Daniel Kalderimis. Photo / Supplied
It is a truism that you get what you measure, or more broadly, our actions are guided by what we consider. As Prime Minister Jacinda Ardern has said, climate change and how best to respond is the defining issue of our time.
This is an issue requiring a co-ordinated international and domestic response — in New Zealand's case through the Climate Change Response (Zero Carbon) Amendment Bill.
But it also requires the focus and attention of the private sector — which is why what one considers and measures becomes important.
In this context, The Aotearoa Circle, a unique partnership of public and private sector leaders, engaged Chapman Tripp to draft a legal opinion for them.
The question we were asked is to what extent (if any) are New Zealand company directors and fund managers permitted or required to take account of climate change considerations in their decision-making?
The question is important due to legitimate concerns on both sides of the debate. Some directors and fund managers fear their duties to their companies and investors could be compromised by pursuing ethical or environmental agendas. Others fear that they would be failing in their duties, and subject to potential liability, if they do not plan for the likely future effects of climate change on their businesses and investments.
The analysis is careful and complex, but our conclusions — which largely reflect common sense — can be shortly stated. We find that climate change has evolved from being a mere environmental or ethical concern to a financial business and investment risk. This does not mean it will pose a financial risk for every business and investment, but it does mean that it needs to be taken into account in decision-making.
Where the identified financial risk is sufficiently material, one would expect directors and fund managers to formulate appropriate strategies for addressing it. This is the same advice that would apply for other material financial risks, such as projected company performance, domestic economic forecasts, global trade disruption or cyber-security concerns.
Given the advice is so simple, you might wonder why there is any controversy at all. In our view, the position is not controversial and our opinion reflects settled understandings. Indeed, attempts are well under way globally and in New Zealand to require companies with public disclosure obligations to consider and disclose material climate change-related risks in their financial statements. Perhaps the most interesting aspect of our analysis is not why company directors need to consider the potential financial impact of climate change on their business, but what such consideration really means.
Financial risk to business from climate change stems from physical risks and transition risks:
• Physical risks include damage to infrastructure from sea level rise; supply chain disruption due to increased severe storm events; and/or chronic changes in weather conditions (e.g., changing rainfall patterns); and
• Transition risks include regulatory risks, such as higher prices on carbon which then affect cost structures; legal risks (compliance with new regulations, litigation); technology risks (new competition resulting from the transition to a low carbon economy); market risks (such as changing supply/demand trends); and reputational risks (such as investor demand for divestment from fossil fuel investment).
• These risks will affect different sectors of the economy in varying degrees and over uncertain timeframes. They are also related — the faster the global temperature rise and the manifestation of physical risk, the more severe the likely regulatory response.
Directors need to consider and respond only to risks that are relevant to their companies. Many company boards will rightly conclude that their businesses are unlikely to be directly affected by physical risks caused by climate change. There are likely, though, to be many companies affected, directly or indirectly, by transition risks. For instance, even if you operate nowhere near a coastline, failing to respond to consumer demand for sustainable products might mean that the market shifts out from under you.
In principle, however, directors should approach climate risk in the same way as any other risk. Risk management steps may include:
• adopting an organisation-wide risk management framework which includes climate risk;
• keeping the board and senior management up to date on climate risk, for example through periodic briefings;
• ensuring there is a sufficiently diverse range of knowledge, skills and experience on the board and within management to identify and effectively address climate risk;
• seeking independent expert advice on the climate risk faced by the company and options for addressing that risk; and
• where material risks are identified, taking concrete steps to address the company's exposure to financial risk from climate change.
For fund managers, the legal context has traditionally been less clear. This is because of the important rule that those who invest other people's money are not entitled to indulge their own ethical or environmental scruples. The courts have long been alert to attempts by fund managers to depart from their core duty of acting in the best interests of fund beneficiaries and for the proper purposes of the fund. These two tests often amount to much the same thing: investing for financial benefit.
The matter came to a head in the 1985 UK decision of Cowan v Scargill, which remains important across the common law world. The case involved a mineworkers' pension scheme managed by a committee of trustees appointed equally by the national coal board and the union. A dispute arose when the union trustees refused to agree to the adoption of an investment plan unless amended to prevent overseas investments and investments in oil. The union wanted investment in Britain and which did not compete with coal.
The court properly concluded that the object of the pension scheme was the financial benefit of its members. The investment strategy adopted needed to promote this object without distraction from competing agendas.
The case, though, has sometimes been understood as requiring a blunt 'profit maximisation' approach on an investment-by-investment basis; with the result that fund managers must by law invest in the highest-returning stocks.
We say that this was never true and is certainly not true today.
There must of course be a single-minded focus on best interests and proper purposes, but the law does not test compliance by retrospectively comparing outcomes.
It does not apply an investment-by-investment comparison to the exclusion of modern portfolio theory. And it does not require focus on short-term non-risk-adjusted gain at the expense of longer-term financial considerations.
The essence of the duty relates to conduct and approach. It is for the fund manager, and not the court, to formulate an appropriate investment strategy. In practice, any assessment will include an expected balancing of diversification, value and risk objectives over the relevant investment period. The overall approach will ordinarily be to seek to secure the best realistic long-term return.
In New Zealand, fund managers are permitted and required to take climate change-related financial risk into account when designing and reviewing investment policies, where to do otherwise could pose a material financial risk to the investment portfolio. Many fund managers are already doing just this.
There are also many funds now specifically mandated to promote sustainable or ESG investment.
But even without a specific mandate, where the identified climate-related financial risk is significant, fund managers would be expected to take action — namely by designing an investment policy which appropriately accounts for that risk. In some circumstances, due to the fund manager's risk assessment, an investment bias in favour of climate change adaptive stocks will be required. While investment approaches will differ, the key is that fund managers turn their mind to the overall objectives of the fund, what investment strategy they consider is best suited, and how climate change financial risk is likely to play into future returns over the relevant investment period.
This opinion comes at a time when there is an important wider debate over the role and greater relevance of environmental, social and governance factors in corporate and investment decision-making.
Regardless of that wider debate, we think the legal analysis of climate change risk, as a potentially material financial risk factor, is no longer controversial.
The focus should be on how best to factor material financial climate-change risk into decision-making.
• Daniel Kalderimis is a partner and Nicola Swan a senior associate at Chapman Tripp, specialising in litigation and climate change.
Read the Sustainable Finance Report here.
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