfire,” he says. But, he adds, they don’t have any excuse for inaction.

Understanding a company’s climate risk has traditionally been complex, says du Plessis, but it’s effectively simple “carbon accounting.” He says businesses must understand the carbon intensity of their business operations, as well as the carbon intensity along their supply chain.

“You don’t know your exposure until you do the analysis, the carbon accounting. Once you can measure your climate impact, you can then drive reduction in carbon intensity through innovation, solutions in efficiency, behaviour and technology,” says du Plessis. “Walmart in the US, for example, is trying to reduce the carbon intensity of its supply chain by changing packaging use and smart logistics.”

This is where climate change risk can become an opportunity, he says. “When you do this analysis, sometimes surprising, counter-intuitive results are found and new, unexpected opportunities arise, for example new products and services.

“It might be that the company finds improved efficiency, lower costs and better use of resources. It could be new products and services, new technology, or new market growth opportunities in areas not previously considered. Or it could simply be improved brand enhancement and reputation with a younger demographic,” says du Plessis.

Climate change and the economy

• In Australia, more than $226 billion in commercial, industrial, road, rail and residential assets around the coast, mostly in urban areas, are potentially exposed to flooding and erosion hazards at a sea-level rise of 1.1 metres.
• This exposure is likely to increase as Australia’s population grows to a projected 35 million people by the middle of the century.
• The impact of extreme heat in 2013 and 2014 on worker productivity through absenteeism and reductions in work performance drove an annual economic burden of nearly $8 billion in terms of productivity losses.
• Heat stress in northern Australia has already reduced labour capacity in the region by 10 per cent over the past few decades, with a further 10 per cent reduction projected during the hottest months by 2050.
• During the period 1 July 1966 to 30 June 2013, insured losses due to bushfires totalled $5.6 billion, equivalent to an annual loss of $120 million.
• Between 2002 and 2003, decreases in agricultural production due to drought resulted in a 1 per cent fall in Australia’s GDP, which is equivalent to half of Australia’s decline in annual GDP following the global financial crisis in 2009.

Source: Climate Change 2015: Growing Risks, Critical Choices, The Climate Council.