Video transcript: Climate change: The coming storm and how to prepare (Part 1)

Transcript for a video recorded for the Audit New Zealand 2020 information updates. This video is about climate change risks to public sector organisations.

Title:
Climate change: The coming storm and how to prepare
Part 1: Climate change risks to your organisation
Lloyd Kavanagh and Stephanie de Groot
MinterEllisonRuddWatts

Lloyd Kavanagh, Partner, MinterEllisonRuddWatts

"Change is coming whether you like it or not" – so says Greta Thunberg.

To be clear, the “coming storm” referred to in the title of this presentation is not the literally turbulent weather to which Greta Thunberg and other environmental activists refer. We’re not going to lecture you about the science or talk to you about the “moral imperative” to act. We’re not going to talk about the fact that there is no Planet B. And we’re not going to talk about whether New Zealand’s efforts are going to make a difference to this global issue.

No – we’re here to talk to you about the metaphorical storm, which is gathering for those in private and public leadership positions, business managers, company directors, and auditors. A storm of increased operational and business risk, and potential liability, which will arise whether or not you believe the causes of climate change are anthropogenic or not. And what to do.

Now first up, I want to address the elephant in the room: the global coronavirus pandemic has caused significant global and personal hardship and devastation. The pandemic is quite rightfully dominating our attention at the present.

But climate change has not gone away. It remains a major challenge and risk to people and the planet. Ironically, the economic slowdown triggered by Covid-19 has had a positive impact on climate. Positively, the world has seen greenhouse gas emissions reduce and air quality improve. But this is a short-term response and the issue of climate change is likely to revert to trend if nothing else changes.

The impact of climate change, as we’ll explain, is so big and so dramatic that we need to act urgently to understand and prepare for a different world. So, this presentation is just as relevant now, as it was back on 10 March when we spoke to the Audit New Zealand Directors and Mangers Conference.

And finally, part of what we will say to you today was also covered in an article I wrote for the October 2019 edition of the IoD’s Boardroom magazine. So, if you’re interested, look out for that.

Now we’ve split today’s presentation into two parts. In this first part we’re covering the three categories of risk that may have a material impact on the performance, position or prospects of the organisations that you’re involved in. These are:

physical risks
transition risks; and
liability risks

And then in the second part of the presentation, we’ll talk about what you can do to mitigate the risk – and where you may find some specific tools relevant to your organisation. So, make sure you watch both parts.

Overall our message is that climate change is a multi-faceted issue. Its origins are environmental but it’s now evolved into a business issue with clear physical, legal, and financial implications.

And here there is a useful parallel with Covid-19. First and foremost, the pandemic is a health issue. But it’s now also clearly an economic issue, with the IMF projecting a comparable impact to the great depression of the 1930s, perhaps. Likewise, climate change starts as an environmental issue and will evolve into an economic issue.

Stephanie de Groot, Senior Associate, MinterEllisonRuddWatts

Physical risks are what we most naturally think of when we refer to climate change.

According to the latest UN and IPCC reports the global average temperature for the past five years is the warmest of any equivalent period on record. If current national commitments under the Paris Agreement were implemented, we will likely see a global mean temperature rise between 2.9°C and 3.4°C above pre-industrial levels by 2100. According to the IPCC, this will result in significant and increasing damage. If the national commitments are not met – and currently we’re not on track to meet them – we could see changes of over 5°C. This change will have catastrophic results.

Even if we are optimistic, if national commitments are increased to limit warming to a 1.5°C increase, the planet will still face unprecedented and irreversible environmental change. This includes:

increases in the frequency and intensity of rainfall and droughts;
ocean warming and increased acidity, ice melt and accelerated sea level rise; and
more frequent extreme climatic events, like wild fires and tropical cyclones.

The Ministry for the Environment has identified many positive and negative impacts in New Zealand of climate change on their website. Those impacts are based on the now optimistic 1.5°C to 2°C range. If you Google “MfE and Likely climate change impacts in New Zealand” you can view the full list of impacts but remember that information is from 2016.

