A perspective on governance from Oceania
Ki te kahore he whakakitenga, ka ngaro te iwi.
(Trans. Without vision and foresight, the people will be lost).
Climate change has moved ‘top of mind’ for corporate directors in Oceania, a region which includes New Zealand, Australia and 12 other Pacific nations, with the publication of the World Economic Forum’s (WEF) – “How to Set Up Effective Climate Governance on Corporate Boards – Guiding principles and questions” in January 2019. The report emphasizes that:
“Good governance should intrinsically include effective climate governance …. Climate change is a new and complex issue for many boards that entails grappling with scientific, macro-economic and policy uncertainties across broad time scales and beyond board terms.”
As climate change evolves from an environmental issue to one of financial risk, awareness is growing of how climate-based risks (and opportunities) can have a material impact on their business performance, position and prospects.
Of the eight top economic risks by likelihood and impact, seven are seen by the WEF as climate-changerelated, i.e., extreme weather events, failure to mitigate or adapt to climate change, natural disasters, loss of biodiversity, collapse of the ecosystem, man-made environmental disasters, and water crises. Those risks are felt acutely in Oceania: all 14 countries have a long coastline, where much of their infrastructure is located. For low-lying places like Kiribati, Tuvalu and the Marshall Islands, their very existence may be threatened. Rising sea levels will affect businesses with property and infrastructure investments in many places, as well as supply chain networks.
The agriculture, horticulture, and fisheries sectors which are significant in many countries are likely to be impacted by volatile weather and warmer seas. As the climate changes, shifts occur in the use of viable land and level of fish stocks. The risk of bio-incursion (the introduction of exotic pests) is a particular concern in New Zealand. Tourism businesses may also be affected as seasonal weather patterns shift or intensify, and biodiversity is impacted. The impact of warmer seas on the Great Barrier Reef, is an example.
Australian bank annual reports in 2018 underscored how drought-induced soil contraction can wreak havoc on building foundations. Spikes in electricity demand caused by hot summers threaten continuity of supply in some parts of Australia.
Moreover, the implications of flooding and storm damage will flow through to lenders and insurers who have exposure to those on the frontline, with a potential to impact the price and availability of finance and insurance in the future.
Economic transition risks
More subtle but equally significant is the risk of economic transition as market forces and government regulations respond to the threat of climate change, whether or not the physical risks materialise.
Stranded assets and new business models
Depending on the magnitude of changes, the value of assets and of businesses will shift. For example, a 2015 study published in Nature magazine estimated a third of oil global reserves, and more than 80% of known reserves would remain unused if targets under the Paris Agreement are met. The value of companies that extract, distribute or rely heavily on fossil fuels may drop when such a risk is priced in.
A January 2019 report by Lazard on the levelized cost of energy found that on an unsubsidised basis, the cost of building new wind and solar electricity generation capacity could be cheaper than the marginal cost of maintaining older coal-fired power plants. In other words, those investing in new-build renewable energy generation may out-perform those committed to keeping legacy coal-fired capacity running.
Investor and consumer reaction
The risk of economic transition also flows from the reactions of investors and consumers. A case in point is the NZ Super Fund, which recently reallocated close to a billion dollars away from companies with high exposure to emissions and reserves, into lower-risk companies, to make its portfolio more resilient to climate change. The NZ Super Fund is open about its motivation: it does not think the market has yet fully priced the impact of climate change. Many other local and global investors, and ratings agencies, are showing a similar sensitivity, changing the cost of capital.
Consumers are also asking questions about the carbon footprint of the goods and services they buy, and for some of them this extends to the social licence to operate. Some concerns are longstanding – e.g. Tesco in the UK has been labelling the carbon footprint of its milk since 2009 – but they are likely to spread to other markets as consciousness increases.
However, the transition to a greener economy is not all downside risk – there are opportunities for agile and well-placed businesses. For example, in New Zealand, we are already seeing advertising promoting the benefits of paper from sustainable forests processed using geothermal power, and of electric vehicles powered by the country’s high proportion of hydro-electric generation.
A further aspect of transition risk arises from governmental responses, including changes to regulatory or taxation regimes. For example, the New Zealand Government has flagged the priority it is giving to climate change, resulting in regulatory change. They have already ruled out new permits for offshore oil and gas exploration, and announced fuel tax increases. A Zero Carbon Act is currently being developed in New Zealand, that is likely to be enacted in 2019. Among over 15,000 submissions received, 91% are in favour of legislation to establish a target of net zero emissions of greenhouse gases by 2050. The existing NZ Emissions Trading Scheme (in place since 2008) is likely to be strengthened and expanded to achieve that.
