New guide details climate-change-related legal risks for the financial sector

Expectations of banks from investors and regulators are growing, says Dr. Janis Sarra

New guide details climate-change-related legal risks for the financial sector

A new guide for the financial sector from the Canada Climate Law Initiative (CCLI) details the risks, opportunities, and current state of the law on climate change and provides a best-practice manual for oversight and governance while looking at the types of decisions bank boards are making as they work towards net-zero emissions.

The guides notes that there has been a “dramatic shift in expectations” for Canada’s 81 federally regulated banks – six of which hold 90 percent of all the country’s deposited funds. These include managing both the climate risks in their own operations and the emissions-producing activity that they are financing. Investors are pushing for decarbonization, using “a range of engagement tools.” Regulators warn climate change presents “a prudential risk to the safety and soundness of the financial system.” And there is growing concern from civil society about “the pace and impacts of capital allocation.”

While banks accumulate climate-related risks, they are also increasingly expected to be leaders in the transition to net-zero, whether through directing financing toward green investments, or squeezing the funding of high-emitting activities. “These changing expectations are creating potential reputational risks,” said the guide.

The “vast majority” of the risks posed to financial institutions are, not in their own operations, but their financing of carbon-intensive sectors, says Dr. Janis Sarra, the guide’s author.

“Without some sort of strategy or transition plan, there is risk of the value of some of those assets diminishing or being unrealizable in the future… that's a huge risk in the transition.”

Since the 2008 financial crisis, countries around the world have closely monitored the amount of capital and liquidity banks hold, she says.

“The safety and soundness of a bank depends on their capital and liquidity adequacy. There's certainly no immediate threat of solvency issues, but there certainly are threats further down the line.”

Sarra is a law professor at the University of British Columbia’s Peter A. Allard School of Law and founding director of the National Centre for Business Law. She produced the guide with contributions from Norie Campbell, a former senior executive at TD Bank Group.

“The idea around the guide is to try to present a balanced picture of what's going on, the growing expectations of investors, of regulators, and of civil society, in respect of banks. And then to offer boards some guidance on how to be proactive, how to not overstate what they're doing, how to engage meaningfully with regulators, civil society, investors, employees, and other stakeholders.”

All of this is framed within an understanding that it must be a “just transition,” as some parts of Canada will endure an enormous impact, and Canada must protect individuals, workers, and communities who rely on the fossil-fuel sector, says Sarra.

The guide cites the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI), in stating their evaluation that the development of “effective climate governance” in the Canadian banking sector is still in its infancy, and there are “varying levels of maturity” when it comes to climate-related risk appetite and strategy.

For the financial sector, generally, the “most immediate” climate-change-associated risks are, what the Task Force on Climate Related Financial Disclosures (TCFD) calls transition risks, says Sarra. These include risks from technological shifts, regulatory change, changing investor priorities, litigation, and reputational and social impacts of shifting customer and community perceptions.

While it was “slow out the gate,” the pace of regulation has accelerated in Canada, says Sarra. This includes OSFI’s proposed regulations on Climate Risk Management, the comment period for which ended Sept. 30.

The financial sector’s transition risks are on top of climate change’s physical risks, which come from the increased frequency and severity of weather events, and include credit risks, potential market loss, insurance risks, and operational risks. In 2020, severe weather caused $2.4 billion in insured losses, and in 2018 and 2019, there were reported insured catastrophic losses of $3.1 billion from 23 weather events. The Fort McMurray wildfire created $4 billion in damage to homes and businesses, and created another $7 billion in indirect costs, said the guide.

“The legal risks in transition are complex,” said the guide. These include managing the legal risk of taking action, such as “setting targets and designing scenario analysis” and the possibility that shareholders or other stakeholders will challenge “the pace and extent of decarbonization portfolios.” Decisions about how to measure emissions also carry risk, as does choosing “how to secure third-party assurance of the efficacy of methodological choices and strategic decisions to shift lending and investment portfolios.” The guide notes that Morgan Stanley, JPMorgan, and Bank of America recently left the Glasgow Financial Alliance for Net Zero out of fear that they would be sued over its decarbonization commitments.

On the other hand, there are also legal risks associated with failing to meet these commitments or failing to disclose material information related to these activities.

There is litigation risk associated with misrepresenting the environmental sustainability of the bank’s products and operations. Last year, German authorities raided the offices of Deutsche Bank and its subsidiary DWS Asset Management over allegations of greenwashing. On this side of the Atlantic, the U.S. Securities and Exchange Commission charged BNY Mellon Investment Advisor Inc for lying about the Environment Social Governance (ESG) considerations involved in its investment decisions on certain mutual funds it managed. BNY Mellon paid USD$1.5 million to settle the charges. The SEC has a task force examining companies’ sustainability claims and is developing new climate-related disclosure requirements.

There is also litigation risk from lack of transparency with shareholders. Shareholders in the Bank of Australia recently sued the bank for failing to disclose climate-related business risks, which included a possible investment in a coal mine. The bank’s financing of new oil and gas projects led to another dispute with shareholders, which is still pending.

In the U.S., class actions around public companies allegedly giving false or misleading statements to shareholders on their management of investments related to carbon emissions are growing in frequency

There is a gap between the complaints from civil society about the “massive funding of high-carbon-intensive sectors” and what banks say in their disclosures about the extent to which they are financing the net-zero transition, says Sarra.

“There are some reputational risks there. Definitely, there are some litigation risks there.”

The guide discusses how to prevent investors brining complaints under securities law, or surrounding misrepresentation or greenwashing, she says.

There may be litigation stemming from physical impacts, with plaintiffs alleging the bank was indirectly or directly responsible for damages associated with climate-related extreme events or chronic impacts, said the guide. There is also legal risk from alleged breach of fiduciary duties. As an example of the latter, an environmental charity is suing the Banque Nationale de Belgique in Brussels for implementing “a corporate sector purchase program that purchases carbon-intensive bonds.” Dismissed at first instance, that case is under appeal.

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