Board members are expected to have adequate knowledge and understanding of climate-related and ESG risks.

By Nicola Higgs, Paul A. Davies, and David Berman

Legislators and regulators around the world have long recognised that one of the most effective ways to drive change is by focusing the minds of management — specifically by attaching individual accountability for ensuring that an organisation meets expected standards. Transitioning to net-zero carbon emissions has now become a critical priority for many governments, and the spotlight is shining on the boards of financial institutions and companies to drive that change.

This blog post highlights recent developments in the EU in this regard. At a time when standards on climate and environmental, social, and governance (ESG) issues are converging globally, these developments will be informative to global organisations wanting to embed best practices in governing the transition.

The EU Perspective: Is the Board “Fit & Proper” to Manage the Climate Transition?

The European Central Bank (ECB) requires that all institutions under its direct supervision conduct a fit and proper assessment of members of the management body (including both executive directors and non-executive directors). Under the ECB’s regime, fitness and propriety is assessed against five criteria: (i) experience, (ii) reputation, (iii) conflicts of interest and independence of mind, (iv) time commitment, and (v) collective suitability.

In its Guide to Fit and Proper Assessments (published for consultation on 15 June 2021) the ECB indicates that, under the fifth criteria of “collective suitability”, the management body is expected to consider (amongst other factors) the knowledge, skills, and experience of its members in the area of climate-related and environmental risks, which are widely acknowledged as a source of significant financial risks. The management body of a credit institution is considered to be best placed to ensure that climate-related and environmental risks are taken into account when developing the institution’s overall business strategy, business objectives, and risk-management framework, and to exercise effective oversight. An adequate understanding of climate-related and environmental risks by the management body in its supervisory function supports effective oversight. Accordingly, bank directors can expect to be asked questions to demonstrate their knowledge of the impact and management of these risks in interviews by regulatory bodies to approve them for their roles.

Trends in Board Climate Accountability Globally

The concept of individual accountability for board members in managing the climate transition is not new. In January 2016, the PRI and UNEP FI launched a four-year project to clarify fiduciary duties in relation to the integration of ESG issues in investment practice and decision-making. The assumption that ESG issues are financially material, and therefore consistent with fiduciary duties, is a fundamental premise of the ESG transition. For this reason, boards across global markets are developing their ESG transition strategy through the lens of their fiduciary duty to act in the best interests of shareholders. Conversely, any failure to appropriately manage the climate transition may be considered a breach of the board’s fiduciary duty.

Other major markets are also honing their expectations in this context: in the UK, for example, the PRA has introduced a Senior Management Function to attach individual accountability to managing climate risk within banks and insurers.

Practical Considerations for the Board

Embedding climate and ESG risk considerations within an assessment of board member competence has important consequences for corporates. Such risks include:

  • Reputational (commercial) risk. Failure to meet the fit and proper standard could be made public, which represents a significant reputational and commercial risk for the corporate and the board members.
  • Litigation risk. Managing any delta between public commitments on the climate and ESG transition and delivering (and being seen to be delivering) on those commitments is a key source of litigation risk.
  • Regulatory risk. In many cases, demonstrating a fit and proper board will be a threshold condition for retaining authorised status, and therefore the ability to undertake licensed activities.

These risks are leading many organisations to consider formal ESG transition plans to support and protect board members throughout the transition journey. Organisations might consider implementing a suitability matrix as a self-assessment tool of the collective suitability of the board, which can be presented to regulators and other stakeholders upon request. For more practical guidance on managing this transition risk, see Latham & Watkins’ White Paper on Governing the Transition to Sustainable Finance and recent guide for boards of US Public Companies on ESG oversight.