The impacts identified by MfE include:

An increased risk of erosion, coastal flooding and saltwater intrusion, threatening coastal property and infrastructure and increasing the need for coastal protection.
Damage to transport infrastructure, causing buckled railway lines and damaged roads, leading to disruption and repair costs.
An increased risk of heat stress, as well as tropical diseases and bio-incursions (or exotic pests), viable land uses, and fish availability changes.

Electricity demand and supply patterns will also change, and as rainfall patterns change and snow melts, the demand for cooling systems will increase.

Physical implications will also flow through those with second-tier exposure to the frontline – for example, lenders and insurers – and impact the price or availability of finance and insurance. Insurers will, as they always do, revise risk models to reflect expected claims. And lenders will insist on insurance as a condition of lending secured on those properties and adjust margins. The Reserve Bank has already called on insurers and banks to reflect climate risk in their decisions – in their 2018 Financial Stability Report.

Some of these physical impacts are already manifesting and they will only increase in severity and magnitude as the climate continues to change.

Whether we are pessimistic or optimistic one thing is certain, the physical changes will have implications for every living thing on the planet and directly affect your organisation, its business, and assets.

Lloyd

However, it is not just the physical risks that we need to be concerned about. As we move to a different climate than we are used to, transition risks present as having the bigger and perhaps more immediate effect. These will be being felt by organisations now.

These include the indirect impacts from public, consumer and investor reactions, and from governmental interventions – for example, new regulation and taxes. And that results in stranded assets, changing organisation and business models, and increased litigation risk.

Talking about public and consumer pressure – the social pressure to act on climate change that’s increasing rapidly and may be heightened from the lessons learned by the response to the Covid-19 pandemic.

The public and consumers are increasingly asking questions about what businesses and government agencies are doing to mitigate and adapt to the physical risks of climate change, the carbon footprint of the goods and services they buy or sell, and how they are now changing their behaviour.

To take just one example, “flygskam” – flight shame – a movement in Europe which shifted travel behaviour last year. It’s not difficult to see that extending to diesel and petrol-fuelled private vehicles, both here and elsewhere. One effect of the Covid-19 lockdown has shown us how different our environments will be with fewer cars. Another example are the changes in dietary preferences, particularly amongst younger groups. There’s a reason why takeaway outlets are finding vegetarian options are their fastest-growing category.

Investors too are changing their priorities. Black Rock, the world’s largest private fund manager, considers the environmental factors that are inherent to a company’s business model, and uses that to decide whether to invest. Closer to home, the New Zealand Superannuation Fund has already reallocated $1billion away from companies with high exposure to carbon emissions and reserves. And the Government has announced that, from mid-2021, the default Kiwisaver schemes will be banned from investment in fossil fuel companies.

In the debt markets, green bonds are emerging as lines of finance for issuers like Auckland Council, Contact Energy, and Westpac last year, and they offer cheaper lines of finance for those who can demonstrate their environmental credentials.

A magnifying glass of scrutiny is also being placed on local and central government and crown entities. This is due to the public service focus of those entities and the unique statutory responsibilities, duties, and powers which relate to, or are affected by, climate change.

For example, under the Resource Management Act, local authorities are obliged to have regard to the effects of climate change when exercising their powers and to identify and manage the risks of natural hazards. They also have to have “emission reduction plans” and “national adaptation plans” prepared under the Zero Carbon Act when they make and amend their regional policy statements, regional plans, and district plans.

Under the Local Government Act 2002, in performing their role, local authorities must take into account the interests and needs of future communities. They must also have a long-term plan in place which includes a financial strategy including significant capital expenditure expected in future years on network infrastructure, flood protection, and flood control.

As the climate change response develops and disclosure is increased, we can expect more public scrutiny and reaction to intensify, particularly for those entities with public functions.