In Australia, the Emission Reduction Fund was established by federal government in December 2014, replacing an earlier carbon tax. It provides incentives for Australian businesses, farmers, landholders and others to adopt new practices and technologies to reduce greenhouse gas emissions. The Australian states have taken other steps, with Tasmania and the Australian Capital Territory legislating to introduce 100% renewable energy targets for 2020 and 2022 respectively. These states, along with South Australia, Victoria, New South Wales and Queensland, have set a target of net zero emissions by 2050.
Competitors from different jurisdictions will be affected differently by contrasting regulatory approaches.
In New Zealand and Australia, directors are increasingly conscious of activist groups using the courts to hold companies accountable.
In 2018, ecology student Mark McVeigh filed a claim in the Australian Federal Court against his superannuation scheme provider, REST, for failing to have, or to disclose, strategies to deal with climate-related risks relevant to his retirement savings. He argued that given the 30-year time horizon, the impact of climate change on investments should be considered now. The case is yet to be heard, but is already prompting other providers to reconsider their position.
Directors are also concerned that liability can be personal. In a widely published 2016 memorandum, leading NSW barrister Noel Hutley SC argued that Australian company directors who failed to consider and to disclose foreseeable climate-related risks be held personally liable for breach of duty under the Corporations Act. He warned that it is “only a matter of time” before Australia sees litigation against a director.
The New Zealand Companies Act similarly requires directors “to exercise the care, diligence and skill of a reasonable person in the circumstances”, similar to that in Australia which requires consideration of the potential impact of climate change.
The other 12 countries in the region have different levels of duty, but many require directors to act prudently and in the company’s best interests, which could also form a basis for liability.
In New Zealand and Australia, comparable duties arise for licensed fund managers and trustees, who in each case must exercise the due care, diligence and skill that a prudent person would exercise in the same circumstances – which is likely to include considering the potential impact of climate change risks.
Regulators such as the Australian Prudential Regulatory Authority (APRA) and the Australian Securities and Investments Commission (ASIC) emphasize the financial risk of climate change beyond the ‘ethical' or ‘environmental' risks. While climate risks are broadly recognised, they are often seen as a future problem or a non-financial problem. In the APRA’s view, “many of these risks are foreseeable, material and actionable now”.
In New Zealand, financial institutions are waiting to see if the Reserve Bank will follow in the steps of APRA and the Bank of England to highlight climate risk for registered banks, insurers and non-bank deposit-takers. When issuing financial products, inadequate disclosure of risk in the offer materials may involve liability for the issuer, and potentially for directors who have not taken all reasonable steps to ensure appropriate disclosure. Again, New Zealand is waiting to see if the Financial Markets Authority will follow ASIC’s lead.
Finally, for listed companies, guidance from the Australian and New Zealand stock exchanges highlights the need for disclosure of non-financial, environmental, economic and social sustainability (ESG) risks.
So what are directors doing?
It is fair to say that the region’s directors have been relatively slow to shift from a perception of climate-related issues as ‘non-financial, environmental' risks to one that apprehends the financial consequences for their business. But that is changing rapidly.
Whether driven to action by their understanding of the underlying economic drivers at play, or motivated by concerns from government, institutional shareholders, financiers or corporate regulators, mainstream sentiment is shifting from ‘Why would this be relevant to our business?' to ‘What are the implications for our business, how should we strategize and manage them, and what should we disclose to the market?'
These are not easy questions to answer. While the direction is clear, the exact location, timing, and magnitude of the impacts is inherently uncertain. Accordingly, boards often look to external governance and sustainability experts to guide diligent consideration of these issues – particularly when grappling with stress-testing and scenario planning across a plausible range of climate futures.
One source is the Taskforce on Climate-related Financial Disclosures (TCFD), chaired by Michael Bloomberg, issued a voluntary framework for disclosure, with the backing of investors such as the US$30 trillion-plus FUM Climate Alliance 100+. Compliance is increasingly seen as a requisite rather than an option.
The WEF’s recent guidelines aim to “increase directors’ climate awareness, embed climate issues into board structures and processes, and improve navigation of the risks and opportunities that climate change poses to business”. It sets out eight principles, each supported with a set of guiding questions to help identify and fill potential gaps:
- Principle 1 – Climate accountability on boards
- Principle 2 – Command of the subject
- Principle 3 – Board structure
- Principle 4 – Material risk and opportunity assessment
- Principle 5 – Strategic integration
- Principle 6 – Incentivization
- Principle 7 – Reporting and disclosure
- Principle 8 – Exchange.
While directors in New Zealand and Australia consider how to use these and similar frameworks to analyse climate change risks and opportunities, alongside other relevant matters, to understand the likely material – and financial – implications, the major challenge for directors is now to find specific tools to help their business mitigate those risks and seize the opportunities.
This article was first published in INSEAD's Corporate Governance Centre Newsletter, March 2019.
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