Financial Law and Climate Change

Contents

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    Executive summary

    The finance sector is grappling with a mosaic of risks and opportunities stemming from climate change. As they hold stakes in businesses and assets across many geographies and parts of the economy, financial institutions must consider how climate risks may affect many different organisations. Finance is also an essential part of the shift to a net zero economy. Financial institutions can move funding away from ventures that cause greenhouse gas emissions and towards those that aim to boost climate change mitigation or resilience.

    Financial institutions are mobilising to address climate change, underlined by initiatives like the Glasgow Financial Alliance for Net Zero, but reaching international climate targets will require further changes to international finance flows. In addition to global agreements which aim to scale up climate finance, governments have started to play a stronger role in aligning financial actors with climate ambitions. There are multiple legal levers in the UK that might help financial actors address climate change and manage the significant risks that this sector is facing.

    • Climate change, through both its physical impacts and the policies that aim to reduce emissions, will have significant impacts on the financial system. The Bank of England, regulators, and many private financial institutions have recognised these risks.
    • Asset managers and owners may need to consider the impact of climate change when carrying out their fiduciary duties. They are also subject to new disclosure and reporting requirements that are likely to grow in scope and rigour.
    • The UK Government’s Roadmap to Sustainable Investing indicates numerous forthcoming initiatives and rules, including a ‘green taxonomy’ that sets legal criteria for which investments can be labelled ‘sustainable.’
    • A range of new sustainable financial products, such as sustainability-linked loans and natural capital investments, have emerged and provide opportunities in the net zero transition.
    • The Climate Change Committee has proposed systemic changes including mandatory net zero targets for investors and directly integrating climate change into Financial Conduct Authority and Prudential Regulation Authority principles. This will drive the need for companies in the finance sector to better under the impacts of their portfolio.
    Key legislationKey cases
    Financial Services and Markets Act 2023

    Climate-Related Financial Disclosure Regulations 2022
    ClientEarth v Financial Conduct Authority

    General impacts

    Climate change causes chronic physical risks, through raising global temperatures and contributing to sea level rise, and acute physical risks, through increasing the frequency of extreme weather events. These events can impact financial institutions’ own operations and assets, but are especially important to this sector because of their broader economic impacts. Physical risks can reduce asset values not only when damage has occurred, but also when damage is becoming more likely (for example to property in a high flood risk area). These risks can also reduce the creditworthiness of certain borrowers, which poses a significant risk to banks and other lenders.[1] After running stress tests in 2022, the Bank of England estimated that British banks and insurers may face up to £340 billion in losses from climate change by 2050.[2]

    Transition risks, which come from society’s response to climate change, are equally important to the financial sector. Policy developments such as changes to carbon pricing mechanisms, financial incentives for green industries, and traditional regulation can influence business cases for investors and borrowers’ creditworthiness for lenders. In many cases, industry is moving faster than policy, [3] so financial institutions must also ensure that they do not rely on industries or businesses that are likely to decline during the net zero transition. Of course, this transition also brings opportunities. Financial actors that prepare for climate policies and capitalise on business trends can gain a competitive advantage.  

    The Bank of England runs stress tests to examine these risks. In doing so, they aim to inform government policy and give firms a clearer picture of the country’s overall exposure to potential climate impacts. Financial regulators recognise these risks and have started to help firms address them. For example, the Financial Conduct Authority (FCA) established the Climate Financial Risk Forum which brings together senior stakeholders to evaluate climate risk and publishes relevant resources. The Prudential Regulation Authority (PRA) has set clear expectations for how firms should embed climate risk into their decision making,[4] and has stated that it will embed climate considerations in its supervisory approach from 2022 onwards. Westminster and Whitehall have also recognised these risks, and the Government has indicated the steps it plans to take to address risks and harness opportunities through papers such as its 2021 Roadmap to Sustainable Investing. Private financial institutions of all types have also started to respond, as indicated by the Climate Policy Initiative’s Net Zero Finance Tracker. However, despite this progress, there is general agreement that both government and industry action remain insufficient for meeting Paris Agreement goals.[5]

    Fiduciary duty

    Financial market participants can be divided into asset owners and asset managers. Asset owners own capital subject to a trust, and invest that capital in the best interests of the beneficiary. In doing so, they can delegate the investment powers to asset managers.

    Under UK law, asset owners are subject to fiduciary duties, and must act in line with the proper purpose of their trust. Part of this duty is to act in the ‘best interests’ of their beneficiaries. Asset owners are also subject to a duty of care to the fund’s current and future beneficiaries. The proper purpose duty means that any factor which is not relevant to the purpose of the fund should not be taken into account. However, factors which would be financially relevant to the fund should be taken into account.

