Maged Girgis, partner at Minter Ellison, points out the growing likelihood of legal challenge for trustee directors that ignore analysis and evidence of global warming in their investment decisions, but he says any decision to include or exclude carbon-intensive assets must be one that involves, analysis, deliberation and information gathering.
Recently there has been an unprecedented amount of publicity on the debate about whether institutional investors (including superannuation fund trustees) should exclude, or divest of, investments in carbon-intensive industries (ie. de-carbonise their portfolios).
The fact that the debate is now ‘front page news’ demonstrates the risks associated with climate change are no longer regarded only as an ethical or moral issue, or a ‘non-financial environmental externality’. Rather, the financial risks and opportunities presented by climate change have become a mainstream financial issue for many in the investment community.
We are now seeing internationally recognised economic and financial organisations debate ‘stranded asset’ exposures and asset divestitures and warn of the significant economic consequences of climate change in the financial press. We are also witnessing a surge in political and regulatory interventions in response to climate change, reflecting community concerns.
Investors now increasingly consider the financial risks (and opportunities) associated with climate change as extending beyond potential physical impacts to include a range of risks which can quickly and significantly affect the value of the investment, such as:
- Community and reputational risk
- Risk of litigation – discussed below
- Legislative or policy (eg. introduction of a price on carbon or international treaties on emissions)
- Closure or restriction of markets
- Disruptive technology
- Inadequate or inaccurate medium to long term business modelling (eg. models based on an unrealistic price on carbon)
- ‘Stranded asset’ risks.
Many of these risks derive from evolving societal, governmental and market perceptions rather than directly from the potential physical impacts of climate change. However, irrespective of their source, they have the potential to quickly and significantly affect the value of investments and, therefore, represent both material financial risks (and opportunities).
These issues cannot be ignored by trustees and their directors as part of the investment governance of their funds, notwithstanding their personal, moral or ideological views on the reality of climate change.
It is fair to say that many trustees are struggling to translate these developments into prudent governance practice, consistent with their statutory and general law duties. This is not helped by the way in which trustees are often approached on the issue of divestiture.
Advocates on both sides of the debate often simplify the issue into a binary choice between ethics (ie. to de-carbonise) and investment returns (not de-carbonise). This approach focuses on a desired outcome to divest or not divest, and largely ignores the processes that the trustee must employ in the discharge of its duties. Under this approach, a trustee that ‘divests’ opens itself to an allegation that it has breached its primary duty to act in the best financial interests of beneficiaries by giving priority to ‘non-financial’, environmental concerns over financial objectives.
However, the issue is far more complex than that. It is the trustee’s process of gathering information, analysis and deliberation that is critical to discharging its duty to exercise the requisite standard of care, skill and diligence and act in the best interests of beneficiaries. The outcome of that process (whether or not to de-carbonise – or any other investment strategy designed to respond to the risks associated with climate change, such as active engagement, tilts, hedges etc.) is not the determinative issue.
In other words, trustees are not duty-bound to decarbonise their portfolios or universally prioritise environmental sustainability. However, nor are trustees able to simply deny or ignore the financial risks and opportunities associated with climate change.
A trustee will be judged against the manner in which it has considered, or built policies and procedures requiring its service providers to consider, the market, reputational and legal issues discussed above. A trustee will need to actively engage with the impact of these financial risks and opportunities on the fund’s portfolio, consistently with their duties.
They will also need to ensure that its investment practices are accurately reflected in its disclosures and other public documents (such as its ESG policy, Statement of Investment Beliefs or any other statement of policy or objectives) to avoid exposure to claims that it has misled the fund’s beneficiaries or the market.
While on first blush it may seem far fetched that the issue of climate change can expose a trustee to legal challenge, recent international developments foreshadow the potential for that sort of challenge in Australia.
Recently, public interest law firm Client Earth revealed that is preparing to launch an action against the trustees of a large UK pension fund for their failure to manage the financial risks to their investments from climate change. The claim is said to be issued on behalf of the members of the fund, which is identified only as a ‘laggard’ near the bottom of climate change risk management ‘league tables’ published by the Asset Owners’ Disclosure Project. If this litigation was to proceed, it would be the first publicly commenced case to argue that a trustee had failed in its duty to consider climate change as a material financial issue.
It is not clear whether the Client Earth litigation will eventuate, nor how it will be framed (ie. as a breach of duty case or a misrepresentation case). However, irrespective of how it is framed, it has the potential to give rise to similar actions against trustees (and their directors) in Australia. In fact, it may be that the media attention given to such a court case is itself the desired outcome of the litigation rather than the award of damages or other legal remedy.
Whatever the outcome in UK, it appears that climate change issues have become very real fiduciary issues for institutional investors in Australia.