A New Climate of Risk: What Companies Need to Know About Novel Categories of ESG Risks
New categories of climate change-related risks could adversely impact current business practices and must be analyzed and addressed.
The SEC’s March 2021 announcements related to the agency’s focus on climate change could signal the start of a new regulatory era for businesses whose activities have a negative impact upon the global environment (e.g., pollution, climate change, resource depletion, toxicity), social welfare (human rights, working conditions, safety) and governance (corruption, bribery, political donations, lobbying) (“ESG”). While final rules and enforcement actions will ultimately determine the extent to which the SEC seizes the clear “opportunity” noted by Acting Chair Lee in her dissent to the prior administration’s rulemaking, “to address climate, human capital, and other ESG risks,” the manner in which the SEC has framed its announcements and requests for comments in the context of climate change suggests that businesses should be bracing themselves for an aggressive approach to the regulation and disclosure of ESG risks.
Climate Change Risks Should Be Evaluated.
We provide here a non-exhaustive summary of major business risks associated with climate change, which companies may wish to consider as part of their internal compliance undertakings as well as with respect to risk disclosures in public and private securities disclosures. Rather than cover well-known risks, including those expressly mentioned by SEC guidance since 2010 (e.g., the impact of climate change regulation, international accords, consumer preferences, and physical damage), we focus on expansive new legal theories of corporate and individual liability that have gained momentum over the past decade—theories of liability whose spread and adoption could create entirely new categories of material risk. These new categories of risks can be summarized as follows:
Liability against an enterprise for directly producing greenhouse gas emissions.
Supply chains, labor, and market risks triggered by climate change.
Potential personal liability of board members for conscious disregard of climate change.
Corporate cancellation stemming from perceived culpability for climate change.
Concerns related to the movement to criminalize “ecocide.”
Companies That Have Materially Contributed to Current Levels of Greenhouse Gas Emissions May Face Direct Liability for Damages Caused by Climate Change.
Companies that have materially contributed to levels of greenhouse gases in the atmosphere will almost certainly have increased exposure to potential liability from lawsuits seeking compensation from climate change-related damage. To date, more than 1,500 lawsuits have been filed around the world against states or private actors for relief. The highest courts in Ireland, Colombia, and the Netherlands have already held that their home countries have potentially violated international legal obligations related to stabilizing the climate, and a current action is pending in the European Court of Human Rights against 33 countries related to their alleged failure to stabilize the climate. The case has been fast-tracked and defense paperwork is due by May 27, 2021.
With courts willing to issue orders against governments, it is probably only a matter of time before (i) courts issue orders against private companies as well, and/or (ii) domestic regulatory agencies seek penalties against private companies domiciled in or doing business in their jurisdictions. There are several lawsuits pending against fossil fuel companies in a variety of jurisdictions, attempting to recover damages for historic emissions caused by such companies. While these efforts have not yet yielded a successful claim against fossil fuel producers, the floodgates of climate litigation appear to be growing commensurate with the levels of carbon dioxide in the atmosphere, and this trend will likely accelerate. Even a single successful lawsuit endorsing private causes of action against businesses under an expansive theory of causation or culpability for tortious conduct could change the risk landscape for businesses that emit greenhouse gases and may make the enterprise uninsurable or saddle it with potential incalculable liability practically overnight. For example, in 2020, the Ninth Circuit held that claims by San Francisco and Oakland against several oil companies for causing a “public nuisance” could be potentially litigated in state court. City of Oakland v. BP p.l.c., 960 F.3d 570, 575 (9th Cir.). A petition for certiorari is currently pending before the United States Supreme Court on this issue, which recently heard oral argument on a related question of the scope of federal review in early stages of climate litigation proceedings in BP p.l.c. v. Mayor of Baltimore, No. 19-1189 (docketed Mar. 31, 2020).
Climate Change Will Produce Risks to Current Business Practices and May Threaten the Profitability and Sustainability of an Enterprise.
