Corporate Governance & Climate Change

19 Aug 2020

Corporate Governance & Climate Change

Board members can help companies develop an integrated strategic approach to addressing climate change risks and opportunities. To achieve efficiency in today's world, boards need to add a suite of expertise onto their boards--responding to new enterprise risks, business complexity, technological disruptions, and social and environmental obligations.

CLIMATE CHANGE IS NOW A GOVERNANCE ISSUE

The message is clear: Climate Change is disrupting business.

In 2019, fifteen weather events caused $130 billion in financial losses. Sea level rise alone is forecast to cost the global economy some $43 trillion by 2100. No wonder the World Economic Forum’s “Top Five Global Risks in terms of likelihood” for 2020 are: extreme weather conditions, climate action failure, natural disasters, biodiversity loss, and human-made natural disasters. Between 2010 and 2019, 115 distinct weather events caused more than $1 billion of damage in the United States. By 2040, the real estate and mortgage markets in Florida will be struggling because of rising sea levels. By that same year, a number of the world’s essential breadbaskets—among them the American Midwest and the Mediterranean—will face a climate that does not provide for the kind of agricultural productivity that these regions currently enjoy.

In short, we are engaged in a climate emergency. Every measure seems to indicate that the world’s climate will soon be unrecognizable to us. For the last 10,000 years, the earth has been perched in a neutral zone between two extremes, the frigidness of the ice ages and the extreme heat of the hothouse earth periods. Data now suggest that if we limit warming to 1.5 degrees Celsius (2.7° F), we can maintain our equilibrium and avoid a hothouse scenario, thereby preventing untenable sea level rises, changing oceanic currents, mass biological extinctions, and food shortages. In order to achieve this 1.5-degree change, however, humans will need to reduce greenhouse gas emissions by 50% in the next ten years and reach a net-zero emissions economy by 2050.

What does this mean for directors?

Thinking about climate change mitigation and climate change risk is now part of the Director’s job. In previous decades, board members often considered climate change separate from the daily imperatives of their organizations and the scope of their obligations as directors—and many directors still subscribe to this view.

But if climate change is going to impact where people live, what they eat, how they work, and what business models remain viable, then directors have both a moral and a fiduciary duty to integrate climate change into their strategic and oversight responsibilities.

Duty of Care

The pressure to act is mounting, as courts worldwide are being asked to adjudicate on issues relating to climate change. Because directors must exercise “reasonable diligence” when informing themselves of all material information reasonably available about issues concerning their business, they are duty-bound to find the most effective way of integrating climate change into governance. Failure to do so may subject some directors to liability for breaching their duty of care.  Given the widespread availability of knowledge about climate change’s current and anticipated impact on people, countries, and businesses, directors can no longer plead ignorance about the topic and the risks it poses for their company.

CLIMATE CHANGE RISK

Companies face three different categories of climate risk: physical risk, transition risk, and compliance risk. 

Physical risk

Physical risk concerns the ways in which a company’s physical assets interact with the physical manifestations of a warming climate. This may directly involve the company’s asset base, perhaps from infrastructure loss due to extreme weather events or rising sea levels. It can also indirectly affect companies, as when climate impacts in other regions disrupt supply chains, customer bases, or global economic health.

Transition risk

The second significant risk category is transition risk: the business threats posed by society’s shift to a low-carbon, circular economy. Historically, many companies expected this transition to be gradual and almost linear—but this prediction no longer seems likely given several driving factors.

First, accelerating technological changes, declining green energy costs, and increasing customer preference for low-carbon options are hastening the abandonment of traditional energy sources. This trend is perhaps most notable in emerging markets, where development often leapfrogs traditional energy sources, investing straightaway in clean energy.

Second, growing momentum for climate change policy—especially outside of the United States—is pushing hesitant industries and organizations to adopt and pursue net-zero-aligned goals.

Lastly, the financial institutions are now throwing their weight in behind climate initiatives. Some of the world’s largest institutional shareholders are acting like activist investors, influencing green technology, and sustainability initiatives by trying to hold their portfolios accountable for meeting the Paris Climate Agreement.

For some companies, climate change poses a disintermediation risk. The coal industry, for example, is threatened by climate change not because coal is going to be any harder to mine in a warming climate, but because green technologies have become more cost-effective than coal. The fact is that coal companies are being technologically disintermediated and, therefore, need to reinvent themselves, which means their boards need to rethink their purpose as organizations and make the investments necessary to achieve this new purpose.

Compliance & disclosure risk

In addition to its moral and business imperatives, climate change action has major disclosure components. Many of the world’s largest institutional investors have joined politicians, customers, and employees in demanding that companies and their boards be proactive about climate and sustainability and find ways to improve disclosures. This poses a significant challenge for companies, who are now expected to make transparent, proactive steps to improve climate change governance and disclosures. In many companies, climate risk disclosures are mandated; there are now over 1,500 laws worldwide covering energy, transport, land use, and climate resilience.

As a result, the landscape of compliance standards and frameworks is vast. Given the overload of information and regulations, sustainability reporting can sometimes be an expensive exercise. Boards need to help determine the most appropriate disclosure methods for their companies and then extend oversight to the supply chain, rather than trusting that your suppliers will be capable and/or willing to supply high-quality disclosures.

BUILDING EFFECTIVE CLIMATE GOVERNANCE

Hindsight: Understanding a situation only after it has happened.

Wall Street giants are beginning to reckon with their roles in climate change. 

BlackRock’s chief executive Larry Fink has indicated that the investment manager is putting companies on watch and will start getting tough on groups who are not taking appropriate action on climate change.

