Embracing uncertainty: How disclosing uncertain information on climate risk can reduce legal liability exposure

By Marcela Scarpellini

As climate related damages increase, the need to allocate funds and apportion blame will inevitably follow. In this context, the mechanisms used for determining responsibility are likely to become, to say the least, very creative.

Pressure for proactive climate action and better response is mounting thanks to legislation and regulation, litigation, shareholder demands, citizens calling for more action, carbon taxes and concrete mitigation and adaptation plans.

The status and intent of current regulations relating to climate change and the legal infrastructure that is expected to support or deter the transition to a low carbon economy, provide a good indication of the stringency and certainty of the measures that will follow.

After Bank of England Governor Mark Carney’s famous warning in his 2015 speech regarding the threat climate change posed to our financial systems, financial institutions and governments started to wake up to the issue. This meant paying attention to – and developing an understanding of – how climate risks might play out and affect businesses future profitability and the stability of the wider financial system. In response, the G20’s Financial Stability Board established the Task Force on Climate-Related Disclosures (TCFD).

Point in time: Disclosure

The TCFD‘s purpose is to provide corporates and financial institutions with a framework for climate risk disclosure in two key respects. First, with regard to the analysis of the physical and transition risks and opportunities they may face due to climate change. Second, with regard to the development of appropriate strategies to respond to the consequences of those risks materialising.

This initiative, which already has 513 official supporters across businesses, advisory firms, and financial institutions, is a voluntary framework. The main political intention behind it – in combination with the EU Directive on Non-Financial Disclosures, EU Shareholders Directive and other upcoming EU financial regulation – is to foster transparency by requiring corporates and financial institutions to disclose information on material impacts of the physical and policy risks (transition risks) connected with climate change.

The TCFD recommendations are just a first step. Increasing transparency is a means to an end, not an end in itself: boilerplate and vague disclosures will not cut it. The intention of climate risk disclosures is to provide legislators with a broad understanding of the current state of investments and business bets into a certain world, in order to come up with evidence-based legislation that actually has a chance of reshaping our economies.

In this context, corporates and financial institutions have started to work out the best ways to generate relevant disclosures. The first attempts to generate this information using the TCFD framework have been released, but there is still a long way to go.

Hot topic: scenario analysis

One of the challenges of applying the TCFD framework has been the use of scenario analysis. Scenario-analyses are forward-looking tools intended to allow users to imagine how a range of possible futures could look, the risks and opportunities entailed in those different futures and get its users to pin down how their companies would be affected if any of those futures materialized. The overarching purpose is to enable firms to develop strategic and resilient business plans to incorporate envisioned or possible changes.

A concrete way in which companies make use of scenario analyses is by using them to understand how their capital requirements might be impacted under a range of plausible scenarios. Using scenario analyses, companies can peer into the future and build resilient responses to a world in which extreme events and their financial impacts are no longer sporadic but recurrent.

Scenario analysis is a time and capacity consuming challenge. Despite this, many companies, particularly within the oil & gas sector, have been using these tools for some time, and companies in other sectors are starting to do so too.

Another significant hurdle for companies performing scenario analysis stems from having to disclose the information generated. Many businesses are wary of this since, it is suggested, the information generated by scenario analysis is just hypothetical, which could, in turn, be misconstrued as a fraudulent, deceptive or incorrect disclosure, potentially opening the door to liability exposure. However, in reality, this constitutes a narrow view of the story.

Understanding risk

Properly understood, scenario-analysis is a risk assessment tool, so the information derived from it is the same in nature as information relating to other risks that might affect a company. Risks are hypothetical by nature and gain validity when substantiated through evidence and justification.

What it takes to reduce disclosure-related liabilities is a thorough and well-presented substantiation of the information provided, with clear and precautionary wording regarding how this information ought to be interpreted and construed.

A stream of forward-looking legal experts, within the Commonwealth Climate and Law Initiative, are of the opinion that disclosing forward-looking information in line with the TCFD Recommendations might, on the contrary, reduce liability exposure. Their claim is justified by understanding the core intentions of the TCFD’s recommendations, namely transparency and accountability. Therefore, firms able to demonstrate that they are acting to understand and manage climate risk will be acknowledged for that in the light of corporate responsibilities such as due diligence and good corporate governance. In understanding the purpose of disclosure, firms are allowed to make mistakes, though they are not allowed to be fraudulent, deceptive and manipulative about the future in order to ensure certain business interests.

As more firms get on board with the TCFD recommendations, using them as guidelines for disclosure, it is likely that they become reference points and that national laws start to be interpreted in light of the most advanced practices. In jurisdictions such as the UK, where an objective test applies to determine the extent and manner in which directors have exercised their duty of care and due diligence, this determination is likely to be done on the basis of what others in the industry are doing. If and when TCFD becomes best-practice, this is likely to become the yardstick against which these determinations will be made [1].

Good practice to reduce liability

Scenario-analysis remains a beneficial tool, despite the fact that it is still becoming an established best practice and mandated by law. To reduce firms’ concerns around liability associated with scenario-analysis, and to encourage them to start using it and disclosing climate risk information prudently, a series of recommendations follows:

• Use proper cautionary language.
• Use a variety of scenarios, at least three would be advisable.
• Place all scenarios within the same section and under the same fonts in your disclosure as to avoid that any be interpreted as being favoured.
• Use multiple sources for data and narratives and seek insights from new sources.
• Use current data and justify your choice of providers.
• Ensure your scenarios reflect the variance (climate, political, social, regulatory) and are relevant to the entirety of the company´s operations.
• Use information derived from scenarios in order to justify likelihood and not infallible certainty.
• Not disclosing any forward-looking information under the false pretence that it might make your company liable is a greater risk than disclosing uncertain information.
• If you are not sure of how to go about it, hire consulting services to guide you along the way.

[1] Concerns misplaced: Will compliance with the TCFD recommendations really expose companies and directors to liability risk? Alexia Staker, Alice Garton & Sarah Barker. Commonwealth and climate law initiative.