- Many financial institutions are not prepared for managing climate risk exposing themselves to increased risk of climate-related litigation and regulatory enforcement. At the same time, increasing numbers of claimants are looking to use litigation to pressure businesses to follow climate friendly policies.
- A number of factors are driving up the incidence of climate related litigation and enforcement which has been most marked in North America but other regions are now catching up. Financial institutions given their critical place in financing economic activity are increasingly the focus of action.
- Until recently, claims with the primary purpose of securing the disclosure of climate-related information have predominated. The focus, however, is moving away from complaints over inadequate or insufficient disclosure to cases scrutinising what prudent financial management means. Greenwashing claims are now also on the rise.
- Financial institutions are well advised to prepare for and mitigate the risk, for example, from reviewing their corporate strategies around climate change and carbon reduction to taking note of regulators’ expectations.
Are financial institutions ready?
Financial institutions are critical players and catalysts for change in the transition to a carbon-neutral economy. This was recognised in the 2015 Paris climate agreement which specifically identified finance as having a key role in mitigating the effects of global warming with large scale investments being needed to significantly cut emissions.
Many financial institutions, however, are not prepared for managing climate risk; a fact that was recently flagged up by the European Central Bank in relation to the banks it supervises.[i] Such statements are a matter for concern as while ESG brings opportunities to the financial sector, it also brings litigation risks that financial institutions must be prepared to manage and defend. While few significant claims have yet to materialise, there are already indications that financial institutions are at risk of a wide range of litigation and regulatory enforcement, ahead of many other sectors of the economy excepting the oil, gas and extractive sectors. These include cases targeting emissions associated with an institution’s investment decisions, cases about what prudent financial management means in the context of the transition to a low-carbon economy and climate (or green) washing cases. Claimants are devising inventive theories to directly attack businesses for alleged climate-related performance and operational deficiencies. Preparedness for such litigation is therefore becoming increasingly important for the sector.
Growth in climate litigation
The trend is dramatically upwards. The UN Intergovernmental Panel on Climate Change reports that climate litigation against the private sector and financial institutions is growing.[ii] The Panel points to a growing consensus that climate litigation is now a powerful force in climate governance and is being used to exert pressure on both public and private entities to reconsider their approach. Since 2015, the year of the Paris climate agreement, the number of climate related litigation cases has more than doubled. In fact, according to Setzer and Highamin Global Trends in Climate Change Litigation: 2022 Snapshot, approximately 800 cases were brought between 1986 and 2014, but since then over 1,200 claims have been made and, of these, 25% relate to the period of the Covid-19 pandemic from 2020-2022.
Reflecting the US’s propensity for litigation, approximately 75% of climate change cases (irrespective of industry sector) were brought in US courts followed by Europe, but the number of cases in other jurisdictions is now growing. What’s more, claims arising out of the extraction of fossil fuels or the supply of carbon based energy are being brought against a more varied group of corporate defendants. So while oil and gas corporates still predominate climate litigation, there are defendants from other sectors, including finance.[iii] In fact, the Network for Greening the Financial System, in a report highlighting the growing risk of climate-related litigation, draws attention to the increasing number of claims being faced by financial institutions.[iv]
Drivers in climate litigation
Why are we seeing such a growth in litigation at this time?
- The US – with still by far the largest number of these types of claims — has a tradition of effecting policy change through litigation. The position is no different now as claimants seek to use the courts as a tool to pressurise governments and organisations to comply with climate-related commitments (e.g. reduction of fossil fuel use); other jurisdictions are now following this path.
- An increasing recognition of the inter-relationship and impact of climate change on justiciable human rights such as Article 2 (right to life) and Article 8 (rights to private and family life and home) in the European Convention on Human Rights. The courts are increasingly prepared to factor in international conventions, as well as human rights and the values they embody, when interpreting domestic legislation in identifying implied duties of care. Moreover, courts are finding that businesses as well as governments should respect human rights.
- A willingness by courts to explore the legal responsibilities of public and private financial institutions for emissions deriving from their investment decisions, also known as “portfolio emissions” value chains.
- A growing awareness of the mis- (or inappropriate) use of ESG claims by organisations coupled with an increasing legal and regulatory appetite to take action against greenwashing. The UK’s former Minister for the City of London recently spoke of the necessity for rules to prevent greenwashing and encourage clear disclosures.[v]
- Voluntary standards such as the UN-backed Principles for Responsible Investment and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) are being reinforced by enforceable regulation — notably, the EU’s Sustainable Finance Action Plan which is in the vanguard.
