Climate change

Climate change will be the challenge of our generation. To transition our economy, based around fossil fuels and carbon since the Industrial Revolution, presents a significant test of resolve for industry and wider society.

The effects of climate change are often less visible than other environmental impacts, but will be experienced most keenly by future generations without dramatic societal changes to slow global temperature rises. A multi-faceted approach by industry, investors and governments is required, and businesses should be looking to move beyond good intentions and start to achieve real results.

The economy’s focus is shifting to sustainable models across the board: renewable energy will replace fossil fuels, electric vehicles will eventually overtake petrol and diesel cars, air and ground heat will replace gas boilers. Businesses face risks, directly from failure to adapt and indirectly from changing customer and consumer appetites, but the opportunities for sustainable businesses should not be overlooked.

As governments set ambitious climate targets, we anticipate a move from the current transparency and reporting regimes to more demanding statutory restrictions and obligations. Current and proposed carbon and energy efficiency reporting and transparency regimes are likely to increase in scope and gain additional regulatory teeth. Ultimately, traditional businesses will need to pivot to more sustainable activities, and innovative solutions will play a key role in this transition.

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Key issues

Climate change mitigation

The UK has had a legally-binding commitment to reduce greenhouse gas emissions since 2008. In 2019, it increased that commitment to achieve net zero emissions by 2050. The EU, on behalf of the whole bloc, followed suit in 2020 with a draft EU Climate Law published in March 2020. A raft of multinational companies from Tesco to BP have separately pledged to achieve net zero carbon emissions by 2050, while Amazon has pledged to achieve this by 2040 and Microsoft aims to be "carbon negative" by 2030.

Emissions reductions can seem relatively easy to achieve – for example, a solar installation on a factory rooftop – but claims made about the benefits of such measures can be misleading and difficult to navigate, as highlighted by prominent activist Greta Thunberg who accused some countries of "creative carbon accounting". The optics of emissions reduction can be skewed by countries investing significantly in overseas carbon offsetting projects, whilst failing to take aggressive action on domestic emissions.

The EU has proposed a controversial "carbon border adjustment", essentially an import tax, to discourage carbon offshoring, which is expected to be adopted in the second quarter of 2021. The UK centre-right think tank, the Centre for Policy Studies, has also supported such a tax for the UK's carbon-intensive sectors such as steel, coal and electricity production. The amount of 'carbon leakage’ through offshoring over the last few decades has been significant and masks the heavy impact of consumer-driven developed economies on the climate.

Legislation requiring emissions reduction has historically been fragmented. A more holistic approach will be needed to achieve temperature increases below 2% or 1.5%, as evidenced by the European Green Deal, the EU’s flagship climate change project and the UK Prime Minister's Ten Point Plan for a Green Industrial Revolution. Both share common themes: renewable energy targets for both power and transport must be more ambitious, new buildings must be more efficient (and existing buildings renovated to improve efficiency), nature must be guarded and restored, and technology, research and innovation aimed at developing new solutions must be accelerated.

Climate change adaptation

All business sectors will be impacted by climate change in some way. Adapting to climate change is not just a matter for the agricultural sector seeking to manage wetter or hotter conditions, nor town planners seeking to control developments on flood plains or in coastal areas. According to the EU Commission, economic losses affecting all business sectors from climate and weather extremes between 1980 and 2017 totalled around EUR12 billion per year, only around a third of which were insured.

Businesses will increasingly be expected to build climate resilience into their operating policies and describe how they will respond to specific physical climate risks. In the manufacturing sector, for example, this may mean contingency planning for supply chain disruption, particularly where there is a high dependency on imports. The dangers of over-reliance on global supply chains were dramatically illustrated by the COVID-19 crisis. The infrastructure sector will be challenged to ensure that networks, structures and materials can withstand more extreme weather events, more frequently. All companies will need to consider how their property portfolio is placed to withstand physical risks.