Stephanie

There has been a raft of regulatory changes and proposals by the New Zealand Government responding to climate change over the past few years.

In 2018, the Government passed the Crown Minerals (Petroleum) Amendment Act, which prevents new permits for offshore oil and gas prospecting, exploration, and mining being issued in New Zealand, except for onshore mining permits in Taranaki.

But most important is the Climate Change Response (Zero Carbon) Amendment Bill, which passed through Parliament in 2019. Its final reading was unopposed, which is highly significant.

The Zero Carbon Act’s purpose provides explicit recognition that New Zealand will develop and implement clear and stable climate change policies that contribute to the global effort under the Paris Agreement to limit the global average temperature increase to 1.5°C above pre-industrial levels, as well as preparing for, and adapting to, the effects of climate change.

The Zero Carbon Act does this via five key things.

It sets greenhouse gas emissions reduction targets to net zero by 2050 (except for biogenic methane – where the target is 24-47% of 2017 levels by 2050).
It sets five-yearly emission budgets as stepping stones to the long-term target.
It requires Government to undertake six-yearly National Climate Change Risk Assessments and implement a Climate Change Adaption Plan in response to that assessment.
It established the Climate Change Commission to monitor and advise the Government.
And it introduces reporting obligations on local authorities, council-controlled organisations, and Crown entities.

The Ministry for the Environment has begun work on the first risk assessment and is in the process of developing the provisional emissions budgets now. The Adaptation Plan will affect all New Zealanders, including your organisations. It’s hard to imagine the plan not relying heavily on land use restrictions under the Resource Management Act, or infrastructure investment decisions under local government and infrastructure legislation.

In terms of reporting obligations, the Zero Carbon Act enables the Minister for the Environment or the Climate Change Commission to request a description of risks and opportunities related to climate change. That includes a description of:

the organisation’s governance in relation to the risks of, and opportunities arising from, climate change;
the actual and potential effects of those risks and opportunities;
the processes that the organisation uses to identify, assess, and manage the risks;
the metrics and targets used to assess and manage the risks and opportunities, including, if relevant, time frames and progress; and
any other matters that are specified in regulations.

The Climate Change Response (Emissions Trading Reform) Amendment Bill (or the ETS Bill) is currently before Parliament, and MfE is working on new regulations to change the ETS settings. The select committee has recently reported back on the Bill, and both the Bill and regulations and are expected to come into force this year.

The ETS Bill will make significant changes to the ETS – the emissions trading scheme. It includes provisions making data about individual ETS participants’ emissions and removals public and putting a price on agricultural emissions from 2025. It also changes the existing ETS model to a cap and trade scheme, introducing auctioning, removing the $25 fixed-price option after the surrender of one NZU (or New Zealand Unit), and allowing the supply of NZUs to be restricted.

Further, on the back of select committee recommendations in April this year, changes are also expected to be made to the Resource Management Act which will enable local authorities to have regard to the effects of greenhouse gas emissions when they make plans also and decide on resource consent applications. This is a significant change as councils were previously, and quite famously, restricted from considering this matter.

Lloyd

Also underway is the Government initiative to act on the recommendations from the international Task-Force on Climate-related Financial Disclosures, which is referred to as the TCFD. That includes a proposal to make climate impact disclosure compulsory for listed issuers, banks, general insurers (including reinsurers), asset owners (that is, institutional investors) and asset managers (that is, investment managers). Some submissions have argued for even wider coverage, for government agencies, and we have yet to hear how the Government will take this forward

But, whether or not obligatory, those TCFD disclosures are a really useful tool for entities to analyse the impact of climate risk, and demonstrate what the entity is doing, how it’s taking the issue seriously. Even if TCFD does not technically apply to your organisation, you should expect stakeholders, the public, customers, and suppliers to start asking for the same disclosure that they’re seeing from listed issuers for whom it’s compulsory.

And then, stranded assets and changing business models.

