How can regulators address the growing threat of climate litigation?

Climate litigation is a powerful and growing source of financial risk that, without urgent action from regulators, may yet emerge as the financial sector’s Achilles’ heel in climate risk management.

“If banks and their counterparties are unprepared for physical- and transition-related risk, and the liabilities this exposes them to, there is a substantial danger that climate litigation can make a messy situation even messier,” warned Catherine Higham, leading expert on climate litigation risk and policy fellow at the London School of Economics’ Grantham Research Institute.

In an interview with Green Central Banking, Higham shed light on the urgent need for the financial sector to adapt to the growing threat of climate litigation and shared her insight on what regulators can do to address this risk.

What can regulators do to stay ahead of the climate litigation risk curve? 

As both an “amplifier” and a distinct avenue of climate risk, litigation presents a unique risk profile that is not yet fully understood by regulators or the financial sector, explained Higham. 

However, while climate litigation is in a relatively early stage, there are still opportunities for regulators and financial institutions to “make sure they don’t end up on the wrong side of the curve”.

Improved transition planning, comprehensive litigation risk assessment methodologies, and clearer regulatory guidance on companies’ climate obligations are measures which could help mitigate future litigation exposure across the financial system, she said.

“Regulators, policymakers, and financial institutions need to be prepared and on top of mitigating climate risk, including making transition plans that plan for how to deal with physical risk…Organisations that are not on top of transition planning are already facing litigation”, she said in reference to an ongoing case brought by shareholders of a Polish energy company, Enea, against its former directors.

In what Higham described as “a clear mishandling of transition risk”, the former Enea directors supported the construction of the controversial Ostrołęka C coal-fired power station project, despite independent evidence suggesting it was at high risk of becoming stranded and likely to be unprofitable. The project was ultimately abandoned in the face of financing difficulties, resulting in a loss of more than US$160mn.

Limitations in quantifying climate litigation risk

Although financial regulators are increasingly aware of climate litigation risks, there is still a pressing need for “an increasingly granular understanding of the different ways in which climate litigation could operate” and the risks these pose to the financial system, according to Higham.

Yet current methodologies used by the NGFS for assessing climate litigation risk largely fall short in accurately representing the scale and distribution of climate-related financial risks, including litigation risk. By subsuming legal risk under the category of ‘transition risk’, for instance, there is a danger financial institutions “will underestimate the potential cost of other kinds of climate risks because they won’t have factored in the potential for litigation”, explained Higham.

Although quantifying this kind of risk remains a thorny issue, with much uncertainty in the trajectory of the climate-related case law, Higham suggested it could be incorporated into existing litigation risk modelling approaches. That said, she emphasised the need for methodologies that tease out the distinct qualities of climate litigation risk in the face of an escalating environmental crisis.

Is there a board-level legal duty to manage climate risks?

Higham noted that there is “already a strong argument” in favour of directors and trustees having a fiduciary duty to manage climate risks, since they are financially material. Despite this, the “exact contours” of these duties remain unclear; and reliance so far on more “open textured” guidance has exacerbated legal uncertainty. 

She pointed to a legal opinion from Lord Robert Carnwath, a former British Supreme Court judge and visiting professor at the London School of Economics, in which he argued the High Court’s decision to dismiss the ClientEarth v Shell case was “a missed opportunity” to clarify what climate-related duties apply under the UK’s Company Act.

“What I think would be helpful would be clarification by regulators and legislators of how these pre-existing duties apply”, said Higham.

Litigation risk and the insurance sector 

Insurance is another area Higham identified in which greater awareness of climate litigation is needed. It is “particularly important” insurers increase understanding both of transition risk cases against directors and officers and risks related to adaptation and physical effects of climate change. 

Insurers should take care to clearly define climate claim coverage to minimise legal disputes over whether or not specific climate damages are covered by a particular policy, she stressed.

Diverging litigation landscapes: US vs Europe

Higham also signalled the “potential for significant divergence between the US and Europe” in terms of climate and environmental litigation risk. 

In the US there are currently several “ESG-backlash” cases as well as those directly challenging new climate regulations, such as the SEC’s disclosure rules, alongside many other lawsuits pushing for stronger accountability.

Such a polarised approach is introducing substantial uncertainty into the trajectory of liability risk in the US, she explained. Not only does such uncertainty exacerbate litigation risk exposure, it also introduces more complexity into the modelling process.

Whereas in Europe, “we are seeing more of a sense that the financial community accepts that climate risks are material financial risks” and a growth in regulation resulting in a “move towards more clear obligations of the financial sector”.

Higham’s overall message is clear: as climate litigation continues to evolve and expand, the financial sector must adapt and learn to proactively address emerging legal risks. 

By implementing Higham’s insights on transition planning, litigation risk assessment, and regulatory guidance, there is hope that regulators and financial institutions can foster a more resilient and sustainable financial system. One that is capable of navigating the complex intersection of climate change, finance, and law.