Investors and financial advisers will be looking at mandatory or voluntary disclosures to identify where capital will be safest.

Climate risk reporting and disclosures

The overall direction of travel is towards a standardised framework for climate risk reporting in the form of the Task Force on Climate-related Financial Disclosures (TCFD). In November 2020, the UK Government published its roadmap for the transition to mandatory climate-related reporting in line with the TCFD recommendations across the entire business and financial community within five years, part of its Green Finance Strategy.

As well as the UK Government, organisations favouring this framework include the UN via its voluntary Principles of Responsible Investment (PRI) and the Financial Conduct Authority. One of the leading voluntary disclosure programmes, the Carbon Disclosure Project (CDP) also relies on TCFD. Though mandatory disclosure rules are still reasonably light-touch for most companies, investor and shareholder demands are likely to drive more stringent reporting and disclosure practices.

The EU will require a higher level of transparency around sustainability risks in the context of financial services and investments via its Sustainable FInance Disclosure Regulation (SFDR). This Regulation will also prevent those covered by it from "greenwashing" by labelling financial products "sustainable" without adequate justification. Disclosures will be supported by the new EU taxonomy for sustainable activities – activities which substantially contribute to at least one environmental objective, do no harm to the other objectives and meet certain criteria can be considered environmentally sustainable for investment purposes. Though not quite a "white list", this list of green activities is expected eventually to be complemented by a list of "brown" activities which may act as a de facto blacklist.

The UK will not implement the EU Sustainable Finance Disclosure Regulation (SFDR) in 2021, although we expect it to implement a more principles-based version as a "UK SFDR".

The UK has also confirmed that it will implement a UK-specific version of the EU's Taxonomy Regulation. The Taxonomy will define the types of activity that are “environmentally sustainable” for the purposes of EU-regulated investment activities claiming to focus on sustainability and is expected to play an important role in the development of green finance and preventing greenwashing. Post-Brexit, the UK technically has the EU Taxonomy Regulation on its own statute book, but no obligation to implement any of the forthcoming technical standards which provide the detail needed to apply the Taxonomy. It may well choose therefore to retain the framework for the Taxonomy, including adopting the six high-level environmental objectives (climate change adaptation, climate change mitigation, water, circular economy, pollution control and biodiversity) but tailoring the detail to suit the UK market.

Emissions trading

Following the end of the Brexit implementation period on 31 December 2020, the UK remains a full participant in the EU Emissions Trading System (EU ETS) for the 2020 compliance year only, and operators must comply with requirements on reporting emissions and surrendering allowances for 2020 by 30 April 2021.

Meanwhile, a UK Emissions Trading Scheme (UK ETS) replaced the EU ETS on 1 January 2021 and the Government has published guidance on participation in the UK ETS.

The Energy White Paper published in December 2020 describes the new UK ETS as the "world's first net zero cap and trade market". The UK ETS will initially apply only to energy-intensive industries, electricity generation and aviation.

The level playing field provisions in the Trade and Cooperation Agreement (TCA) require the UK and EU to each have in place and maintain an effective carbon pricing system from 1 January 2021 for as long as this remains an effective tool in the fight against climate change. The Energy White Paper confirms that the UK Government is open to linking the UK ETS internationally, and the TCA commits both sides to giving this serious consideration.

To provide continuity of emissions trading for UK business, the UK ETS is expected to be similar to the EU ETS.

The EU ETS covers around 45% of the EU's greenhouse gas emissions and is the primary mechanism for limiting emissions from the heaviest emitters, including power stations, industrial plants and airlines. Companies are allocated an emission allowance which can be traded on the carbon market to ensure that operators remain within their cap or buy additional allowances. All operators must remain within the overall, EU-wide emission cap or ceiling set by the EU Commission.

