In the UK, the two directors’ duties most relevant to climate change arise under the Companies Act 2006. First, according to section 172 of the Act directors are under the fiduciary duty to promote the success of the company for the benefit of its members as a whole. There is an express obligation under section 172 to ‘have regard’ to certain factors when acting in good faith to promote the success of the company. These factors include ‘the impact of the company’s operations on the community and environment’ and ‘the likely consequences of any decision in the long term’. Climate change is often relevant for both of these factors. Second, under section 174 of the Act directors must ‘exercise reasonable care, skill, and diligence’.
Given what the Bank of England tells us about ‘the breadth and magnitude’ of climate risks to entities across the whole economy, directors should consider climate risks when fulfilling their duties under both sections 172 and 174.
There have been five recent developments which, I suggest, heighten the standard of care and consideration to which UK directors must bring to bear on climate risks and climate change.
The first is that the TCFD will be mandatory across the UK economy. In accordance with the UK government’s TCFD roadmap, it will extend beyond premium listed issuers as it does today, to apply to a wider group of companies, banks, insurers, pension funds and asset managers by 2025. For companies, the Financial Conduct Authority has said these TCFD disclosures should be in the Strategic Report. In order for directors to sign off on that report, they must act with due care, skill and diligence to ensure the processes underlying these disclosures are robust and reasonable.
The second is financial statement integration. Last year, the international accounting standards body, the IFRS trustees, released educational materials on how the requirements of existing IFRS accounting standards apply to climate issues. This brings climate within audit remit, and Big 4 auditors in the UK are increasingly raising climate risks as a key audit matter. An influential coalition of investors have called on the largest multinational companies to produce Paris-aligned accounts.
The third is the market signal from governments setting net zero emissions targets. UK companies now operate in a jurisdiction with net zero emissions target set in law. This is an issue for multinationals and global supply chains. When the US sets the target as flagged, nine of the world's ten largest economies will have net zero emissions targets. Directors needs to consider how to guide their companies through the disruption so that their companies not only survive but thrive in the transition.
The fourth is escalating regulatory and shareholder expectations for scenario analysis and climate transition plans. In July 2020, the Bank of England Prudential Regulation Authority wrote in a ‘Dear CEO’ letter to banks and insurers that firms have until the end of 2021 before a supervisory ratchet. Under the auspices of the Climate Action 100+, investors controlling $52 trillion are assessing companies’ strategies and disclosures against a net zero benchmark. And as we saw with the Chevon and Exxon AGMs this year, investors are voting for shareholder resolutions and for nominee directors to shake up climate transition plans. Now we have the International Energy Agency’s net zero emissions scenario, which sets out an emissions pathway that gives us an even chance of limiting global warming to 1.5°C. Many companies have relied on IEA forecasts and scenarios to inform their forward-looking assessment of prices, asset valuations and corporate strategies. For these companies, I suggest that a failure of directors to have regard to the IEA's net-zero emissions scenario in their governance, strategy, risk management and disclosure practice would be manifestly unreasonable.
The fifth is climate litigation, particularly with the landmark Shell ruling in the Netherlands. By ordering Shell to reduce its emissions by 45% by 2030, the court acknowledged this would have significant impact on Shell’s growth plans and corporate strategy.
These five developments suggest that the standard of care and consideration is heightened for all UK directors. But the standard might be increased even further: the endogenous nature of climate risk as a financial and systemic risk further heightens the actions required of banks, insurers and high-emitting firms, which would in turn impact on the standard of care for directors of those companies overseeing climate risk management and climate strategy.
Lord Sales, Justice of the UK Supreme Court, discussed this extra-curially in August 2019. His Honour said that ‘as things stand, there is much force in the view that directors may and, increasingly, must take into account and accord significant weight to climate change in their decision-making’.
So how much weight? The UK is not a shareholder primacy jurisdiction, but rather adopts ‘enlightened shareholder value’. Thinking back to the section 172 factors, including the impacts on the community and the environment, it could be open to a company director to decide when promoting the success of the company that other factors outweigh the impact of the company’s operations on climate change, such as the need to provide short term shareholder returns or to provide ongoing employment for its workforce operating a carbon-intensive asset.
Back to Lord Sales. His Honour said that ‘under certain circumstances, however, their companies’ interests may be so implicated by climate change effects that their general fiduciary and due care obligations actually require them to cause their companies to take action to reduce their contribution to climate changing activity’.
I think what His Honour is alluding to is the idea that externalities can be directly internalised, for example, by means of a carbon price or compensatory damages for causing or contributing to climate impacts, such as the litigation brought by approximately 20 US cities and states against the carbon majors.
I want to suggest that externalities might also be indirectly internalised through the endogenous nature of climate risk.
In a 2018 report, the Bank of England explained that the decisions we take today, in part, determine the magnitude of climate-related financial risks in future. In this way, climate risk is not just like any other financial risk.
It is not just transition risk that can be internalised but physical risk too, particularly on medium and long-term investment and planning horizons.
The understanding that climate risks involve radical uncertainty and endogenous risks suggests that some directors are required to do more. These could include UK directors of high-emitting companies, as well as banks and insurers that finance high-emitting companies and which are themselves exposed to systemic risks if climate risks materialise on a sufficient scale. I suggest that these directors may, and increasingly must, act to reduce their impacts on climate change, to help finance and bring about the net zero transition in a way that limits warming to 1.5°C in order to promote the success of their companies.
Ellie Mulholland is the London-based Director of the non-profit Commonwealth Climate and Law Initiative and a Senior Associate in the climate risk governance team of commercial law firm MinterEllison.
This is the first of a series of posts on ‘Business Law and the Transition to a Net Zero Carbon Economy’. This series consists mainly of posts summarizing papers presented and presentations made at the 5th Annual Oxford Business Law Blog conference on ‘Business Law and the Transition to a Net Zero Carbon Economy’ which took place online on 25 to 27 May 2021. The recordings are available here. This post is forthcoming in Andreas Engert, Luca Enriques, Georg Ringe, Umakanth Varottil and Thom Wetzer (eds), Business Law and the Transition to a Net Zero Carbon Economy (CH Beck - Hart Publishing 2021) (forthcoming).