The topic of climate change is complex, and what makes it further complicated is that many board directors don’t really know where their responsibilities lie in relation to it, if they have any role at all. The 2019 World Economic Forum (WEF) attempted to provide some clarification at their annual meeting in Davos by publishing guidance on climate governance corporate boards.
Several issues have prompted boards to consider how climate change is becoming a viable business disruptor. The Paris Agreement, new legislation and new recommendations by the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) have placed a spotlight on climate change. These issues, combined with the increase in awareness of the physical impacts and risks as outlined in the Special Report of the Intergovernmental Panel on Climate Change (IPCC) on Global Warming 1.5°C, are motivating corporate leaders to engage and sort out their responsibilities to shareholders and stakeholders on the matter. The issue calls for the board’s response to investors, regulators and other stakeholders on how they can establish an integrated, strategic approach to considering climate change and the associated risks and opportunities.
Defining Climate Governance
The structure or rules and processes that companies form so that they can manage their responses to the financial risks and opportunities is called climate governance. We can divide the climate-related risks into two primary categories — physical risks and transitional risks.
Physical risks relate to the risks that disasters such as hurricanes, floods, fires, droughts and sea level rises could occur and seriously damage or disrupt a company’s ability to conduct business. The disruption could affect operations, the supply chain or administration and prevent the company from operating efficiently or at all.
Transition risks refer to risks that the company doesn’t see coming or risks that stem from the board’s failure to address regulatory market changes that surfaced due to the global transition to pursuing a carbon-free, clean energy economy. To be clear, climate risk doesn’t refer to the risks that society faces as a result of climate change. It only refers to the financial risks that the company and its shareholders face as a result of climate change.
Oil and gas companies are increasingly facing legal action from city governments, non-governmental organizations (NGOs) and advocacy groups because of greenhouse gas emissions and their negative effect on climate change.
What Are the Principles that WEF Recommended?
WEF settled on the following eight principles of corporate climate governance:
Principle 1: Climate accountability on boards. The board should take responsibility for ensuring the company’s long-term resilience to climate risks.
Principle 2: Command of the subject. The board should be properly informed about climate-related risks and opportunities and able to make relevant decisions.
Principle 3: Board structure. The board should implement the right board and committee structures to ensure that climate risks and opportunities are understood, managed and reported.
Principle 4: Material risk and opportunity assessment. The board should ensure that management fully identifies climate-related risks in the short, medium and long term, assesses their materiality and takes appropriate action according to the materiality of the risks.
Principle 5: Strategic integration. The board should ensure that management factors material climate-related risks and opportunities into the company’s strategy, risk management process and investment decisions.
Principle 6: Incentivization. The board should align executives’ incentives with the long-term success of the business. This may include climate-related targets in executive incentive schemes.
Principle 7: Reporting and disclosure. The board should ensure that the company discloses its material climate-related risks, opportunities and strategic decisions to all stakeholders – especially investors and regulators. These disclosures should be included in financial reporting.
Principle 8: Exchange. The board should stay informed on current best practices in climate governance by maintaining dialogue with peers, policymakers, investors and others.
What Is the Board’s Role in Climate Governance?
Climate change may potentially affect a company’s strategic risk. In that sense, the board has a responsibility to manage climate risk in the same manner as any other strategic risk.
Climate change may be identified as a board director’s fiduciary duty or be listed under the corporate governance code. Either way, board directors have a responsibility to act with due care, skill, knowledge and diligence. That means that boards have a responsibility to identify, assess, address and disclose material climate risk. Board directors of companies like oil, gas, energy, transportation, agriculture, food, forestry, materials and financial services are especially vulnerable to climate risks, and such companies may face legal action for not giving their board duties due diligence.
The Importance of Having an Effective Climate Governance Structure in Place
An effective climate governance structure sets the stage for board directors to assess risks and opportunities that are related to climate change. The structure ensures that boards will make the time to incorporate climate change data into strategic decision-making. Taking the time for planning ensures that the board will be well equipped to deal with threats and communicate appropriately with shareholders about climate change matters.
Climate Change Is an Accepted Business Risk
The Task Force on Climate-Related Financial Disclosures (TCFD) was established in 2015 and paved the way for the recognition of climate change as a financial risk to businesses. TCFD recognized climate change as an issue that could destabilize the global financial system. The goal of TCFD is to improve disclosures around climate-related financial risks to better inform investors, lenders and insurers.
Another sign that climate change has become an accepted business risk is that regulations about climate change are increasing around the globe.
In France, business owners, asset managers and insurers are required by law to disclose climate risks in their portfolios. In the United States, the United Kingdom, Canada and Australia support the idea that corporate laws mandate companies to disclose material climate-related financial risks such as the environmental disclosures that are required by the 2014 EU Directive on disclosure of non-financial information and diversity information.
Finally, shareholders are increasingly issuing proposals and starting campaigns to force companies to disclose their climate risks and their strategies so that shareholder value is protected over the long term.