Institutional investment, corporate governance and climate change: what is a trustee to do?

26.01.2015 Maged Girgis, Sarah Barker

Recent publicity surrounding the exclusion or divestiture of stocks in carbon-intensive industries shows that leading investors are reviewing the financial risks (and opportunities) associated with climate change. However, with debate on climate change often pitched around ideological poles, many superannuation fund trustees are struggling to translate these developments into prudent governance practice, consistent with their statutory and general law duties. This article looks beyond the political debate to consider what recent developments on climate change mean for the legal obligations of fund trustees, and the implications for boardroom practice. In doing so, they note that focus on the outcomes of investment (or divestment) decisions may have obscured the key legal issue – that of diligent process.

Change is occurring, in two contexts: science and economics

Institutional stakeholder viewpoint

The relationship between climate change issues and financial wealth continues to rapidly, and radically, evolve.

Historically, climate change was often regarded as an ethical issue for investors – a 'non-financial environmental externality' that was secondary to, and largely inconsistent with, the investment imperative to maximise financial returns.

Over the past decade, more funds have applied an integrated Environmental, Social and Governance (ESG) approach in which 'responsible' investment practices have been applied to generate both positive external outcomes and benchmark financial returns.

More recently, however, the financial risks and opportunities presented by climate change have become a mainstream issue for the investment community. Debates over 'stranded asset' exposures (eg the IMF, OECD, WorldBank)and asset divestitures play out in the financial press. Recognised economic and financial institutions warn of the significant economic consequences of climate change. And, globally, we are witnessing a surge in political and regulatory interventions in an attempt to deal with climate change and the resulting community concerns.

These developments illustrate that, increasingly, market stakeholders view the financial risks (and opportunities) associated with climate change as extending beyond its potential physical impacts, toencompass market, reputational and legal issues, such as:

  • Community and reputational risk which can quickly and significantly affect investment value (take for example, the speed and impact of the anti-coal seam gas campaign in NSW)
  • Litigation against investee companies for first or third party damage (eg. damage to third parties due to a firm's failure to adapt to climate change risks, or damage to company itself via shareholder derivative action due to cost/loss of value from the failure to adapt)
  • New laws or policy developments that may result in rapid re-pricing of assets (eg. intergovernmental agreements on emissions restrictions)
  • Closure or restriction of markets (eg. Chinese Government's tariff on Australian thermal and coking coal (later revoked upon settlement of the FTA))
  • Technology quickly developing towards lower carbon emissions (eg. developments in battery storage technology, rapid uptake of distributed energy solutions – particularly in emerging markets, rapid uptake of electric vehicles)
  • Relative cost competitiveness between fossil and renewable energy sources
  • Oil and gas price fluctuations (eg. high prices impacting on the relative cost competitiveness of alternatives such as electric vehicles, low prices reducing the viability of capex on unconventional fossil fuel reserves such as oil tar sands, shale fracking)
  • Inaccurate business modelling of medium to long term projects (eg. unrealistically low internal price on carbon)
  • Maladaptive short-term strategies, ie. investments that may deliver short-term economic gains but exacerbate vulnerability to potential climate change related issues in the medium-long term (eg. locking in capital-intensive infrastructure in a carbon-intensive business, ignoring 'stranded asset' risks)
  • Exploiting opportunities to increase market value across asset classes (eg. active engagement with investee companies around climate change exposures and strategies, recognition of market value perceptions around energy-efficiency for real estate / infrastructure, lower costs of capital and insurance)

Many of these factors are driven by evolving societal, governmental and market perceptions which go beyond the potential physical impacts of climate change. However, irrespective of their source, these factors present both material financial risks and opportunities, which must be actively considered in the pursuit of wealth-based interests.

Developments in governance law

The last few years have also seen the legislature, regulators and the courts hold directors and trustees to higher standards of professionalism and pro-activity to satisfy their duties of due care, skill and diligence.

The Superannuation Industry Supervision Act now holds trustees to the standard of the 'prudent superannuation trustee' rather than merely the 'ordinary prudent person'. Further, APRA, ASIC and the ASX continue to revise their guidance on expected standards of governance. Finally, findings against directors in cases such as Centro and James Hardie have reinforced the courts' view that 'due care and diligence' requires directors to be both informed and engaged, and to actively monitor corporate implementation of strategic plans and policies.

Together, these developments have the potential to significantly impact the way in which trustees and their directors approach the governance of their funds. Regardless of a trustee's personal, moral or ideological views on the reality of climate change, it simply cannot ignore the financial risks associated with the issue discussed above.