Disclosure and due diligence
Until recently, claims with the primary purpose of securing the disclosure of climate-related information have predominated. For example, complaints made of fund managers over the adequacy of their disclosures, which it is argued are needed to fully inform shareholders and wider stakeholders about their investments. An Australian pension fund has faced arguments that it was in breach of its trustee’s legal duties by failing to comply with the TCFD’s risk management and reporting recommendations. While not creating a legal precedent, the case was seen by the industry as setting a benchmark for the standards that pension funds must meet going forward.[vi] There is also the potential for claims arising out of poor data quality in jurisdictions where financial institutions are required to provide extensive disclosures related to climate and ESG-related KPIs, yet many of the underlying corporates are not currently subject to the same disclosure standards. Although somewhat circular, where a material risk of climate litigation is identified, the failure to disclose that risk and its nature would breach an entity’s disclosure obligations.
Related to the disclosure of information, questions around liability can arise from the sufficiency of corporate due diligence by energy and extractive businesses, which is also of potential relevance to the financial institutions that help finance them. Moreover, the prospect of investors claiming, for example, that financial intermediaries failed to conduct appropriate ESG due diligence on the investments they promote and sell is no longer a remote risk. The EU’s proposed Corporate Sustainability Due Diligence (CSDD) Directive will be a game changer increasing the scope for litigation risk. Companies in scope, including financial businesses, will have to implement due diligence processes to protect human rights, the environment and responsible governance. They will also need to establish a climate plan detailing, among other things, to what extent their business model and strategy are compatible with the target of limiting global warming. The opportunity for claimants to find fault will grow. To illustrate the risks of litigation, in a case on which Baker McKenzie acted for the successful claimants, the UK Government’s own 2050 net zero plan was found to be unlawful because it gave insufficient information on how the target would be achieved.[vii]
Cases are targeting ‘portfolio’ emissions
The focus, however, is moving away from complaints over inadequate or insufficient disclosure to cases scrutinising what prudent financial management means. In their report, Setzer and Higham refer to the growing focus on private and public financial institutions arising from the Paris climate agreement and the recent Glasgow Climate Pact, at COP26, that called upon financial institutions to enhance “financial mobilisation” to achieve climate plans. In this context, litigation has sought to examine the responsibility of financial institutions for their portfolio emissions. To date, these have generally concerned pension funds — entities whose decisions are by their very nature concerned with the long term. In litigation brought in England and Wales against one of the largest University pension funds, it was said that the trustees had mismanaged the scheme, for example, by over-investing in fossil fuel assets with excessive valuations.[viii] It was argued that management were in breach of their directors’ duties under company law and fiduciary duties in failing to develop credible disinvestment plans, thereby prejudicing the value of the fund. This was despite the pension fund having targets to be carbon net zero by 2050. In similar vein, leading US universities face litigation brought by local state governments to the effect that the failure to divest from fossil fuels has breached their fiduciary duties to prudently invest their funds. While these and similar cases have achieved varying degrees of success, they are gaining traction and incentivizing institutions to adapt their policies and investment strategies to mitigate potential litigation and reputational risk.
Climate and ESG-related greenwashing
Litigation and enforcement action against financial institutions for greenwashing can arise from a variety of failings. Examples include:
- inadequate or inconsistent disclosures of institutions’ own climate and ESG-related policies and practices to their customers;
- inadequate due diligence around ESG statements in public company disclosures resulting in accusations of “greenwashing”; and
- inaccurate disclosure and inappropriate sales practices over ESG investments, also posing “greenwashing” concerns.
To give some context, it was reported last year that more than half of climate-themed funds were failing to live up to the goals of the Paris climate agreement, while just over 70% of funds promising ESG goals fell short. One key finding pointed to the relative lack of standards and regulation governing the marketing of such funds with multiple terms to describe ESG and climate-themed funds.[ix] There is even confusion over the respective categorisation of funds introduced by the EU’s Sustainable Finance Disclosure Regulation as “light or “dark” green. This is liable to increase the risk of allegations being made against fund managers around greenwashing. Enforcement staff, especially in the US where ESG regulation is currently enforcement-led, will likely focus their efforts on identifying what they view to be inaccurate or incomplete disclosures on ESG-related issues, and on misconduct involving the management and sale of ESG investment products by asset managers and financial intermediaries.
To provide greater transparency to facilitate sustainable investment decisions, various jurisdictions are introducing regulation. Under the EU’s Sustainable Action Plan and the UK’s Roadmap to Sustainable Investing, what was once voluntary disclosure, is increasingly mandated. The US Securities and Exchange Commission has also announced rulemaking, but with a longer time line. While this delay may be good news for financial institutions in the short-term, it increases the complexity and weight of regulation that financial institutions must follow.
