Climate change, the financial system and the lead up to Paris: What does it mean for Australian boards and directors?

The Climate Institute (TCI) recently published a discussion paper on the potential systemic risks posed by climate change to the stability of the Australian financial system.

Navigating Sustainability and Your Fiduciary Duty
Al Gore (Huffington Post), September 2015

Business success beyond the short term: CEO perspectives on Sustainability
PricewaterhouseCoopers 17th Annual Global CEO Survey, September 2015

The Landscape of Climate Exposure for Investors
Climate Policy Initiative, August 2015

The Cost of Inaction: Recognising the value at risk from climate change
Economist Intelligence Unit, July 2015

Australia’s Financial System and Climate Risk
The Climate Institute, July 2015

TCI’s discussion paper examines the exposure of Australian financial markets and participants to ‘climate risk’, including the potential physical, economic, fiscal and regulatory risks associated with climate change in the transition towards a low carbon economy. The discussion paper contributes to a growing body of work attempting to measure the impacts of climate change in financial terms to investors and the broader economy.

The discussion paper raises a number of key points for consideration:

• Exposure of Australian banks through business loans and residential mortgages: The paper argues that Australia’s big four banks are exposed to climate risk due, in part, to significant loans to companies with carbon-intensive assets, such as those in the energy, natural resources and transport sectors. It also argues that concentration in residential property and mortgage debt increases banks’ financial exposure to climate risk, on the basis that Australia consists largely of coastal properties.
  
  
• Exposure of superannuation funds and changes in investor behaviour: The paper notes that a number of global investors, insurers and market indices providers have either voluntarily or mandatorily begun incorporating climate change into their decision making by screening or excluding fossil fuel investments. This includes Norway’s Government Pension Fund Global, global insurer AXA, index providers such as FTSE, MCSI and Bloomberg, and Australian superannuation funds such as HESTA and LG Super.
  
  
• Exposure of Australia’s economy via capital markets and sovereign debt: The paper argues that climate change and uncertainty around Australia’s climate change policy may result in macroeconomic shifts, which could theoretically affect Australia’s financial stability and sovereign debt position, given Australia’s interconnectedness with foreign capital markets.

The paper recommends that Australian financial authorities conduct an in-depth review of the systemic risks presented by climate change. It also raises the broader concern that a disorderly transition to a low carbon economy may cause carbon-intensive asset owners to seek to sell all at once, potentially resulting in financial system destabilisation.

Global and national developments on climate change in the lead up to Paris

Internationally, much of the political and economic discussion around climate change has been focused on the lead up to the United Nations Framework Convention on Climate Change in Paris in December 2015.

The ‘Paris Agreement’ will come into effect in 2020 and seeks to keep global warming to 2°C since the 2009 UN Climate Change Conference in Copenhagen, as well as mobilise funds for developing nations to help mitigate the impacts of climate change.

Prior to the Paris Conference, countries have been encouraged to announce their policy commitments to their post-2020 emission targets, referred to as Intended Nationally Determined Contributions (INDCs). According to commentators, as at 1 September 2015, 29 international governments have announced their INDCs, which account for approximately 65% of all global greenhouse gas emissions.

On 10 August 2015, the Australian Government submitted its own INDC, announcing plans to reduce greenhouse gas emissions by 26-28% on 2005 levels by 2030. Commentators have noted that Australia’s 2030 target is low in comparison with other developed nations.

What effect do these global developments have on investor behaviour and financial institutions? 

In the lead up to the Paris Conference, there appears to have been a global campaign calling on companies to divest themselves of fossil fuel holdings. Some Australian local councils, for example, have decided to prohibit investments in fossil fuel from their investment portfolios. Newcastle Council recently voted to exit holdings in Australia’s big four banks if they continue to fund fossil fuel projects.

Similarly, there has been a recent trend among the Australian investment community towards sustainable investment and low carbon financial products such as fossil-fuel exclusionary indices. For example, Thomson Reuters and Future Super have recently launched two share market indices that include “strict negative screening on direct and indirect fossil fuels in addition to traditional ESG scoring”.

There appears to be increasing demand for green bonds among investors as well, with commentators noting that the green bond market will have trebled in size over the year ahead. The same commentators have noted that the increasing popularity of sustainable investment options is likely to attract Australian superannuation funds. However, it is unclear at this stage how effective such instruments will be in minimising climate risk.

Will organisations and financial institutions be required to provide greater disclosure of greenhouse gas emissions? 

There is a growing body of research suggesting that companies and pension funds that score higher across ESG metrics have better long-term financial performance. The Governance Leadership Centre has also previously considered this link between ESG and organisational performance.

As pointed out by The Economist Intelligence Unit, there is currently no standardised set of metrics or indicators for the disclosure of climate change related information. “Much of the data which feeds into ESG tools is based on voluntarily disclosed information, which makes challenging the task of aggregating, assessing and using relevant ESG inputs to inform investment decisions.”

In the lead up to Paris, there may be increasing pressure on companies, particularly on financial institutions, to provide greater disclosure of their ESG inputs, including greenhouse gas emissions.

In a recent example of this, the Australasian Centre for Corporate Responsibility (ACCR) attempted to introduce an ordinary resolution at the Commonwealth Bank of Australia’s (CBA) 2014 AGM, on the basis that CBA’s annual report did not contain certain disclosures around emissions and fossil fuel risks associated with projects and companies that CBA had financed. The Federal Court in July 2015 dismissed the ACCR’s application, stating that shareholders cannot require an AGM to consider a resolution “expressing their opinion on matters as to how a power vested in the board ought to be exercised.”

While the ACCR was unsuccessful in this instance, and has since appealed the decision, the issue highlights how disclosure of greenhouse gas emissions is likely to affect the ESG disclosure practices of financial institutions and the decision making processes of their boards.

What does this mean for directors and boardrooms? 

Mark Carney, Chairman of the G20’s Financial Stability Board, describes the issue of climate change as a “tragedy of horizons”; that is, a failure of governments and businesses to incorporate long-term considerations into their decision making.

A recent survey of global CEOs by PricewaterhouseCoopers bears this out. In its survey, less than half of CEOs considered resource scarcity and climate change in the top three global megatrends that will transform their business over the next 5 years. Further, only 33% of CEOs in the financial services industry considered that resource scarcity and climate change would transform their businesses.

Several commentators have considered climate change in the context of directors’ broader fiduciary duties.

Chair of General Investment Management, Al Gore, has stated that “investors and companies have a fiduciary duty to include sustainability in decisions. Extending this logic one step further, not only is it permissible for fiduciaries to incorporate sustainability into the capital allocation process, failure to do so may constitute a breach of fiduciary duty by intentionally overlooking the possibility of maximizing long-term risk-adjusted returns”.

The AICD Governance Leadership Centre will continue to monitor political and economic developments on climate change to analyse how such risks may impact on Australian boards and directors.