But does this mean that a trustee is now duty-bound to ensure that asset valuations consider these financial risks? Are they already reflected in market price valuations? Are the relevant risks measurable with sufficient certainty? Should funds exit from investments in exposed sectors, or is that an over-reaction? What does it mean for competing pressures around risk tolerance, value growth, dividend yield, liquidity and diversification? When is it 'material'? And is it really an issue for trustee boards at all, or one that should be left for their consultants and investment managers?

What do these developments mean for trustees in practice?

Fiduciary duties

In short, the sharp evolution in the relationship between climate change and financial wealth suggests that, as with any material financial risk, an inactive, reactive or passive approach to its governance may be inadequate to discharge a trustee's duties of due care and diligence in pursuit of the best interests of fund beneficiaries.

It is the process of information gathering and deliberation that is critical to satifying the duty of due care and diligence. The decision that results from that process, to divest or not to divest, or to exclude or not to exclude, is not the determinative issue. Rather, the relevant inquiry is whether, in their oversight of fund performance against its objectives, a trustee is appropriately informed and engaged with relevant risks and opportunities, has sought expert advice where appropriate, has applied independent judgment to the matters at hand, and has constructively evaluated the strategic consequences of material issues using methodologies and assumptions that are appropriate for their forward-looking purpose.

So what does this mean in the context of climate change issues and the fossil fuel divestiture debate? It is not to say that trustees are duty-bound to decarbonise their portfolios, or that environmental sustainability must be universally prioritised. Nor does it suggest that trustees of 'open' funds must reconsider the nature of their fund beneficiaries' collective 'best interests' and extend them to incorporate external, ethical, moral or ideological goals. But it does mean that boards must actively engage with the impact of these financial risks and opportunities on their portfolios.

On the one hand, a knee-jerk, blanket directive to exclude mining, resource or utility companies from the investment universe may fall short of minimum standards of diligence. On the other, so may a governance approach that is entrenched in the denial or ignorance of the financial risks and opportunities associated with climate change, or a 'strategic management' approach that such risks do not require action without regulatory direction.

In practice, there is simply no substitute for trustee engagement with and evaluation of any economic or strategic issues that may materially affect the performance of their fund. As demonstrated by recent developments, climate change is increasingly becoming one such issue.

Misleading disclosure and reporting

Risks or opportunities associated with climate change also present challenges for disclosure and reporting obligations. Trustees must ensure that their investment practices continue to accurately reflect the fund's stated beliefs, objectives and public commitments.

There is a growing disconnect between ideological commitments to 'sustainability' and the investment strategies required to implement them. Over-statement of the 'responsible' characteristics of an investment option or policy, or ineffectual policy implementation, may expose the trustee and directors to claims that they have misled their fund beneficiaries or the market.

Trustees are required to consider not only whether their Statement of Investment Beliefs recognises the risks or opportunities of climate change, but also how these beliefs are implemented. Are they reflected in investment policies, strategies, mandates, incentive structures and practices? What performance metrics are applied, measured and evaluated? And how does management, and in turn the board, monitor processes and performance on point?

A starting point for diligent governance

Many trustees are overwhelmed by the scale and complexity of the governance challenge at hand. To simplify the process, a number of preliminary questions can be asked. The following list is not intended to cover all aspects of risk under the trustee and directors' duties and related obligations, or as a replacement for legal advice in a particular context. However, trustees may find it useful as a ready reference.

  • Have your trustee board, General Counsel and Company Secretary received specific training on their statutory and fiduciary duties in the light of recent legislative updates and Court decisions?
  • Do your trustee board, General Counsel, CIO, asset/fund managers, analysts and consultants receive up-to-date, specific and appropriately-qualified briefings on the financial risks associated with climate change?
  • Has a review been conducted on current portfolio exposures to climate change risks including emissions profiles and stranded asset risks?
  • Does your Statement of Investment Beliefs include a recognition of financial risks or opportunities associated with climate change? How are those Investment Beliefs, or any other public commitments around environmental sustainability, implemented? How are they reflected in investment policies, mandates, incentive structures and practices? What hedging options are available? What are the different implications across fixed income, equities and direct ownership asset classes? What valuation and performance metrics are applied, measured and evaluated? And how does the board monitor processes and performance on point?
  • What does your trustees' Directors' & Officers' Insurance policy cover, and exclude, in the context of governance failures around climate change risks and opportunities?



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