Morgan Stanley has committed to tallying their climate impact and publicly disclose how much its business activities contribute to climate change. This shift in policy stems from increasing pressure from activists, investors, and regulators who have begun to focus on how big banks underwrite fossil fuel projects like pipelines and power plants that contribute to rising temperatures and ecosystem degradation. Morgan Stanley is hoping that its effort to tally greenhouse gas emissions from its investments will contribute to a more sustainable banking industry without upsetting the economy.

Maersk, Microsoft, Unilever, Apple, and several other leading companies have committed to transition to a net-zero global economy. The initiative is known as Transform to Net Zero, and these corporations plan to utilize their power of procurement to drive the action through their respective supply chains to affect all businesses in the economy.

Insight: The capacity to gain an accurate and deep understanding of something.

If these recent events with Wall Street’s giants have demonstrated anything, it’s that ESG issues are not slowing down because of the pandemic but, in fact, getting faster and faster. Companies and their board members can no longer wait and see about ESG and climate action but must instead be proactive. More and more shareholders and stakeholders expect effective climate action and governance from their companies. The impetus towards greater corporate responsibility is not only coming from the top down but from the bottom up.

Calls for accountability from the bottom up

Last month, a 23-year-old law student filed a class-action suit accusing the Australian government of failing to disclose the financial risk of climate change to those investing in government bonds. In 2016 a Peruvian farmer filed claims in a German court against German energy giant RWE, arguing that RWE, as a climate change contributor, was partly responsible for melting of mountain glaciers near his town and should pay 0.47% of the cost the farmer needs to protect his farm from an encroaching glacial lake. Calls for accountability from corporations and governments are growing and will be part of the new normal.

Calls for accountability from the top down

Senior members of the legal system are also calling for greater accountability. Carol Hansell, a senior partner with Hansell LLP, which provides corporate legal, government relations, and communications advice, put out a legal opinion when she released her “Putting Climate Risk on the Boardroom Table.” In her legal opinion, she states that directors on Canadian corporate boards are legally obligated to address climate risk and that “directors must put climate change on the board’s agenda as more than just a discussion point or an education session.” 

Foresight: The ability to predict what will happen or be needed in the future

By definition, you cannot make an informed decision if you are not informed. Climate change presents a new and complex issue for many boards that require the appreciation of both scientific and economic effects over a broad time scale. Yet board members are tasked with the responsibility of maintaining their company’s well-being while cultivating its resilience during these uncertain times. To do so, they must stay informed and exercise their due diligence when confronted with these new realities.

How to Build Effective Climate Governance

Boards need to integrate climate into their strategy, bringing their company’s practices and financial targets in line with the world’s climate goals. Yet many directors lack a thorough understanding of (a) climate science and (b) the technologies, stakeholders, and economic theories that have emerged to prevent widespread climate catastrophe. Here are four ways to build effective climate governance:

Education: One of the World Economic Forum’s principals of climate governance is that directors have “command on the subject.” Directors need to be climate change competent. Training and certifications are available, and there is abundant reading material from climate-related commissions, initiatives, and organizations. Because the job of the board is to hold management accountable for the resilience of the company and the long term value creation to its shareholders, directors need to be able to articulate how climate change risks are being managed, how compliant the company is today, and what the path to full compliance looks like.

Diversity: Diversity of thought is critical. An effective board includes environmental/sustainability in their skillsets composition, especially companies that need to rethink their company’s long-term identity and purpose in light of climate change and disintermediation.

Advisory boards: An advisory board can provide a dynamic perspective, counsel, and guidance in ESG matters. Before making long term strategy and decisions, boards and executives need to have a detailed understanding of the impacts that climate change will have on the business model of the company, its product, and its assets. Advisory boards can serve this function. Additionally, it’s important to monitor foreseeable policy changes related to climate change to anticipate both risks and opportunities.

Climate and ESG related risk committee: Boards should ensure that the right depth of oversight is given to climate change. Often a separate committee will be needed, a committee that can fully discuss the material aspects and elevate discussions about climate and other ESG issues to the general board agenda.

Guiding Principles

In addition to these, The World Economic Forum provides a straightforward set of principles that are designed to increase climate awareness, embed climate consideration in board structures, and improve navigation of climate risks and opportunities.

Principle 1: Climate accountability on boards

Principle 2: Command of the subject

Principle 3: Board Structure

Principle 4: Material risk and opportunity

Principle 5: Strategic integration

Principle 6: Incentivization

Principle 7: Reporting and disclosure

Principle 8: Exchange

Although broadly applicable and useful for organizations, these principles should not be taken universally and applied to all companies across sectors. They are intended to serve as tools to help strategic climate decision making, mitigation, and action.

Though it is not listed as one of the principles, boards also need to consider an organization’s purpose; it’s “raison d ‘être.” As we transition into a low-carbon economy in order to resolve our climate challenges, all companies and boards will need to reassess their role and purpose in a society genuinely.

Oversight: The action of overseeing something.

Companies without effective climate governance structures in place will struggle to make informed strategic decisions about how to work the risks and opportunities presented by climate change into their long term strategy—and, for some, this will lead to the collapse of their position in the market.

About the Authors

Mary Francia is a Partner in Odgers Berndtson’s Board Practice and based in their Atlanta office. She brings 25 years of international leadership and executive management experience in Telecom, Consumer Electronics, Media, and Healthcare to help boards with composition strategy and succession planning.

Helle Bank Jorgensen is the CEO of Competent Boards, which offers the global online Competent Boards Certificate Program with a faculty of over 80 global board members: executives and experts. She is a strategic, as well as operational, ESG adviser to boards, executives, and investors.