Navigating climate compliance challenges

November 2024  |  COVER STORY | RISK MANAGEMENT

Financier Worldwide Magazine

November 2024 Issue

Climate change is one of the biggest threats facing the globe. Some regions of the world will get warmer, some drier, others wetter. This shift will not only impact our health but also the ecosystems we depend on. Unless action is taken quickly, extreme weather events such as flooding, storms, droughts and heatwaves, among others, will intensify and become more frequent.

Some communities and regions are more vulnerable than others, but many countries are inadequately prepared for escalating climate risks. 2024 will be warmer than 2023, according to Petteri Taalas, secretary-general of the World Meteorological Organisation.

Over the past 40 years, notes the European Environment Agency (EEA), extreme weather events accounted for between 85,000 and 145,000 human fatalities across Europe. More than 85 percent were due to heatwaves. Economic losses from weather and climate-related extremes in Europe reached around €500m over the same period. How countries respond to the crisis will shape the future.

In an attempt to combat climate change and its potentially devastating impacts, governments around the world have committed to meeting net zero carbon emissions targets and transitioning to green energy. These goals require significant public and private sector investment and substantial policy reform. But the regulatory outlook is complicated. Clear guidance on being sustainable and hitting net zero and carbon neutrality goals is often lacking. Some regulations, such as the Federal Trade Commission’s (FTC’s) Green Guides, are out of date.

As regulators grapple with how to measure, classify and monitor climate-related financial risks and issue new mandates, companies are facing expanded legal and compliance obligations. They must adapt to the climate risk landscape accordingly. Thinking strategically about environmental, social and corporate governance (ESG) challenges is part of the solution. In a fraught marketplace, those that do may turn their response into a competitive advantage.

Rise and report

Companies have been voluntarily reporting on climate risks for over two decades using tools like Global Reporting Initiative standards and Carbon Disclosure Project questionnaires. Consequently, regulations (which are relatively recent) are in some cases tailored to voluntary standards, explains Suz Mac Cormac, a partner at Morrison Foerster. Securities exchanges in over 120 countries have, for example, endorsed the International Financial Reporting Standards (IFRS) S1, for sustainability-related financial disclosures, and S2, for climate-related disclosures. Additionally, about 20 regulators have signalled their intent to adopt the standards.

“Companies may start their compliance journeys using these tools as a baseline,” says Ms Mac Cormac. “The most comprehensive regulation for now is the European Union’s (EU’s) Corporate Sustainability Reporting Directive (CSRD), which transcends directly-in-scope companies and implicates their suppliers, customers and counterparties across the globe, including US and Chinese companies. In addition to disclosure regulations like the CSRD, regulations requiring corporate action like the EU’s Corporate Sustainability Due Diligence Directive (CSDDD) are on the horizon. Penalties for non-compliance include monetary fines such as those under California laws, and loss of investment opportunities and customers if companies are unable to provide requisite ESG data or demonstrate compliance.

“To mitigate these risks, companies should map their operations and business to regulations, conduct gap assessments, establish good data governance and collaborate with subject matter experts for compliance and strategic support,” she adds.

According to Liz Malone, counsel at Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates, the landscape is rapidly evolving, both in terms of substantive regulatory requirements mandating reductions in greenhouse gas (GHG) emissions and regulatory requirements focused on disclosing climate-related information. “In the US, the Environment Protection Agency (EPA) has steadily been proposing emission reductions in certain industries and over 20 states have established emission reduction goals,” she points out. “Europe is likewise continuing to implement and expand its GHG emission trading regime.

“In the area of disclosures, we have seen numerous jurisdictions impose sweeping disclosure requirements with respect to climate risks, including requiring the disclosure of GHG emissions, the financial risks associated with climate change regulations and extreme weather events, and how a company manages those risks,” she continues. “Disclosure regulations have been adopted or proposed by, among others, California, the US Securities and Exchange Commission (SEC), the EU and the UK. Two of the biggest challenges for multinational companies in this area are harmonising the disclosure of climate-related information across multiple regulatory regimes and ensuring that climate-related goals are aligned with other business objectives and plans and commercially feasible within the applicable time frame.”