Supply chains, labor, and market demand are three critical components of enterprise infrastructure that will be impacted by climate change:
Supply Chains: In March 2021, a single ship (the Ever Given) caused days of delay to international shipping routes by getting stuck in the Suez Canal. This was a poignant illustration of the sensitivity—even delicacy—of international commerce and the disruptions that can be caused when key infrastructure is negatively impacted. Companies must assess and disclose how climate-related impacts—longer and drier droughts, more powerful storms and hurricanes, hotter global daytime and nighttime temperatures, increasing humidity, flooding from rising seas—could affect sensitive infrastructure and supply chains they rely on in order to conduct their businesses. Many of these impacts are likely to increase the costs of doing business, perhaps even dramatically. A company that relies heavily on supply chains from a part of the world likely to experience increased flooding and stronger storms should assess the risk of how a warming world will affect that supply chain. A company that has a seasonal supply chain may need to consider whether shifting rain patterns or longer heat waves may impact the growing season or the quality of the product. Because these types of disruptions can be foreseeably anticipated, and because of their potential scope of disruption, they are likely to be considered material and must be delineated and disclosed in applicable disclosure documentation.
Labor: Many companies outsource their labor needs to parts of the world that are already experiencing significant forms of climate disruption. Companies that rely on labor from countries like India, Bangladesh, or the Philippines (by way of non-exhaustive example) may face the possibility of unsteady labor conditions caused by increasing strength of hurricanes, floods, and heatwaves. Such natural disasters not only interrupt business, they also destroy infrastructure, creating more onerous and dangerous working conditions after the disaster has left its acute phase. As sea levels continue to rise, displacement and migration from these countries will further increase. One billion people are expected to be displaced by 2050—just thirty years’ time—as a result of climate change related impacts. Companies should assess the vulnerability of their labor teams in areas likely to face displacement because of climate change, as such labor pools may become increasingly disrupted.
Shifts in Market Demand: Climate change will lead to shifts in market demand that may make certain products and services unattractive in the years ahead. Coastal real estate is a prime example of an industry that has yet to face the inevitable market correction of the reality of rising sea levels, and businesses that cater to coastal properties (including related industries such as tourism) may find themselves without customers sooner than they realize. Long before the ocean has submerged coastlines, sea water will have already seeped into aquifers and wells or caused damage to underlying infrastructure that will prove costly to remedy, with any such remedy being temporary. Businesses must accept the reality that glaciers are melting (relevant to mountain industries), animals are shifting their migration patterns in response to warmer temperatures (relevant to ocean and land use, including fisheries), and that oceans will rise anywhere from 0.3 meters to up to 2.5 meters by 2100, depending on how quickly greenhouse gas emissions are reduced. A rise of up to 2.5 meters would spell disaster for many of the world’s commercial hubs, including New York and Shanghai. Businesses must avail themselves of the available climate science and assess how these predictions may impact their enterprise over the years and decades ahead.
Corporate Board Members Should Assess the Risks of Personal Liability Related to Breaches of Their Duty of Care.
In certain circumstances, corporate law imposes liability on corporate directors who are derelict in their duty of care, and specifically, when they fail to impose systems or controls or ignore red flags triggered by an ongoing reporting system, causing damage to the corporation. In Delaware, this concept is known as Caremark liability, from the landmark case In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). Caremark liability gives shareholders a right to sue derivatively against corporate directors to recover damages to the corporation caused by the breaches of the duty of care.
Caremark liability is “among the most difficult of claims in [Delaware] to plead successfully,” Teamsters Local 443 Health Servs. v. Chou, No. 2019-0816-SG, 2020 WL 5028065, at *1 (Del. Ch. Aug. 24, 2020). That being said, Delaware courts do permit such claims, particularly where directors are aware of “red flags, but act[] in bad faith by consciously disregarding their duty to address the misconduct alerted to by such red flag.” Id. at *51. When corporate directors flout or act in defiance of mission-critical laws and regulations, directors may be held personally liable for damage they cause to the corporation. Id. at *53.
In the context of climate change, much of the conduct that is creating a warming planet remains legal and permissible under domestic laws. However, it is not a secret that the planet is warming, and it has been scientifically established that the burning of fossil fuels is the chief cause of that warming. Companies that materially contribute to greenhouse gas emissions, fail to disclose internal knowledge or metrics regarding the true impact of their emissions, or that fail to adapt the enterprise to a warming world, could encounter creative claims from stockholders who allege that directors breached a duty of care by failing to account for foreseeable and known climate risks and acted in bad faith by ignoring such risks. The absence of specific federal regulation also does not shield business activity from liability for business torts or other applicable state law (although this is itself an increasingly litigated issue). Additional rulemaking from the SEC could have a bearing on the interpretation of the clarity of such red flags. Indeed, the SEC’s recent call for comments requests input on the potential adoption of clear standards and criteria that could decrease the evidentiary burden of making a finding of liability on an enterprise. Directors should assess their own personal risks of liability and also confirm the extent of protection provided by applicable indemnification agreements and provisions of corporate charters and bylaws, as well as coverage provided through Directors and Officers policies.
