Pathway to sustainable development: legal risks of climate change for the finance sector

One of the key risks financial institutions face today is the complex legal and regulatory landscape that has developed to address the challenges of climate change. Edwina Kwan, partner at King & Wood Mallesons, explains that the targets of climate litigation have gradually diversified.

This is a result of the important role finance flows play in the global shift toward a low-carbon, climate-resilient economy[1]. The stakeholders range from pension funds to banks and import-export institutions, which not only face the continuing indirect risks arising from climate action brought against clients and investees, but are also increasingly the direct targets of climate action for their roles in financing projects associated with significant carbon emissions.

When reviewing the development of recent climate action, several key areas of risk have emerged.

Governance and disclosure of climate-related financial risks.

Disclosure is widely accepted as one of the key tools by which to manage climate-related financial risks. In what has come to be identified as the “third wave” of climate litigation, financial actors have become increasingly targeted for their failure to disclose, or insufficient disclosure of, climate-related financial risks. There is a growing body of cases, in which the cause of action can be broadly categorised into:

1. Breach of disclosure obligations found in corporations law, where shareholders and members bring proceedings against companies and trustees for lack of transparency in providing information on climate-related business risks.
2. Breach of directors or trustees’ duties for failure to consider the impacts of climate change on the performance of the company or fund’s investments.

To date, in Australia, the full scope of these duties and disclosure obligations has yet to be fully tested. In 2019, the Retail Employees Superannuation Trust was subject to proceedings commenced by a member in the Federal Court of Australia for alleged breaches of the duty to act with proper care, skill, and diligence in failing to consider the impacts of climate change on the fund’s investments and failing to provide information related to climate risks[2]. The parties reached settlement prior to hearing.

In 2021, shareholders of Commonwealth Bank of Australia (CBA) sought the disclosure of internal documents relating to CBA’s financing of fossil fuel projects, pursuant to a shareholder application to inspect company books and records[3]. While the scope of this claim is limited to the production of information under a specific request to inspect the books and records of the company, it is yet to be seen whether any further related actions are commenced as a result.

The use of directors’ duties and shareholder rights to bring climate-related claims by stakeholders reflects the evolving nature of climate change litigation.

Beyond disclosure, a further challenge for stakeholders in the financial sector will inevitably be to track developments in relation to the parameters of such disclosure, and what would be considered sufficient with respect to climate risks.

Prudent financial management of climate risks.

As observed in the Grantham Research Institute’s 2022 report on global trends in climate change litigation, there has been a gradual shift from climate cases concerned with disclosure to those concerned with what prudent financial management means in the context of the transition to a low-carbon economy[4].

The focus of the latter is broader, placing a greater emphasis on the responsibility of boards and senior management to consider the impacts of climate change in their decision-making processes and business plans.

In the UK, Friends of the Earth commenced action in 2021 against UK Export Finance (UKEF) for its decision to make a US$1.15 billion investment in an LNG project in Mozambique[5]. The applicants challenged the legality of the decision on the grounds that it was inconsistent with the UK’s obligations under the Paris Agreement, and that UKEF had failed to make sufficient enquiries about the amount of scope-three emissions that would be emitted in the project. Friends of the Earth’s appeal against an initial dismissal ultimately failed on jurisdictional grounds.

More recently, on 9 February 2023, ClientEarth filed a derivative action against Shell’s board of directors – with the backing of institutional investors holding more than 12 million shares in the company – for an alleged failure to mismanage material and foreseeable climate risk and breach of directors’ duties under the UK Companies Act.

ClientEarth has claimed that by failing to adopt and implement a climate strategy that properly aligns with the Paris Agreement, Shell’s directors have failed to promote the success of the company for the benefit of its members. As part of their obligations, the directors were required to consider, among other factors, the likely consequences of any decision in the long term and the impact of the company’s operations on the community and the environment.

This action represents a significant milestone in climate litigation as it demonstrates that company directors can be challenged to uphold their legal duties to manage climate risk by preparing companies for the net zero transition.

The UKEF and Shell cases demonstrate the role of the boards of financial stakeholders in managing climate risk by preparing companies for the net zero transition. The cases also highlight the need for boards and management to take care to integrate climate considerations into their overall business strategy and risk appetite, and to evidence such considerations in their decision-making processes as appropriate.

Regulatory guides provide a useful starting point. For instance, APRA’s 2021 Prudential  Practice Guide (CPG 229)[6] sets out a view on best practice for prudent boards and senior management of financial institutions to respond to climate change. The guide describes responsibilities of oversight, including adopting a long-term view in assessing climate risks, incorporating climate considerations into business risk matrixes, and implementing appropriate policies and tools to manage climate risk exposures.

Greenwashing risks

Amid growing investor demand for ethical investment options, there is an increased risk of greenwashing when financial stakeholders present their offerings as more environmentally friendly, ethical, or sustainable than they actually are.

In Australia, overstating or misrepresenting green credentials can constitute greenwashing under various existing legislative frameworks. For financial stakeholders, it is important to take note of the increasingly stringent approach to greenwashing for financial products.

Greenwashing claims have been commenced in the Australian courts, including a landmark case in August 2021 in which the Australasian Centre for Corporate Responsibility commenced proceedings against Santos for its claims that it produces “clean fuel” and plans to reach net zero emissions by 2040.

This case is the first greenwashing proceeding worldwide to challenge the veracity of a company’s net zero emissions target as being misleading rather than simply inadequate. The case is currently pending before the Federal Court.

ASIC has also taken action against five entities for reported greenwashing since October 2022, including against an investment manager and a superannuation fund for overstating investment screens that claimed to prevent investment in companies involved, respectively, in significant tobacco sales and in “polluting”.

The first court proceeding commenced by ASIC for greenwashing was against Mercer Superannuation in February 2023, for allegedly misleading statements regarding its superannuation investment options – which it claimed were not invested in carbon-intensive fossil-fuel, alcohol or gambling companies.

Unlike ASIC’s previous greenwashing actions, which resulted in the subject companies paying infringement notices, in this case ASIC seeks declaratory and adverse publicity order relief in addition to injunctive and pecuniary orders. This will likely proceed to hearing due to the significant public interest and be used as a something of a test case for other financial stakeholders.

Climate change litigation has also been commenced against financial stakeholders in relation to human rights obligations. Rights-based arguments have increasingly been used in climate change related cases.

In April 2023, the Tiwi Islands traditional owners lodged human rights complaints against 12 banks, including the big- four Australian banks, over a A$1.5 billion (US$995.7 million) loan to Santos to finance the high-profile Barossa gas project. These complaints followed shortly after Santos lost an appeal, in December 2022, against a decision that overturned approvals for the project, on the basis that it had failed to properly consult traditional owners as required by regulations.

While these complaints are currently being brought under the banks’ own human rights grievance procedures, it is foreseeable that the traditional owners may take future action against certain banks in relation to their financing of the Barossa project.

Risk associated with climate change extends to all sectors. Financial stakeholders will also need to adapt to a new risk matrix in light of increased climate and associated financial risks. Ensuring strong governance and disclosure of climate-related financial risks, undertaking a climate risk mapping exercise, and having clear, credible climate-related targets and offerings that can be substantiated, will assist financial stakeholders in managing climate risk.

This article first appeared in KangaNews Sustainable Finance H1 2023.