Under-Priced Physical Climate Risks Subject to Legal Correction

Legal action can work as a mechanism to scale adaptation finance.

Financial institutions lacking a thorough understanding of climate-related litigation risks may face legal action to correct mispricing of physical climate risks by the projects and companies they finance, a new report says. But such litigation can lead to a scaling of adaptation finance.

Speaking at a presentation of the report, Sarah Barker, Partner, Head of Climate Risk Governance at law firm MinterEllison, said providers of finance to projects which contribute to climate change could suffer a subsequent repricing of physical risks “because of the discovery mechanism that occurs through the litigation process”.

The paper by MinterEllison was produced in partnership with UNEP FI. It builds on UNEP FI’s work programme of research into adaptation and adaptation finance, and focuses on the relationship between physical and liability risks, and the potential impact of such legal action on adaptation finance.

Adaptation finance can be defined as resources directed to activities aimed at reducing the vulnerability of humans or nature to the impacts of climate change by increasing adaptive capacity and resilience.

The report provides a basic framework that allows institutions to consider the range of climate-related liability risks to a borrower, book, portfolio or system.

Financial institutions must first understand the magnitude (likelihood x impact) of that risk in a given context, and its materiality to be able to quantify the potential credit risk impact of climate change litigation to a given project, the report says.

Barker explained that the paper seeks to provide “foundational concepts”, based on which financial institutions can go the next step to determine materiality for their own and unique circumstances.

These high-level concepts include a taxonomy that defines cases in which ex-ante and ex-post claims for physical risks can materialise; how liability risk can act as a mechanism to put forward in time the materiality of physical risk; and how liability risk can have a direct risk impact on a particular institution or project or work as an indirect risk transfer system across portfolios and across financial systems.

Availability of adaptation finance

The released paper also provides key input from which institutions can understand climate change litigation as a mechanism to reduce barriers to the availability of adaptation finance.

One of the key findings of the report is that “legal action can reduce barriers to the deployment of adaptation finance at the necessary scale”.

“Climate change litigation and other legal action can act to reduce a number of the main barriers to the necessary scaling of adaptation finance identified by the Global Commission on Adaptation (GCA) and UNEP FI, including inadequate incentives for private finance, weak conventions in the financial industry and operational gaps at institutional levels,” the report writes.

Accordingly, institutions should consider the financial impact of legal action relating to physical risks, which extend far beyond the direct cost and credit risk to individual borrowers or insured entities.

“The market signal can also have secondary impacts at a portfolio level (with sector, geographic or jurisdictional contagion) and where impacts drive a shift of such magnitude to impact the financial system, tertiary impacts. These include financial shocks and regulatory capital impacts, which can flow through to the broader economy,” the report adds.

Ellie Mulholland, Senior Associate, Climate Risk Governance at MinterEllison, explained that it is challenging to quantify this rapidly evolving area as “potential appetite for climate litigation is changing, court appetite for hearing disputes involving climate issues is changing, and the underlying legislative and regulatory frameworks are changing”.

She added that as a consequence of inaction under the high global warming scenarios, such as 3 or 4 degree warming, “legal action relating to physical risk and adaptation action is more likely”.

Barker added that the firm will, potentially, develop a ‘plug-and-play’ risk management tool that financial institutions can apply in assessing the materiality of litigation risk via a framework of threshold risk materiality indicators for liability exposures associated with physical risk to climate change.

Such tools and methodologies for the robust materiality assessment of liability risks shall support financial institutions to adequately price these risks and allow these to respond with risk mitigation measures that reduce financial risks to institutions, and to communities and societies at large.

In 2017, MinterEllison and the 2 Degrees Investing Initiative published a report about litigation risk as a driver and consequence of the energy transition.

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