    While historically relevant factors to consider were thought to be financial factors only, modern analysis[6] of fiduciary duty has concluded that ESG factors should be taken into account by asset owners, in order to fulfil their fiduciary duty; and must be taken into account where they have been identified as financially material. Going further, asset owners are likely to be permitted to invest in accordance with ESG-positive aims (so-called ‘impact investing’), provided that these do not jeopardise the long-term financial health of the fund.[7]

    While asset managers are not directly subject to fiduciary duty, they are generally subject to contractual relationships with their asset owner clients to invest in line with fiduciary duty; therefore, asset managers should also be conscious of the nature of fiduciary duty.

    Litigation Risks

    The prospect of climate change litigation poses direct and indirect risks to financial institutions. The growing number of potential avenues for climate litigation against corporates[8] pose a risk to banks that finance or invest in defendant organisations. Claims do not need to be successful to have impact given the reputational damage that high-profile claims might have on defendants. Bank themselves may also face claims if they fail to disclose, adapt to, or mitigate foreseeable risks. Institutional investors have been successfully challenged in Australia for failing to align their investments with net zero targets.[9] Central banks may also need to start considering their exposure to litigation risks. In 2021, ClientEarth sued Belgium’s central bank for supporting fossil fuel companies when implementing quantitative easing.

    In ClientEarth v Financial Conduct Authority, the FCA faced a climate-related judicial review related to an oil & gas company’s listing on the London Stock Exchange. Claimants argued that the prospectus had not properly addressed climate issues and the risks they pose to the company and investors. The claim was unsuccessful.

    Disclosure requirements

    Climate-related disclosure rules initially rose to prominence through nongovernmental initiatives, in particular the Taskforce on Climate-related Financial Disclosures (TCFD). Since then, they have become mandatory for some UK firms, with the government intending to expand coverage to more firms over time. These requirements are relevant to financial actors when ensuring their own compliance with climate-related regulations, and also when assessing other organisations’ exposure to climate-related risks as investors or lenders. General corporate climate disclosure requirements are discussed in the company law section of this resource. These rules require that companies explain how organisations are managing climate risks, increasing accountability and transparency.

    The FCA has developed specific disclosure and reporting requirements for asset managers and asset owners. Under these rules, relevant entities must disclose the environmental impact of their operations generally as well as specific products and portfolios in accordance with TCFD guidelines. From 2022, these rules applied to UK asset managers with over £50 million in assets under management and asset owners with over £25 million in assets. From 2023, this threshold will be changed to £5 million in assets under management. Extra-legal initiatives such as the Partnership for Carbon Accounting Fundamentals may help financial institutions with this disclosure.

    In addition, pension funds (which are among the largest asset owners in the world) in the UK are also required to set out policies for considering financially material considerations over the time-horizon of the scheme, including climate change.[10]

    How financial law can help drive the net zero transition

    ESG integrity and green taxonomies

    The creation and promotion of ‘ESG’ (Environmental, Social, and Governance) investing has been the financial industry’s key response to climate change. This form of investing targets companies with a more positive impact on the environment and society. In doing so, it aims to utilise the huge volumes of capital that financial institutions control to tackle climate change. ESG investing has rapidly risen to prominence. In 2021, some estimates put the total volume of assets in sustainable or ESG-focused funds at $2.7 trillion worldwide,[11] with the total assets that have seen some ESG integration higher.[12] This has also led to increased scrutiny of ESG investments, with many experts and organisations arguing that ESG investing often fails to deliver on its purported climate benefits.[13] Common targets of criticism include ambiguity caused by a patchwork of ESG framework and data distribution companies, and a lack of clarity as to which ESG investments are truly ‘green.’

    Recognising the potential for ESG investing to drive emissions reductions, but also the various problems plaguing this emerging industry, some governments have considered setting their own standards to give investors more certainty as to the climate impact of their activities. This was largely pioneered by the EU’s Taxonomy for Sustainable Activities, which establishes a framework of environmental objectives, and the EU Sustainable Finance Disclosure Regulation (SFDR), which requires financial entities to publish sustainability information, including their policies on integrating sustainability factors into their investment decisions, and the impacts of financial products on the Taxonomy’s environmental objectives. Like many other areas of climate policy, the UK has indicated that it may follow a similar path in the Government’s Roadmap to Sustainable Investing. This could impact actors across the ESG investing landscape. Businesses may alter their activities to fit within the taxonomy so that they can be considered ‘green.’ The creators of investment products would be most directly impacted, as they would have to comply with taxonomy rules or face penalties for misleading potential investors. Investors themselves would ideally benefit from more certainty that their money will be going to sustainable businesses, and reduced time spent investigating these claims.

