Directors' duties and climate risks: business as usual?

Answer

It is now widely accepted that human-induced climate change is a reality. The traditional assumption regarding climate change was that it was purely an environmental, or ethical, concern. Companies viewed it as an issue of moral significance, but not an issue which posed any real risks beyond its reputation. This is no longer the case.

Climate change is now a corporate governance issue. Consumers and investors alike are placing increasing levels of pressure on companies to consider climate-change-related risks in their management and reporting obligations. There is also a growing risk of litigation being brought against companies, and their board members who fail to adequately manage these risks. Mark Carney, former governor of the Bank of England, has warned that companies which fail to adapt to climate change will go bankrupt "without question". Wealthy investors are also getting serious about the environment. Jeff Bezos, CEO of Amazon committed $10 billion to climate-change-related causes earlier this year and last week he gave $791 million to 16 groups fighting climate change.

Claims against directors and other professionals for failing to manage climate change are without question a developing risk and one that insurers and their lawyers are watching carefully.

Climate change as a financial risk

Climate change is now a headline issue. The risks have transitioned from being purely ‘environmental’ or ethical issues in nature, to issues which create foreseeable financial risks (and opportunities) in the short, medium and long-term.

The financial risks of climate change can be split into two broad categories – physical risks and transition risks. Physical risks are those risks directly caused by the environment, such as extreme weather events and changing climate conditions (eg, hotter, dryer). These risks affect physical assets, agriculture and workers, causing asset values and productivity to decrease. Economic transactional risks (and opportunities) are caused by the realignment toward a low-carbon economy, either through increased state intervention (regulation) or market forces. Both transitional risks and physical risks will have detrimental effects on financial institutions, including insurers.

In addition to physical and transitional risks, climate change also exposes directors and trustees of major financial institutions to litigation risks, arising from their failure to properly manage the above-mentioned risks.

Climate change: insurance risks

A company director can, in certain circumstances, face a claim directed against them in their personal capacity (discussed below). If such a claim materialises, a director will look to either the company or the company's directors' and officers' (D&O) liability insurance policy to indemnify them. The D&O policy is intended to indemnify a company's directors against liability for wrongful acts (including defence costs) for breach of trust, breach of duty, negligence and wrongful trading

A D&O policy will usually contain an exclusion for any acts or omissions while acting as a trustee of the company's pension scheme. As such, a separate Pension Trustee Liability (PTL) policy will need to be taken out. This policy is intended to indemnify a trustee against claims for wrongful acts, including breach of duty.

Insurers are increasingly aware of the risks of claims being brought against directors and pension trustees for failing to properly account for the risks created by climate change in the performance of their duties. The extent to which climate change risks are relevant to the duties of directors and pension trustees is considered below.

Climate change and the impact on directors' duties

The Companies Act 2006 (Section 172) imposes a legal duty on directors to "promote the success of the company" and to "exercise reasonable care, skill and diligence" (Section 174). In acting to promote the success of the company they must consider a range of factors, including the impact of their decision in the long-term and the impact of the company's operation on the community and the environment (Section 172(1)(d)). A director must therefore consider both the company's effect on the environment and conversely the environment's effect on the company (ie, climate change risks). If a director does not deal with these considerations, they may find that they have failed to act on risks and opportunities that climate change creates in the future, opening themselves up to potential liability.

As a director owes a duty to the company itself, it is the company who must act. The decision to take action would be made by a majority vote of the board. Therefore, so long as a board remains united, no action will be taken. Directors will generally be reluctant to act against a fellow director.

If the board is unwilling to action a breach of duty, a shareholder may instigate a derivative action under Section 260(3) of the Companies Act 2006. A derivative action allows a shareholder to stand in the shoes of the company and commence enforcement proceedings on behalf of the company. By way of example, a shareholder may feel that the directors have failed to mitigate or adapt to the risks of climate change by failing to invest in new technologies which are necessary to operate in a carbon-free economy. The lack of investment and reliance on old technology has caused the company's share price to fall and the shareholder wants to force the directors to take action to protect the share value from falling further.

There are also examples of NGOs purchasing shares in order to pursue a derivative action against directors alleging breach of duty, with the objective of influencing a company's behaviour. For example, ClientEarth has recently successfully challenged Enea SA's decision to construct a new coal-fired power plant in Poland. The NGO argued that the construction of the power plant imposed an indefensible financial risk to the company, given the falling price of renewables, rising carbon prices and potential statutory reforms. Derivative actions are a powerful tool for NGOs who may otherwise lack the sufficient locus to take action against the company.

Such claims however can only proceed with leave of the court and are generally dependent on the shareholder establishing that the company has suffered loss as a direct result of the breach, that the shareholder is acting in good faith and that the proceedings are in the best interests of the company. This will be assessed by determining whether a hypothetical director fulfilling their duty to promote the success of the company would bring the claim.

While the UK courts may not yet have experienced significant volumes of climate-change-related litigation (particularly in the context of directors' duties), this cannot be said for the rest of the world, particularly the US and Australia. The UK may well start to see a growing trend of shareholder activism, with minority shareholders bringing derivative actions in order to influence corporate behaviour surrounding climate change.

Climate change and Pension Trustee Duties

Trustees of pension funds owe the beneficiaries of the fund numerous duties. These duties overlap to a large extent with the duties owed by directors to their company. Pension trustee liability in relation to climate change risk assessment and management may arise in similar circumstances to that of company directors, albeit from an investment perspective more so than a managerial perspective.