The fourth phase of the EU ETS started on 1 January 2021, and will see a faster decrease in the overall emissions cap, from an annual rate of 1.74% to 2.2% per year. The scheme will also be revised to provide greater focus on industries and sectors at highest risk of carbon leakage (i.e. the relocation of activities outside the EU to escape the constraints of the EU rules), with fewer free allowances for other sectors. These operators will therefore face a choice between improving their emissions performance or accepting the increased cost of business as usual. International credits from CDM projects cannot be used to meet EU ETS obligations in the fourth period.

For companies seeking to drive genuine environmental performance improvements beyond baseline legal compliance, it may not be enough to rely on the UK or EU ETS. The temptation is to cover existing emissions using free or traded allowances, although a focus on how to cut those emissions would be the more sustainable option.

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Risks and opportunities

Risks

Initially, the impact of failure to address climate-related risks will be financial. We expect the regulatory framework to continue to allow "brown" activity as well as "green", but the cost of choosing brown will eventually become prohibitive, as a result of new fiscal measures and increased operating costs. As governments work out how to speed up the low carbon transition and achieve the right trajectory for net zero, this risk will only increase.

Investor pressure will make life difficult for companies which fail to pursue emissions reductions and adoption of robust climate policies. Such businesses may cease to be viable targets for investment, as a result of the combined effect of increased transparency requirements on companies and investors pursuing their own ESG agenda.

Public disclosure requirements, as well as increasingly complex regulatory reporting and compliance frameworks, are likely to lead to more litigation and regulatory action.

Opportunities

Accelerating the pace of change towards a low carbon future is full of opportunity for innovators. The EU recognises that a significant part of its financial package for the EU Green Deal should be directed towards funding R&D and innovation start-ups to enable entirely new products and services to come to market.

Equally, there is opportunity for established businesses which are willing to challenge traditional thinking about their product and service offerings and internal processes and procedures. There is no doubt that meeting government as well as corporate ambition in terms of emissions requires a revolution rather than an evolution. Though there may be initially significant capex costs associated with innovation and climate-based policies, ultimately these are expected to lead to lower opex costs for businesses through, for example, energy efficiency savings or raw material acquisition/recycling.

Implementing coherent climate change mitigation and adaptation programmes should not only lead to opex cost savings in the longer term, but also manage future litigation risk and resource challenges. Reputational gains for those organisations that are seen to be doing the right thing should not be underestimated.

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Best practice

An appropriate climate change response depends on the nature of the business. Incremental steps towards a goal in several areas can have a significant impact, cumulatively, on a long term basis. Change brought about by sustained effort over a period of time will be evident as a result of mandatory and voluntary reporting schemes. Key measures include the following:

ensure that current climate change/sustainability-focused policies (i) are fit for purpose, (ii) comply with climate change and energy efficiency rules, (iii) represent legal baseline targets (iv) are dependent on the business's ambition, stretch goals, and (v) are reviewed on a regular basis
consider which areas of the business could easily be adapted to ensure better emissions performance: Is the business purchasing (or could it install) renewable energy? Does its travel policy strike the right balance between onsite relationship-building and unnecessary business travel? Do employee-facing policies require simple measures such as turning off lights or activating energy-saving modes on computers, where appropriate?
consider supply chain emissions, particularly if the EU's carbon border adjustment tax comes into effect. Should procurement policies take account of supplier performance, or the performance of products/services purchased (e.g. minimum energy efficiency standards for hardware or data centres)
investment criteria will need to integrate sustainability factors at a more rapid pace in light of tightening regulatory requirements

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Overview of relevant law and regulation

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Our work

As governments, investors and the markets push for change, the most immediate challenge from a legal perspective is achieving a broad understanding of the rapidly-changing regulatory landscape. As the UK and EU commit to a carbon-neutral future, we expect to see a raft of new regulations as well as voluntary, market-led schemes contributing towards meeting the 2050 goals.

We help clients to comply with their legal obligations in relation to climate change, energy efficiency and carbon reporting, to formulate appropriate responses to the increasing demands of investors, shareholders and customers in understanding these risks, and in finding ways to transition to more renewable and clean technologies.

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