    Of course, the design of a green taxonomy in the UK will dictate its impacts and may be subject to heavy debate. This was the case in the EU, when regulators announced an intention to classify certain uses of natural gas as ‘green.’ Regulators and supporters of this aspect argued the importance of gas as a transition fuel between coal and renewables, whereas critics suggested that calling a fossil fuel ‘green’ is misleading and would not give investors clarity.[14] Once implemented, any ambiguities in the taxonomy may lead to legal issues if regulators disagree about whether investment products should be labelled as ESG-aligned or similar. The Green Technical Advisory Group, an independent expert group that advises the Government on its Green Taxonomy, has published multiple detailed papers suggesting approaches to implementing the taxonomy.

    Other sustainable financial products

    Equity stakes in corporations that meet ESG rules are not the only financial asset relevant to climate change. Debt finance instruments can also be designed to drive the net zero transition. ‘Green bonds’ are similar to regular bonds but specifically go towards financing projects with a positive impact on the climate. These bonds have been issued by international financial institutions, private entities and governments. In the UK, the government has issued ‘Green Gilts’ for institutional investors, which raised £16 billion after the first two issuances in 2021. National Savings & Investments, a government saving scheme, has also now begun to offer green bonds to retail investors. The Climate Bonds Initiative supports enhancing climate solutions through debt capital markets globally. 

    Loans may also support sustainability objectives. Green or sustainability loans can fund projects that focus on climate change mitigation or adaptation, for example retrofitting buildings. Sustainability-linked loans, by contrast, tie loans for other projects to sustainability performance metrics. The Sustainability Linked Loan Principles can inform how to structure these instruments. Compliance and voluntary carbon markets have created other types of climate-related financial products. Institutional investors may consider investing in carbon credits, which represent greenhouse gas emissions reductions or removals. Derivatives markets are also emerging alongside carbon markets, which may provide helpful price signals to firms and regulators. As awareness of the biodiversity crisis – a problem separate but highly interlinked with climate change – grows, there are increasing opportunities to invest in ‘natural capital.’

    Mandatory net zero targets and stewardship rules

    The UK Government is accountable to its net zero target under the Climate Change Act, and many private organisations have voluntarily set their own net zero targets. The Climate Change Committee (CCC) has suggested going a step further and requiring that financial institutions set net zero targets, create plans for how they will meet these targets, and report against them.[15] The Committee suggests requiring five-yearly goals to mirror the Government’s carbon budgets. This change would move net zero target-setting from a voluntary exercise – which can bring reputational benefits – to a compliance requirement that would need to be performed alongside close analysis of regulatory requirements. The CCC has also suggested that the Stewardship Code, which already requires that investors consider long-term value and sustainable benefits, incorporates net zero goals.[16] 

    General regulatory reforms

    Regulators, namely the FCA and the PRA, clearly play a large role in decarbonising financial services. Many existing and prospective policy reforms, for example disclosure requirements for asset managers, can occur through regulatory changes. Enshrined as regulatory principles in the Financial Services and Markets Act 2023, the FCA and PRA are obliged to have regard to the UK’s commitment to net zero and its environmental targets under the Environment Act 2021. Groups such as the Grantham Research Institute[17] and E3G[18] supported these changes, and also warned of potential environmental harm if other principles promote an approach focused only on short-term economic growth. Parliamentary scrutiny may help ensure that financial regulators effectively utilise methods such as cost-benefit analysis when setting policy that might impact the climate. The CCC has emphasised the importance of metrics and tools for tracking financial flows and their impact on the UK’s net zero target.[19] 

    The UK’s finance sector and global climate action

    As a global financial services hub, the UK is home to financial institutions with a reach far beyond the country’s borders. This extends to the sector’s impact on the climate. Analysis carried out in 2019 found that UK-based financial institutions financed around 1.8 times the volume of emissions that occurred within the UK.[20] As such, climate-related financial law and regulation in the UK has a global reach. Even looking beyond UK-based institutions, rules and initiatives in the UK may help change behaviour in other markets. While not directly attributable to the UK alone, certain developments such as mandatory climate-related reporting have been pioneered in the UK and are now being deployed by other regulators, for example the USA’s Securities and Exchange Commission. These efforts are buttressed by international collaborations such as the IFRS’ International Sustainability Standards Board, and the Partnership for Carbon Accounting Financials. More broadly, international climate negotiations under the UNFCCC may be important for scaling up public and private climate finance. Climate finance remains a central tenet of the Paris Agreement and must flow from highly developed countries like the UK to the developing world, but the international community has missed many key targets.[21]


    [1] Ricardo Martinez et al, ‘Embedding Climate Risk into Banks’ Credit Risk Management’ (Deloitte Insights, 10 December 2021). < https://www2.deloitte.com/uk/en/insights/industry/financial-services/climate-change-credit-risk-management.html>.