A pension trustee owes duties of care and skill in the administration of a pension. Among the core duties owed by a trustee are the duties to act prudently, act in the best interest of scheme beneficiaries and to exercise their wide-ranging investment powers. These investment powers should be exercised for the proper purpose of the pension scheme, which is generally interpreted as maximising returns for its members.

Trustees have a statutory duty to consider financially material factors in their investment decisions. As of October 2019, trustees are required to disclose in their statement of investment principles (SIP) how they manage financially material considerations (including climate change) in administration of the pension scheme. They aren't, however, required to consider climate change, other than to the extent it is a material financial risk.

Considering climate change in the context of financial risk aligns with a trustee's duty to act in the best interest of its members. If a trustee was to take into account climate change as a moral viewpoint – as opposed to a financial risk – when making an investment decision, they would still be required to show financial grounds for their decision or risk breaching their duty to act in the best interest of their members.

As such, in determining whether to take climate change into account when making an investment decision, the emphasis is still firmly placed on financial considerations (ie, to what extent climate change will affect the investment portfolio). In November 2020, one of Australia's largest pension funds (REST) settled a lawsuit brought by a fund member alleging breach of fiduciary duty for failing to adequately consider the risks of climate change in managing investments. While the settlement did not set a legal precedent, it may encourage similar lawsuits around the world. 

If a pension trustee fails to consider and manage the risks created by climate risk in performance of their duties, and the pension fund loses value as a result, they may find they are personally liable for the losses caused.

Disclosure requirements of directors and pension trustees

The accurate reporting of a company's financial position and the risks and opportunities it faces due to climate change are becoming increasingly important. Shareholders are increasingly looking for companies to report more fully on climate risks and for this disclosure to be transparent. For instance, a significant number of institutional investors, with over $34 trillion of assets under their management, are now asking companies to report in accordance with the recommendations of the Taskforce on Climate-Related Financial Disclosure.

Directors may also face separate liability for misreporting risks, as this can potentially mislead investors and other company stakeholders. Section 90 of the Financial Services and Markets Act 2000 (FSMA) provides a statutory remedy to shareholders who suffer loss due to an untrue or misleading statement, or an omission of necessary information within a prospectus of listing particulars (or a supplement to those documents). Such a claim may be brought directly against the directors or the company itself. Section 90A extends liability for misleading statements or omissions made within company announcements and publications. Unlike Section 90, a Section 90A claim may only be pursued against the issuer. 

The general duties owed by company directors have a strong link to corporate disclosure and reporting. A company's disclosure will reveal the extent to which its directors have considered climate risks in performance of their duties, as discussed above. The absence of reporting on the risk would suggest that the risks have not been considered by the directors, potentially breaching their duties owed to the company.

Climate risk reporting is a major source of litigation in both Europe and the US.

As noted above, pension trustees are required to disclose in their SIP how they take into account financially relevant considerations in management of the scheme. The Pension Scheme Bill contains new regulation-making powers regarding climate change risks and sets out requirements for how these will be assessed, managed and communicated to scheme members.

Climate change litigation: a growing risk?

As social norms change, so too will the expectations of what amounts to “reasonable care, skill and diligence”. The financial risks caused by climate change are now material and measurable in the short to long-term. There is an expectation by both shareholders and pension scheme beneficiaries that the financial risks of climate change will be considered by directors and trustees in performance of their duties. This expectation is enhanced by the increasing awareness of the financial risks through industry guidance provided to trustees and directors, which will form the basis of a court's consideration of the reasonableness of the actions taken by a director or trustee.

Although the UK courts have not yet had to consider whether and in what circumstances failure to assess and manage climate-change-related risks would breach a company director's duties or those of a pension's trustee, the issue is increasingly likely to come before the courts.

Beyond the UK, climate litigation is on the rise. The proliferation of climate litigation internationally is normalising the concept of corporate accountability for foreseeable climate-change-related losses and loss attributable to misleading or inadequate disclosure. While a significant proportion of these cases have involved governments (as opposed to directors or pension trustees), these cases should not be ignored by directors or trustees, as they demonstrate the potential risks that will be faced if they fail to properly consider the risks of climate change in the performance of their duties.

Despite the procedural hurdles of a shareholder pursuing a derivative action, the risk of an action being brought against a director is real. Although the cost of pursuing a claim (including the risk of paying the director's/trustee's costs should a claim be unsuccessful) is potentially enormous, as we have seen, activists are being encouraged by wealthy third-party funders to take action.  

Notwithstanding the success of individual claims against a director or pension trustee, climate litigation is being used as a tool to promote awareness of a company's responsibility for climate change and the expectation that a corporate should be held accountable for climate change. Over time, this increased awareness may create an environment where the courts are more willing to find that a director has failed to assess and manage climate risks. There are also personal and corporate reputational issues to consider, regardless of the outcome of the litigation.

Conclusion

Company directors and pension trustees must have a thorough understanding of the financial risks created by climate change. If they fail to account for these risks in carrying out their duties, they risk litigation being brought against them in their personal capacity. While litigation of this nature is still uncommon in the UK, insurers should ready themselves for the likelihood of claims being made under D&O and PTL policies in the near future.

Charlie Underwood is a trainee solicitor at RPC.