The changes that we’ve been talking about – physical and transitional – will shift the value of businesses and assets. A 2015 study published in Nature magazine estimated that a third of global oil reserves, half of gas reserves, and 80% of known coal reserves will remain unused if targets in the Paris Agreement were met. That means that the companies carrying those reserves need to look at the values on their balance sheets.

In New Zealand, IAS 36 requires annual consideration as to whether there is any impairment in the value of the entity’s assets. That includes, as a result of changes to the extent to which the assets are expected to be used, or to the market, economic or legal environment in which the entity operates. Clearly, the changes we’ve just described need to be considered to find whether assets will be impaired.

Both boards and auditors are struggling to come to terms with this. The Australian Accounting Standards Board in March 2019 stated that regulators have noted that, and I’m quoting here, “entities are struggling to apply the requirements of IAS 36 in the light of modern-day business challenges including how to factor in the effect of risks relating to climate change”.

In a similar vein in January 2019, European asset managers of over €1trillion, wrote to the big four audit firms and audit committees of leading oil and gas companies, saying the financial statements that they were publishing were not giving enough weight to a potentially rapid transition towards a low-carbon future as governments implement the 2015 Paris Agreement to curb climate change, and they expected to see more challenge by audit committees and auditors. In our view, that’s as relevant to the New Zealand Government sector, as to the private sector. which is a nice segue to the next, and critical, topic – liability risks.

Stephanie

One of the latest trends is the use of litigation by activists to raise the profile of climate change, in New Zealand and overseas.

In late 2017, the High Court upheld a judicial review challenge by Sarah Thompson against the Minister for Climate Change Issues for failing to review the 2050 emissions reduction targets under the Climate Change Response Act 2002. The Court found that the Minister’s review had failed to take into account, as a mandatory consideration, the IPCC’s recent report. The High Court also rejected the Crown’s argument that climate change issues involved policy judgements and were not appropriate for judges to determine. Importantly, the High Court accepted judges could address climate issues and the IPCC reports provide a factual basis on which decisions can be made.

In August last year, Mike Smith, Chair of the Climate Change Iwi Leaders Group, filed High Court proceedings against eight high-profile New Zealand businesses, alleging that the companies’ carbon emissions constitute a public nuisance, and that failing to address them breaches duties owed to him. All defendants sought to strike out the proceedings. The High Court on 3 March this year struck out the nuisance and negligence claims. But Justice Wylie left open the possibility of the law of tort recognising a new duty which might assist Mr Smith. This is expected to be tested on appeal.

Across the ditch, activists are also at work:

In Australia, in 2017, Abraham and five or six other shareholders of the Commonwealth Bank of Australia sued the bank, alleging that it violated the Corporations Act of 2001 with the issue of its 2016 annual report, which failed to disclose climate change-related business risks – specifically including possible investment in the controversial Adani Carmichael coal mine. Before the court issued any decision, the shareholders withdrew their suit after the bank released a 2017 annual report that acknowledged the risk of climate change and pledged to undertake climate change scenario analysis to estimate the risks on the bank’s business. The bank’s financial reports are now regarded as a model, and the litigation worked.

Also in Australia, in 2018 an ecology student, Mark McVeigh, claimed in the Australian Federal Court against his superannuation scheme provider, REST, for failing to have, and failing to disclose, strategies to deal with climate-related risks relevant to his retirement savings. A trial is scheduled to take place in Sydney in July this year. In the meantime, REST, as have other schemes has changed its approach.

We expect that the activists will keep coming.

Lloyd

So, liability risks. Those with statutory duties are particularly at risk. In the cases Stephanie has discussed demonstrate, they clearly demonstrate that those with statutory responsibilities that relate to, or require a climate change response, are at risk. They should be attuned to the issue.