    [2] Bank of England, ‘Results of the 2021 Climate Biennial Exploratory Scenario (CBES)’, (Bank of England, 2022). <https://www.bankofengland.co.uk/stress-testing/2022/results-of-the-2021-climate-biennial-exploratory-scenario>.

    [3] Peter Parry, Neelam Phadke, Alasdair Robbie and Joe Scalise. ‘How Energy and Resource Executives Think about the Transition’. (Bain and Company, June 14 2022). <https://www.bain.com/insights/how-energy-and-resource-executives-think-about-the-transition-enr-report-2022/ E>.

    [4] Prudential Regulation Authority, ‘Climate-related financial risk management and the role of capital markets’ (Bank of England, 2021). <https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/2021/october/climate-change-adaptation-report-2021.pdf>.

    [5] See e.g. the United Kingdom’s country profile on Climate Action Tracker.

    [6] UNEPFI, Fiduciary Duty in the 21st Century (2019) <https://www.unepfi.org/wordpress/wp-content/uploads/2019/10/Fiduciary-duty-21st-century-final-report.pdf>.

    [7] UNEPFI, Freshfields Bruckhaus Deringer, A Legal Framework for Impact (21 July 2021) <https://www.freshfields.com/en-gb/our-thinking/campaigns/a-legal-framework-for-impact/>.

    [8] Catherine Higham and Honor Kerry, ‘Taking Companies to Court Over Climate Change: Who is Being Targeted?’ (LSE Grantham Institute, 3 May 2022). <https://www.lse.ac.uk/granthaminstitute/news/taking-companies-to-court-over-climate-change-who-is-being-targeted/>.

    [9] McVeigh v Retail Employees Superannuation Trust (2018) NSD1333/2018. This case did not proceed to court, but settled with an agreement by the defendant to consider climate-related risks as part of its investment activities.  

    [10] The Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations 2021.

    [11] Saijel Kishan, ‘ESG by the Numbers: Sustainable Investing Set Records in 2021’ (Bloomberg, February 3 2022). <https://www.bloomberg.com/news/articles/2022-02-03/esg-by-the-numbers-sustainable-investing-set-records-in-2021#xj4y7vzkg>.

    [12] Bloomberg Intelligence, ‘ESG assets may hit $53 trillion by 2025, a third of global AUM’ (February 2023, 2021). <https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum>.

    [13] See e.g. Sanjai Bhagat, ‘An Inconvenient Truth About ESG Investing’ (Harvard Business Review, 31 March 2022). <https://hbr.org/2022/03/an-inconvenient-truth-about-esg-investing>.

    [14] Jennifer Laidlaw, ‘What the Inclusion of Gas and Nuclear in the EU Taxonomy Could Mean for Investors and Asset Managers’ (S&P Global, 22 February 2022). <https://www.spglobal.com/esg/insights/what-the-inclusion-of-gas-and-nuclear-in-the-eu-taxonomy-could-mean-for-investors-and-asset-managers>.

    [15] Nick Robins, ‘The Road to Net-Zero Finance’ (Climate Change Committee, December 2020). <https://www.theccc.org.uk/publication/the-road-to-net-zero-finance-sixth-carbon-budget-advisory-group/>.

    [16] Ibid.

    [17] Rob Macquarie and Brendan Curran, ‘Shifting the Trillions: Financial Regulation Reforms in the UK and their Relevance for Climate Action’ (LSE Grantham Institute, 24 March 2022). <https://www.lse.ac.uk/granthaminstitute/news/shifting-the-trillions-financial-regulation-reforms-in-the-uk-and-their-relevance-for-climate-action/>.

    [18] E3G, ‘E3G Response to Proposals for Reform for the Financial Services Future Regulatory Framework’ (E3G, 3 March 2022). <https://www.e3g.org/publications/e3g-response-to-the-proposals-for-reform-for-the-financial-services-future-regulatory-framework/>.

    [19] Robins (n 12).

    [20] World Wildlife Fund. ‘The Big Smoke; The Global emissions of the UK Financial Sector’. (WWF, 2021). <https://www.wwf.org.uk/sites/default/files/2021-05/uk_financed_emissions_v11.pdf>.

    [21] Jocelyn Timperley, ‘The broken $100 billion promise of climate finance – and how to fix it’. (Nature news feature, 20 October 2021). <https://www.nature.com/articles/d41586-021-02846-3>.