But aligning corporate sustainability goals with compliance obligations is no simple feat. “The first challenge for companies is determining which regulations apply to a company directly or indirectly through customer and supply chain relationships – and both the breadth of applicability across an organisation and timing for compliance,” says Ms Mac Cormac. “Secondly, nuances in regulatory requirements and constant changes make it difficult for companies to build compliance programmes that can be replicated across reporting regimes. Companies are now faced with high compliance costs and inundated sustainability teams.

“Third and most importantly, there is a gap between compliance needs and initiatives for competitive advantage. High compliance costs make it difficult to secure budgets to embed sustainability in operations – for example, securing funds to conduct in depth materiality assessments or climate-risk impact scenarios analysis (such as high insurance and migration issues) can impact assessments focused on evaluating how climate risks affect core business and operations. Finally, companies struggle with strategy development and often run the risk of siloing sustainability in legal departments without sufficient leadership and support from other practice areas such as finance, procurement and marketing,” she adds.

Elusive harmonisation

Companies are increasingly encouraged or obliged to report on their sustainability efforts, but a lack of harmonised expectations across jurisdictions creates a challenge. Sustainability reporting standards are being held back by a number of factors, including a diversity of objectives among standard-setting organisations. This creates a problem for companies when it comes to consistently communicating their sustainability efforts.

One hurdle is defining sustainability itself. Definitions vary widely to include concepts such as corporate social responsibility and ESG. Certain factors that contribute to these concepts also attract assorted definitions – some, for example, view nuclear power as a ‘green’ investment, while others disagree. Adding to the complexity, the definition of ‘sustainable’ has also evolved in different regions over time.

Blame for the uncertainty can, at least partly, be attributed to the number of standard-setting organisations around the world. Comprised of not-for-profit organisations, business groups, charities and non-governmental organisations, it is unsurprising that there is a diversity of definitions. Opinions on how to approach sustainability reporting lead to disagreement on compliance requirements.

The ongoing work of the International Sustainability Standards Board (ISSB), which is developing a global baseline for joined-up corporate sustainability disclosures that meet investor standards, signals perhaps the clearest movement toward harmonisation. The aim is to generate accurate data on environmental impacts, enabling stakeholders to effectively interpret this data.

In the meantime, legislation will continue to evolve and motivate companies to act. But different regulatory frameworks and policies may apply to an organisation, depending on where it operates. In the US, for example, the SEC’s climate rule has received plenty of attention. While that rule is currently stayed pending legal challenges, companies that do business in California – even those private companies not organised under the laws of California – need to pay attention to the state’s disclosure requirements, explains Ms Malone.

“As an example, companies doing business in California that make claims about being ‘net zero’ or ‘carbon neutral’ or achieving significant GHG emission reductions must disclose on their websites information that substantiates those claims,” she says. “Additionally, companies doing business in California and exceeding statutory revenue thresholds must disclose their GHG emissions – whether material or not – as well as information about their climate-related risks on their websites.

“Likewise, by 2025, some 3000 US-based companies are expected to be subject to the European Union’s climate disclosure requirements covering physical and financial risks, climate strategies and GHG emissions,” she continues. “Europe also has sweeping disclosure laws addressing broader ESG topics, including biodiversity, pollution and impacts on communities and workers. Failure to comply with these requirements could lead to regulatory fines, investor activism campaigns, and reputational harms.”

Regulatory requirements will continue to impose greater demands. In Europe, measures such as the CSRD will be key. This EU directive requires all large companies and listed small and medium-sized enterprises to publish regular reports on their environmental and social impact activities. It is intended to help investors, consumers, policymakers and other stakeholders evaluate companies’ non-financial performance. In this way, it encourages these companies to develop more responsible business practices.

