Climate-related risk: a rising bar for directors’ responsibilities

There is a growing body of commentary on the implications of climate change for Australian companies and their directors. Investors and regulators alike are demanding better climate-related financial disclosures and are alive to 'greenwashing'.

Climate change and a range of other issues including modern slavery, have been swept up in a tide of broader ESG momentum. As a result of this groundswell, climate-related risk has shifted from a corporate social responsibility feature, to an important consideration for all Australian corporates in two important ways. First, in identifying climate-related risks and opportunities, and second, in addressing how they are reported.

What are climate-related risks?

Climate-related risks tend to be characterised as ’physical‘ or ’transition’ risks. Physical risks include events like floods, cyclones and fires. Transition risks are those risks that result from the transition to a lower carbon economy and may include asset write-downs and devaluations for carbon intensive assets, litigation related to environmental damage and costs associated with increasing environmental regulation and ESG-related shareholder activism.

Shifting corporate obligations

It’s trite to say that the ground is shifting when it comes to companies’ obligations to manage and report climate risks and opportunities, but there is now general agreement among regulatory and industry bodies that climate risk demands a considered response from companies and their directors.

Most observable is increased attention from bodies including ASIC (Managing climate risk for directors), APRA (Understanding and managing the financial risks of climate change) and RBA (Climate Change and the Economy); new and amended financial reporting frameworks to cater to climate-related risks from the Task Force on Climate-Related Financial Disclosures (TCFD), the AASB and AUASB and ASX Corporate Governance Council; and support for consideration of climate risk from investor bodies including the Investment Association and the Investor Group on Climate Change .

The challenge 

While there is clear support for companies to consider their exposure and respond to climate risk, the challenge lies in how best to meet those obligations. How can companies, their directors and officers ensure they are properly considering, managing and reporting climate risks? Just as important are practical considerations: how can sound decisions be made about the ways that climate risks will materialise in the face of insufficient data? 

It is always a challenge to manage risk with imperfect information, in an uncertain and changing environment. All that the law can expect is for directors to make well-reasoned judgements based on the best information available. That said, there needs to be a process so that as new information becomes available, prior decisions can be reviewed and updated if necessary.

Good board oversight requires that directors ensure the entities they lead both respond and describe how they are responding to the potential short and longer term implications of climate-related matters.

The ASX Corporate Governance Principles and Recommendations suggest that a listed entity should establish a sound risk management framework, periodically review the effectiveness of that framework and disclose whether it has any material exposure to environmental risks, including climate risk and if so, how it manages or intends to manage those risks.

It is now widely recognised that climate risks are linked to systemic financial risk and that the management of climate risks may impact an entity’s ability to create long-term value for security holders (see for example, Governance Institute of Australia, Climate change risk disclosure: A practical guide to reporting against ASX Corporate Governance Council's Corporate Governance Principles and Recommendations). Even where entities are not directly part of ‘high risk’ sectors (such as mining and resources, energy, asset ownership/management and agriculture) the systemic nature of climate risk may expose a broad range of entities to financial risk.

With a focus on maintaining investor confidence both ASIC and the ASX Corporate Governance Council strongly recommend that listed entities, their officers and directors look to the TCFD framework to guide their consideration of whether they have a material exposure to climate risk and if so, how to make disclosures which are useful for existing and potential investors, lenders and other creditors.

The TCFD framework recommends that companies make disclosures in relation to four key areas:

1. governance structures with respect to climate risks and opportunities;
   
   
2. strategy around the actual and potential impact of climate risks and opportunities;
   
   
3. risk management structures to address climate risks and opportunities; and
   
   
4. metrics and targets used to assess and manage, such risks and opportunities.

To make climate risk disclosures, organisations need to go beyond a siloed approach to disclosure in discrete sustainability reports and deep-dive into a rigorous assessment of their exposure and management practices in order to satisfy regulators and investors. A good example is BHP’s latest annual report. While BHP does produce a sustainability report it has specifically included in its financial statements an analysis of the 'risks associated with changes in climate patterns, as well as risks arising from policy, regulatory, legal, technological, market or other societal responses to the challenges posed by climate change'.

Directors’ duties 

The 2019 update of the Hutley SC and Hartford-Davis landmark 2016 legal opinion on how Australian law requires company directors to consider, disclose and respond to climate risk settled that directors who do not properly manage climate risk could be held liable for breaching their legal duty of due care and diligence under section 180(1) of the Corporations Act 2001 (Cth) (Corporations Act). There are two key questions raised by this provision: what is the nature of the duty and exactly to whom is it owed?

As to the nature of the duty, the degree of care and diligence required of a director depends upon the nature and extent of the foreseeable risk of harm. Today there are material and understood issues associated with climate risks that would likely be regarded by a court as foreseeable.

On the second question, in general directors owe their various duties to the company as a separate legal entity. Sometimes this is interpreted to mean only the members as a whole, however most commonly it is now taken to require directors to consider the interests of: existing members (who have the most immediate financial holding in a solvent company); the company as a commercial enterprise (as opposed to the interests of individual members); creditors of the company (in certain circumstances); and beneficiaries (if the company is a trustee or responsible entity or similar). Cases like Bell focus on the company as a separate legal entity and emphasise that directors owe their duties to the company as a separate legal entity. On this view, the interests of shareholders and the interests of the company are seen as correlative not because the shareholders are the company but, rather, because the interests of the company and the interests of the shareholders intersect.