In October 2019, The Aotearoa Circle sponsored a legal opinion from a major firm, endorsed by Alan Galbraith QC, that, under current New Zealand law:

the Companies Act requires directors to act reasonably to inform themselves about, consider and decide how to respond to climate change risk, as they would for any other financial risk; and

the Financial Markets Conduct Act requires licensed fund managers to take climate change into account when making investment decisions and/or designing investment policies, where to do otherwise would pose a material financial risk to the investment portfolio.

This shouldn’t be a surprise because the conclusions broadly follow the view of leading New South Wales barrister Noel Hutley SC, who argued, in opinions in 2016 and 2019, that Australian company directors who fail to consider and to disclose foreseeable climate-related risks could be held personally liable for breaching their duties under the Corporations Act. Hutley warned, and again, this is a quote, it’s “only a matter of time before we see litigation against a director who has failed to perceive, disclose or take steps in relation to a foreseeable climate-related risk”.

In New Zealand, the Crown Entities Act adds another layer. It imposes broad duties on members of statutory entities to exercise the care, diligence, and skill of a reasonable person, taking into account the nature of the entity, the nature of the action, and the position of the member and nature of the responsibilities undertaken by him or her.

Personally, I think the greatest risk for directors and auditors lies in relation to claims of defective disclosure.

I highlighted earlier the disclosure requirements under IAS 36, and potentially under the new TCFD proposals when they come in. Failure to comply with accounting and reporting standards, including IAS 36, gives rise to significant legal liability for directors. Under the Companies Act, where a company fails to comply with the applicable financial reporting standard, every director of the company is held to have committed an offence and is liable to a fine not exceeding $50,000, subject to defences, including that the board took “all reasonable and proper steps” to ensure compliance. And I will come back to that in the second part.

The directors of a company making a regulated offer of financial products under the FMCA need to satisfy themselves that the relevant offer disclosure contains all material information, including material risks to the issuer. It’s easy to see, how once the potential financial impact of both those physical and transitional risks of climate change that we’ve been talking about are contemplated, how they could be influential on an intending investor and therefore be material.

Directors can be liable to pay compensation or pecuniary civil penalties for deficit disclosure by the company, unless they have a defence – in this case as a defence, that they took “all reasonable steps” to ensure the required disclosure.

As mentioned earlier, these are, in my view, the avenues that activists and disgruntled investors will look at in the future.

We have not yet seen much consideration of the potential liability of auditors in New Zealand, but we are seeing discussion in Australia as to whether financial statements which neglect the implications of climate change can be said to give a “true and fair” view. The public warnings we referred to earlier from fund managers in Europe also serve to put auditors on notice. I don’t think we doubt that in due course those activist litigators will look to auditors as well.

Looking further to the local government sector, it’s notable that leading New Zealand QC Jack Hodder issued a paper in March 2019, to the Local Government Association, warning that “there are local indications that, in some form, climate change litigation will get real traction” against local authorities too.

That litigation risk to local government comes primarily from the statutory responsibilities and powers that have been assigned under the Local Government Act and the Resource Management Act we mentioned earlier. There’s an obvious risk of judicial review but also of other forms of litigation – submissions and objections on policy and planning documents and private claims grounded in tort, such as that that Stephanie explained that Smith is taking in his case. Litigation of this type is not new to local government but the focus on climate change is and is likely to increase, particularly if the changes to the RMA that Stephanie mentioned are enacted.

This risk is also enhanced by the current political fashion to declare a “climate emergency”. While doing so may be a way for local authorities to increase the focus on the issue and call for greater national support, they need to be aware in doing so that they are creating extra duties and responsibilities. To me, declaring an emergency implies an urgent need for action and failing to take that action will trigger at least criticism or potentially litigation by activists.

Stephanie

To summarise, what we have hopefully demonstrated today is that there is a new set of risks that may have a material impact on the performance, position or prospects of the organisations you lead, or in which you audit. These risks will need to be understood and plans implemented to respond to them, just as would be done for other risks.

In the next part of this series we talk about how you can manage these risks – and where you may find specific tools relevant to your organisation.

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