Is Climate Change a Governance Issue?

Climate change has been described as the greatest challenge of our time. It might also be the great governance challenge for boards in the next 10 years.

That is not to present an alarmist view of climate change or suggest boards take radical action on governance of climate-related risks. Nor is it to downplay the good work of many Australian organisations in the past decade with sustainability reports and other initiatives in this field.

But this view recognises that climate change, from a governance perspective, is moving to a new phase – one where global investment markets progressively factor organisation climate-related risks into company valuations and other investment metrics.

One need only look at trends in Corporate Australia to understand the significance of this change. Several of the country’s largest superannuation funds and fund managers now have sophisticated internal Environmental, Social and Governance (ESG) teams that assess ESG risks for corporates and overlay that information into broader portfolio decisions.

On the securities sell side, at least three of Australia’s largest investment banks now have specialist ESG analysts who assess corporate performance in this area. Although it is still early days, market scrutiny on corporate ESG performance, including climate risks, is rapidly rising.

Authors in this special climate change newsletter from the Governance Leadership Centre pick up on this trend. Sarah Barker, Special Counsel at Minter Ellison, examines the opinion of Noel Hutley, SC, on the extent to which the law permits or requires Australian company directors to respond to climate change risk – a must-read analysis for every director.

Barker says Hutley’s opinion confirms that, from an evidentiary perspective, risks associated with climate change have evolved from “ethical environmental” to material financial issues, and that directors who fail to grapple with them are legally exposed.

Hutley warns that directors who perceive that climate change presents risks to their business should assess the adequacy of their disclosure and reporting of them.

Australasian Investor Relations Association CEO, Ian Matheson, makes a similar point from an investor relations perspective. Matheson says ESG data is moving from qualitative to quantitative in the eyes of investors, meaning it is becoming more material.

This trend has significant market disclosure and reporting implications for companies, and by default their boards, on climate-related risks. Boards must be satisfied the organisation’s investor relations processes, which often involves the chairman in meetings with key stakeholders, is effectively communicating the ESG strategy to the market.

Ian Dunlop, the former Chair of the Australian Coal Association, writes in this issue that the “implications for boards and directors [from climate change] are profound”. He says: “Climate change will be the most important issue of the next few decades for large and small companies alike and, if handled sensibly, the real source of growth. Lack of knowledge of its real risks and opportunities represents a major governance failure.”

Dunlop says the business community, and its boards, must show leadership on climate change debate. But he argues there is much “climate denialism” in Australian boardrooms and that “Australian directors have been notable by their absence from this debate”.

For boards, the complexity of climate change science is compounded by an issue that cuts across many governance tasks. Boards that pigeonhole climate risks as a “sustainability” issue will need to think broadly about its implications.

Here are 10 to consider:

1. Organisation values and ethics

Climate change responses ultimately require trade-offs. From an environmental perspective, which projects will the board approve and which will it reject, despite their commercial appeal? How does the organisation’s climate-change response adhere to its values?

2. Board composition

Nobody expects boards to have directors who are climate specialists or sustainability experts. But boards of organisations that are higher carbon emitters should ensure they have sufficient understanding of climate risks and responses. And every director of every organisation should understand the growing importance of ESG.

3. Board sub-committees

In time, climate change could be as much an issue for the audit and remuneration committees as it is for the sustainability committee. Boards will need to take a multi-dimension approach to an issue that cuts across a range of governance tasks and influences corporate strategy.

4. Stakeholders

As shareholder representatives, boards need to understand the ESG perspective of their organisation’s investors. For example, are their industry superannuation funds or global pension funds on the share register and do they have a strong view on climate risks? What are the shareholder expectation of the organisation’s response to climate change?

5. Investor relations

Boards should ensure their organisation has adequate process to report on, and disclose to the market, any climate-related information that could have a material effect on the share price. Understanding the investor relations team’s ESG skills, and responsibility lines for communication of this information to the market, is a good place to start.

6. Activism

Stakeholder activism towards companies that are higher carbon emitters continues to grow. It started with mining and energy companies, before spreading to financiers that lend capital for these projects. Boards must be prepared for more vocal, public and sophisticated activism campaigns that fuel media stories and risk damaging corporate and board reputations.

7. Impairments

Challenging the assumptions behind valuations could become more complex for boards if climate change affects asset prices. For example, excessive water usage leads to lower land value for an organisation, or climate change affects the values of properties near the sea. Understanding how the external audit firm views climate change risks in asset valuations and potential asset impairments is a worthwhile exercise.

8. Capital management

An organisation’s climate performance, in areas such as carbon emissions and water usage, is expected to have a bigger impact on the cost of capital in coming years. Boards will need to understand the linkages between the organisation’s environment performance, its market capitalisation and how that affects the rate at which capital is provided for projects.

9. Remuneration

There was heated debate in the latest AGM season about some boards linking executive pay to “soft performance targets”, such as customer satisfaction. As climate change becomes a bigger factor in corporate performance (at least for some companies) boards might consider linking environment targets, such as a reduction in the organisation’s carbon emissions, to executive short and long-term incentive plans.

10. Director liability

The link between climate change and director liability seems tenuous at face value. But as climate change risks become more material, and disclosure obligations increase over time, some directors may have to demonstrate they exercised a sufficient duty of care in climate-change related risk management and strategy – particularly as shareholder class actions emerge. Noel Hutley’s view that directors who fail to grapple with the climate change issue could be “legally exposed” is prescient advice for the governance community.