A further complication for financial institutions over their adherence to voluntary commitments or pledges has surfaced recently. Members of the Glasgow Financial Alliance for Net Zero have voiced concern that following increasingly ambitious net zero carbon targets, set unilaterally by third parties such as UN standard-setting bodies (e.g. the Race to Zero campaign), may expose them to legal and regulatory risk should they fail to meet them. Especially in the US, this exposure will only grow as regulatory rules currently under deliberation will require additional disclosures around all targets or commitments made by a business. Conversely, a further disincentive to making voluntary commitments or pledges arises from the risk of lawsuits alleging that an investment institution has prioritised them to the detriment of fulfilling its fiduciary duties to maximise the return on investment.
How do financial institutions improve their preparedness?
Management and legal counsel should not assume that all decisions on climate-related law will be jurisdiction specific, as courts can be heavily influenced by international treaties and soft law when interpreting local requirements. As such, one national court’s reasoning on climate-related liability could be replicated by courts in other jurisdictions. Nor should the costs of litigation be underestimated. Beside the direct legal costs and lost management time involved, there is the potential for compensation payments, financial penalties and, of course, the reputational cost to the business brand. Moreover, depending on the circumstances of each financial institution, the cost of capital and financing may rise as counterparties and customers are less willing to do business.
So what actions would financial institutions be advised to take:
- Developing case law suggests that boards and management should review their corporate strategies around climate change and carbon reduction. Are they sufficiently detailed and realistic? Arguably, financial institutions that finance energy businesses and other carbon generators will be most exposed.
- Ask whether ESG commitments are sufficiently realistic or attainable for the business to follow, what due diligence has been conducted to substantiate them and will be necessary in future? Against a backdrop of fragmented regulation across jurisdictions with the prospect of a global baseline standard that builds on the TCFD framework with more granularity and standardisation still someway off, for cross-border businesses putting together a robust strategy to track and comply with voluntary and mandatory standards is essential.
- Take note of regulators’ expectations of the businesses they supervise. Globally, the Basel Committee on Banking Supervision has published principles for the effective management and supervision of climate-related risks. Besides governance, these include appropriate policies, procedures and controls, the incorporation of climate-related financial risks into internal control frameworks, as well as managing monitoring and reporting.[x]
- Be aware of the courts’ focus on “scope 3 emissions”.[xi] Businesses may be held accountable for what end-customers do with their products or services — in effect a trend towards companies being held responsible for their supply chains. Beside the activities inherent in running any business in the case of a bank, for example, this might include its lending exposure.
- Focus on the quality of due diligence and other processes for selecting loans and investments, monitoring such lending and investments and their alignment to a financial institution’s disclosed approach to providing ESG finance. The EU’s proposed CSDD Directive will not only introduce formal requirements in the EU, but will potentially apply to large companies with registered offices in a third country with net turnover over a specified threshold in the EU.
- To counter climate-related greenwashing financial institutions should carry out documented, evidence-based reviews of their entity and product level disclosures and statements around ESG, substantiating how they implement ESG investment processes. Additionally review the degree to which internal ESG practices are consistent with those disclosures and written policies and procedures.
- When making climate / ESG-related disclosures, it is vital to understand the associated litigation and regulatory enforcement risks, together with mitigation strategies, including the use of relevant contractual terms to limit liability. Be prepared for increased scrutiny and the need to demonstrate the accuracy of disclosures and statements for both regulators and a wider class of stakeholders.
As well as sanctions for non-compliance, a key risk is reputational damage in the “court of public opinion”, impacting talent recruitment and retention, as well as third party, customer and other stakeholder relationships, all of which potentially undermine a business’s long-term success. Despite the challenges that ESG brings, the focus on increased transparency and accountability also brings the opportunity to be ahead of the curve, showcasing a financial institution’s purpose, sustainability goals and progress toward them, its engagement with key stakeholders and the corresponding impact on its approach to ESG issues.
[i] ECB, Press Release, Banks must sharpen their focus on climate risk, ECB supervisory stress test shows, 8 July 2022.
[iii] Setzer J and Higham C (2022) Global Trends in Climate Change Litigation: 2022 Snapshot. London: Grantham Research Institute on Climate Change and the Environment and Centre for Climate Change Economics and Policy, London School of Economics and Political Science.
[iv] NGFS, Climate-related litigation: raising awareness about a growing source of risk, November 2021.
[v] Remarks by Richard Fuller MP, Economic Secretary (and former City Minister) at HM Treasury, 19 July 2022.
[vi] McVeigh v Retail Employees Superannuation Trust (January 2018).
[viii] Ewan McGaughey v The Universities Superannuation Trust Limited.
[x] Basel Committee on Banking Supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.
[xi] Scope 3 emissions are the result of activities from assets not owned or controlled by an organization, but which indirectly impacts in its value chain.