The gathering storm - and how to prepare

“On the one hand, good governance should intrinsically include effective climate governance… On the other hand, climate change is a new and complex issue for many boards that entails grappling with scientific, macro-economic and policy uncertainties across broad time scales and beyond board terms.” – World Economic Forum, January 2019

With the evolution of climate change from an “environmental” issue to one with clear financial risks, directors are becoming more aware of climate-based threats and opportunities that may have a material impact on their business’s performance, position or prospects. The challenge is to find specific tools relevant to the business they govern.

Three types of climate change impacts on business are now emerging more clearly, and more quickly than expected.

Physical risks

In January 2019, the World Economic Forum (WEF) identified seven of the eight top economic risks by likelihood and impact as climate change-related: extreme weather events, failure of climatechange mitigation and adaptation, natural disasters, biodiversity loss and ecosystem collapse, man-made environmental disasters and water crises.

These physical risks will directly affect many New Zealand businesses. For example, the agriculture, horticulture and fisheries sectors are likely to be impacted by more volatile weather or warmer seas. As the climate shifts, so do viable land uses and fish availability – and the increased risk of bio-incursions (introduction of exotic pests) is a particular concern. In addition, tourism and businesses with coastal property and infrastructure investments may be affected.

Physical implications will also flow through those with second-tier exposure to the frontline (eg lenders and insurers) and impact the price or availability of finance and insurance.

Transition risks

Transition risks are being felt by businesses already, and these can either be negative or positive for particular businesses. There are the indirect impacts arising from regulation, investor and customer reactions, stranded assets and changing business models.

New regulation

The Climate Change Response (Zero Carbon) Amendment Bill is currently before the New Zealand Parliament and is expected to be enacted by the end of 2019. It proposes to:

  • set greenhouse gas emissions reduction targets to net zero by 2050 (except biogenic methane – where the target is 24-47% of 2017 levels by 2050)
  • set emission budgets as stepping stones to the long-term target
  • require government to implement policies for climate change adoption and mitigation
  • establish a Climate Change Commission to monitor and advise.

The United Kingdom’s Climate Change Act 2008 shows it is possible for legislation of this type to significantly reduce emissions while growing an economy – and that the legislation shifted the competitive balance for many companies.

In addition, the New Zealand Government’s agreement, in August, to act on recommendations from the Task Force on Climate-related Financial Disclosures will likely create further transparency for investors and others on the climate change impacts for listed companies, banks and insurers in particular.

Investor and customer reaction

Consumers are already asking questions about the carbon footprint of the goods and services they buy, and for some it goes to the social licence to operate. One example is the “flygskam” (flight shame) movement in Europe.

These consumer concerns are likely to spread to other markets as climate consciousness increases. However, the transition will not all be downside risk.

We have already seen advertising promoting the benefits of paper from sustainable forests processed using geothermal power.

Investors too are changing their priorities. For example, the NZ Super Fund has reallocated close to a billion dollars away from companies with high exposure to emissions and reserves into lower-risk companies, to make its portfolio more resilient to climate change.

Green bonds are also emerging as lowercost lines of finance with Auckland Council, Contact Energy and Westpac NZ having made successful issuances this year.

Stranded assets and changing business models

These changes shift the value of businesses and assets. A 2015 study published in Nature magazine estimated a third of global oil reserves, half of gas reserves, and more than 80% of known coal reserves would remain unused if targets under the Paris Agreement are met.

Liability risks 

One of the latest trends is the use of litigation by activists to raise the profile of climate change, in New Zealand and overseas.

In August 2019, Mike Smith, chair of the Climate Change Iwi Leaders Group, filed High Court proceedings against eight high-profile New Zealand businesses alleging the companies’ carbon emissions constitute a public nuisance and that failing to address them constitutes negligence or breaches other duties.

In 2018, in Australia, Mark McVeigh claimed against his superannuation scheme provider, REST, for failing to have, and failing to disclose, strategies to deal with climate-related risks relevant to his retirement savings.

The case is a prompt for New Zealand licensed fund managers and supervisors to reflect on their duties under the Financial Markets Conduct Act, both of disclosure and prudence.

The public sector, too, is not immune to the risks, with New Zealand QC Jack Hodder issuing a paper in March 2019, warning that “there are local indications that, in some form, climate change litigation will get real traction” against local authorities.

Directors’ liability risk could be personal, too.

Leading New South Wales barrister Noel Hutley SC argued, in opinions issued in 2016 and 2019, that Australian company directors who fail to consider and disclose foreseeable climate-related risks could be held personally liable for breaching their duties under the Corporations Act. Hutley warned that it is “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”.

We expect to see a similar opinion commissioned by the Aotearoa Circle in New Zealand soon, given the Companies Act contains a similar duty “to exercise the care, diligence and skill of a reasonable person in the circumstances”.

What should directors do?

Whether driven to act by their understanding of the underlying economic drivers at play, or by the concerns of governments, and corporate regulators, mainstream director sentiment is shifting from “why would this be relevant to our business?” to “what are the implications for our business, how should we strategise and manage them, and what should we disclose to the market?”

These are not easy questions. While the direction of travel is clear, the timing, magnitude and location of impacts is uncertain.

The WEF’s How to Set Up Effective Climate Governance on Corporate Boards – Guiding principles and questions provides one approach. It sets out eight principles, each with guiding questions to help identify and fill gaps.

Principle 1

Climate accountability on boards Climate change should enliven directors’ governance duties as with any other issue presenting financial risks.

Principle 2

Command of the subject Boards should be composed of directors who collectively have sufficient awareness and understanding of how climate change may affect the business.

Principle 3

Board structure A board should determine how to most effectively embed climate into its board and committee structures.

Principle 4

Material risk and opportunity assessment he materiality of climate-related risk and opportunities in the short, medium and long term should be assessed at the company and understood by the board.

Principle 5

Strategic and organisational integration Once a board is aware of the extent climate change might drive material risks and opportunities for its operations, it can integrate climate-change considerations into the organisation’s strategy.

Principle 6

Incentivisation A board should ensure that executive incentives are aligned to promote the longterm prosperity of the company, including climate-related targets and indicators.

Principle 7

Reporting and disclosure A board should ensure that material climate-related risks, opportunities and strategic decisions are consistently and transparently disclosed to all stakeholders – particularly investors and, where required, regulators.

Principle 8

Exchange of ideas Boards should maintain regular dialogue with peers, policy makers, investors and other stakeholders to share methods and stay informed about the latest climate relevant risks, regulatory requirements, etc.

This article first appeared in BoardRoom, the Institute of Directors bi-monthly magazine keeping members informed of relevant governance and business issues in New Zealand and overseas.

Lloyd Kavanagh (IDP-C (INSEAD), AMP (Wharton), LLB (Otago)) is  a recognised thought-leader on key governance issues, and leads the firm's financial services practice. In December 2017, he presented at the Tokyo UNEPFI Regional Roundtable for Sustainable Finance in Asia Pacific on ‘Investors duties and obligations to integrate ESG issues in New Zealand and Australia’. He has been a company director in New Zealand and internationally, and was a board member of the Financial Market Authority’s predecessor, the NZ Securities Commission.

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