In addition, the EU Carbon Border Adjustment Mechanism (CBAM) will help mitigate carbon leakage and level the playing field in the global market. For certain corporations operating within the EU or seeking to trade with it, understanding the CBAM is essential for climate disclosure. It primarily targets EU importers of carbon-intensive products from industries including iron and steel, cement, aluminium, fertilisers and electricity generation. Companies outside the EU, operating in regions without similar carbon costs as those in the EU, may face CBAM tariffs when importing into the EU.

Going forward, the Sustainable Finance Disclosure Regulation (SFDR), the EU CSDDD and Streamlined Energy and Carbon Reporting (SECR) in the UK will create additional challenges for companies to navigate.

Going for goal

Against this backdrop, companies need to evaluate ESG and climate-related risks arising from their business operations and address them in their risk management frameworks.

“To be successful and cost effective, climate risk management must first be prioritised as part of core business strategy – not a siloed consideration,” notes Ms Mac Cormac. “To achieve this, we recommend that a company establish climate-risk management oversight at the board level, with support from management and cross-functional teams. Secondly, companies should conduct materiality assessments to identify climate risks and opportunities. Based on findings, the board should set strategic direction and identify key performance indicators (KPIs), while management develops metrics and targets to integrate KPIs into day-to-day activities and manage performance.

“Management teams should collaborate with subject matter experts to develop policies and processes to operationalise climate risk considerations in internal operations, vendor management and throughout product lifecycles. As reliable data is at the heart of ESG management, companies should collaborate with trustworthy data partners to ensure that actions and strategy considerations are backed by data and can be substantiated,” she adds.

As the world continues to battle climate change and drive forward the transition to net zero, related compliance demands will mount. ESG compliance, for example, has moved on from being a voluntary, self-reporting process; today, it is an increasingly regulated business activity.

There is, however, a growing divide between how organisations operate and what is expected of them in the US compared to other jurisdictions, most notably Europe. While there has been some pushback against ESG initiatives in the US, the EU has moved at speed to pursue its targets. This further complicates the landscape for multinational organisations.

Implementing risk mitigation strategies will be vital. Companies must plot a course through the vast array of rules and standards to which they are subject. Doing so requires extensive planning.

“It is important to ensure that all relevant stakeholders within the organisation are coordinating when setting climate-related goals, identifying climate-related risks and drafting disclosures,” suggests Ms Malone. “This coordination should take place early and often. For example, the legal, sustainability, finance and engineering teams all need to work together when setting climate-related goals to ensure that those goals align with other business objectives and plans, are commercially feasible within the applicable time frames, and are communicated in a manner that is consistent across platforms, complies with mandatory disclosure obligations and uses appropriate terminology.

“Additionally, companies considering setting a climate goal, such as achieving net-zero emissions, need to evaluate what disclosure obligations will be triggered by setting that goal and whether the goal will expose the company to greater litigation risk,” she continues. “California, for example, requires covered companies with these types of goals to disclose how they track progress against that goal. So, if a company has a long-term emissions goal, it may wish to also adopt interim milestones or a specific plan to reach that goal to ensure that accurate, compliant and transparent disclosures can be made.”

The fight against climate change will present many impediments, not least financial costs which will only rise. In response, businesses must evaluate actual and potential climate-related outlays, and how they may affect the supply chain. They must also consider who their stakeholders are, involve them in the process and discuss ways to optimise the benefits derived from climate compliance.

Additionally, companies need to provide clear, comprehensive and accessible information to consumers and stakeholders. This includes ensuring disclosures are accurate, relevant and easily accessible. By being fully open and accountable on ESG and sustainability performance, businesses can effectively align their operations with future goals. All of this will, however, be carried out amid constantly evolving and increasingly stringent compliance regulations, requirements and standards.

© Financier Worldwide

BY

Richard Summerfield