Companies Must Assess the “Cancellation Risk” Stemming from Their Perceived Culpability for Climate Change.
In the past, companies used to analyze the fallout from bad acts and their destructive impacts as “Headline Risk” and treat such fallout as public relations challenges, rather than material risks to their business operations and bottom line. Social media has changed this calculus in a way that is not presently reflected in corporate disclosures—instead of “Headline Risk,” now it is more appropriate to speak of “Cancellation Risk,” e.g., being completely canceled, de-platformed, or made irrelevant through coordinated but diffuse action of millions of people connected through memeified cancel culture.
Thus far, the weapon of “cancellation” has been primarily deployed against individuals who have allegedly violated significant cultural and legal boundaries, with severe or even fatal consequences to the value of their personal brands. With members of Gen Z listing climate change as the top challenge of our time, cancellation will likely, in time, be used against companies perceived to be harming the environment and materially contributing to climate change.
Businesses that find themselves at the center of attention from social media users in response to specific or an ongoing pattern of environmentally destructive acts could see the effects of “cancellation” in a variety of different ways, including through viral calls for de-platforming such businesses from communication or commercial channels, e.g., from Twitter, Facebook, Amazon—all of which have the discretionary right to remove any user. As has now been repeatedly demonstrated in the non-corporate sphere, it can be hard or even impossible to recover from the cascading impacts of cancellation. Companies that rely on social media and/or third party channels for user acquisition, distribution, sales, and marketing must now be attuned to the presence and disclosure of these risks.
Risks Related to the Crime of Ecocide.
A growing international legal movement is seeking to define and eventually prosecute the crime of “ecocide,” and there are significant efforts to have the International Criminal Court (ICC) define, adopt, and prosecute the crime. While there is no accepted definition of ecocide under international law, one popular working definition is “acts or omissions committed in times of peace or conflict by any senior person within the course of State, corporate or any other entity’s activity which cause, contribute to, or may be expected to cause or contribute to serious ecological, climate or cultural loss or damage to or destruction of ecosystem(s) of a given territory(ies), such that peaceful enjoyment by the inhabitants has been or will be severely diminished.”
Practitioners arguing for the adoption of ecocide generally focus their attention on “harmful industrial activity” causing climate and ecological damage, and highlight the mining, oil and coal, agriculture, cement, and textile industries as potential targets of prosecution. Thus, businesses in these industries should be particularly aware of the ecocide movement and understand the risks of potential liability under domestic and international law for engaging in conduct that might be considered ecocide, in the same way they may assess the risks associated with any other international human rights violation.
Companies and Investment Funds Should Work with Counsel to Determine the Necessity of Updating Risk Disclosures.
The SEC’s announcements, coupled with its creation of a 22-person Climate and ESG Task Force, sends a clear signal that now is the time for companies to carefully reevaluate their climate-related regulatory and disclosure obligations. Even before the SEC releases its final rulemaking or initiates enforcement actions, companies should commence conversations with their counsel to assess their obligations under the SEC’s existing materiality standard, which requires issuers to determine what climate-related information reasonable investors would view as important in making the decision to buy or sell securities.
Companies that directly emit significant greenhouse gases, including oil and gas companies, heavy manufacturers, and other energy-intensive industries, are unlikely to be surprised by the push towards increasingly aggressive regulation pertaining to their business practices. They may, however, need to work with regulatory and securities counsel to consider the increasing credibility of risks of legal claims that were once considered highly speculative, or risks that have been acutely exacerbated in an era when their business practices overlap with a novel and chaotic social app-mediated market landscape.
Companies in industries that rely on fossil-fuel driven infrastructure such as agriculture, food, transportation, construction, and certain cryptoeconomy companies should also take this opportunity to assess the scope of their impact upon climate change, and work with counsel to disclose risks that may become material.
Finally, companies or investment funds promoting “green,” “clean,” or “impact investment” opportunities should critically assess their marketing materials, applicable investment criteria, strategies, processes, metrics and compliance policies and controls. A significant portion of the SEC’s recent guidance concerns the appropriate use of frameworks, principles and standards that can be employed both for the assessment of climate and other ESG risks as well as the promotion of ESG-related returns.