In addition to the duty of due care and diligence, a failure to properly consider and manage climate risk may also place directors at risk of offending the section 181(1) duty requiring directors to act in good faith in the best interests of the company and for a proper purpose. In the context of this duty, Kenneth Hayne AC QC remarked to the 2019 CPD climate roundtable that consideration of the best interests of a company requires greater focus on the corporate entity and those affected by its actions 'in pursuit of the long-term financial advantage of the enterprise'. This perspective is important because it frames the matters the board needs to consider across a spectrum from the emergence of a corporate opportunity to the perception of a foreseeable risk of harm.

Reporting requirements

There is relatively little specific prescriptive regulation of climate risk disclosure in Australia for reporting companies. 

ASIC regards climate-related disclosures in a company’s operating and financial review under section 299A(1)(c) of the Corporations Act to be required where climate risk is a material issue that could affect the company’s achievement of its financial performance. Even where a company forms the view that climate risk is of no present material impact, increasing expectations from regulators and investors will necessitate an explanation of these decisions.

In the Centro decision, approval of the annual financial statements of Centro was considered to be both an obligation that arose in the context of the duty of care and diligence, as well as a specific statutory obligation imposed on each director individually. In that case the Court found that a director’s declaration regarding annual financial statements must be to the effect that in the director’s opinion the financial statements and notes are prepared in accordance with the legislation. In the context of Centro, it is reasonable to expect that a court would find that directors have both a general and specific duty in relation to climate-related risk. It is now well understood that adequate risk disclosure is an important aspect of a director’s obligation to ensure that the financial statements properly describe risks that could substantively impact the entity’s ability to create or preserve value for security holders over the short, medium and long term.

The evidence that directors need to consider climate risk is supported by the growing number of companies that are reporting on climate risk expressly, particularly those adopting ESG reporting based on the TCFD framework and the United Nations Sustainable Development Goals. KPMG has reported that 78 percent of ASX100 companies acknowledge that climate risk is a material financial risk, up from 52 percent in 2017. Further, 58 percent of the ASX100 report using the TCFD framework rising from 16 percent in 2017.

Disclosure challenges

Climate risk disclosure entails various challenges. This includes using scenario analysis as a tool to predict possible outcomes upon specific climate-risk scenarios manifesting, and quantification of the impact of physical risks by assessing scientific outputs against financial-sector inputs. Both methods are far from established and present difficulty in achieving industry and cross-sector alignment from a regulatory perspective.

Climate risk can evaluate the resilience of a company’s assets and inform strategy. These risks can be assessed alongside the other threats and opportunities that the business faces when making capital expenditure decisions or allocating capital.

There is a growing expectation that companies also report on how they assess and manage climate risk. Indeed many listed companies already have been or are beginning to engage with and develop their use of such practices, for example, BHP has been publishing scenario analyses used to assess how climate change may affect its businesses since 2015, and in 2020 it published the BHP Climate Change Report 2020 that describes their latest portfolio analysis.

Best practice in preparing financial statements and the company’s operating and financial review in particular, is evolving but it is likely to include:

• an assessment of the nature of the company’s exposure to climate risk including measuring assets and liabilities taking into account the impact of climate risk;
  
  
• if the entity does not have a material exposure, an explanation of why the board believes that to be the case. Material climate-related assumptions and associated uncertainties should be disclosed even if there are no quantitative impact; and
  
  
• for both entities that have and do not have current material exposure, providing information explaining how future climate risk will be monitored, evaluated and managed.

Given the current class action environment in this jurisdiction we expect to see a growing focus on climate-related disclosure. This will require disclosure that is thoughtful, robust and supported by sound authentication processes. It is interesting that following settlement of litigation brought against it for failure to adequately consider climate risk, Rest Super released a statement acknowledging the importance of actively identifying and managing the financial impact of climate risk. 

Companies should also be careful of 'greenwashing' since ASIC has indicated that it will focus its attention on companies that over-emphasise the extent to which they have considered climate risk related issues that could result in consumer harm.

Future outlook 

Many companies are already actively engaging with climate risk through TCFD framework disclosures, and assessment and management more broadly. In just one example, Woodside Petroleum Ltd, Australia’s largest independent dedicated oil and gas company, recently announced that it would allow its shareholders a say in its climate reporting through a non-binding advisory vote in its 2022 AGM. These 'say on climate' resolutions are viewed as driving engagement between investors and companies on climate risk and are being backed by influential groups like the Australian Council of Superannuation Investors. We anticipate that this will require more transparency from listed entities including climate risk related targets and enhanced reporting through these annual non-binding votes by shareholders.

With the all-consuming focus of the COVID-19 pandemic shifting, a US re-entry into the Paris climate accord, US President Biden’s aggressive climate bill forecast for unveiling in April 2021, talks of EU climate tariffs on Australian exports, and legal proceedings against the Australian Government for failing to disclose climate-risked posed to government bonds to kick off, it can be expected that climate risk will feature heavily in the Australian media, and policy-making and regulatory agendas in 2021 and beyond. This is only likely to magnify investor and ASIC interest in company and director approaches to climate risk.