Climate Change: Risks and Implications for Company Directors

The evolution of our understanding of climate change from an ethical or environmental issue to one that presents foreseeable financial and systemic risks (and opportunities) has significantly changed its relevance to the governance of both corporations and investors with serious implications for the duties of directors and officers. This article focuses specifically on rules under German law regarding directors’ duties and obligations as they pertain to climate change.

Climate change poses an existential risk to humanity, the planet and the global economy on a scale never before seen. The 196 parties to the Paris Agreement have agreed to pursue efforts to limit the temperature increase to 1.5°C above pre-industrial levels. In 2018, the European Commission adopted an Action Plan on Sustainable Growth to identify future legislative steps on climate change. 

The EU has made substantial progress in preparing and implementing climate change-related policy and legislation. In June 2021, European Regulation (EU) 2021/1119 (the European Climate Law) entered into force, which includes a legally-binding objective for the EU to reach climate neutrality by 2050, a commitment to negative emissions after 2050, and a target of at least a 55 percent reduction of net emissions of greenhouse gases by 2030 compared to 1990. The related set of policies and legislation is likely to have significant impacts on the legal and commercial contexts in which companies operate – as developments which are likely to take effect in the short and medium-term, they affect directors’ governance of their companies and disclosure of material risks.
 

Corporate Governance and Diretors’ Duties in Germany

The German Federal Government (Bundesregierung) – in a world first for a government – set out binding national climate targets in a Climate Protection Act that entered into force on 18 December 2019. The Climate Protection Act provides for a gradual reduction in greenhouse gas emissions compared with 1990 levels, with at least a 55 percent reduction target by the year 2030. In the long term, the Federal Government is pursuing the goal of greenhouse gas neutrality by 2050. This goal is also clearly stated in the Act.[1] In August 2021, following a ruling by the German Constitutional Court [2], the Climate Action Law was strengthened, including introducing a more ambitious greenhouse gas reduction target of 65 percent by the year 2030, and 88 percent by the year 2040. [3] 

The German Federal Financial Supervisory Authority (BaFin) [4] requires regulated entities to manage climate risks and to integrate them into their risk management frameworks. With a guidance notice published in December 2019, updated in January 2020, BaFin has provided its supervised companies, in particular banks, insurance companies, pension funds and capital management companies, with non-binding good practice guidelines on how to deal with sustainability risks and, in particular, climate risks.[5] BaFin has also proposed amendments to its minimum requirements for risk management (MaRisk) to include the integration of ESG risk management into the general risk management framework. [6]

In March 2022, the Sustainable Finance Committee (SFB) of the German Federal Government published a report on 31 recommendations on how the German economy can be transformed with a sustainable financial system, including on policy, reporting obligations, knowledge building and financial products. [7] The SFB recommended that the German government increase the number of companies subject to reporting under the Non-Financial Reporting Directive (NFRD) and that TCFD-aligned reporting be made mandatory.

On 27 June 2022, the new version of the German Corporate Governance Code (DCGK) was published and entered into force. [8] The responsible Commission previously adopted the new version on 28 April 2022. [9] The DCGK has, in a previous version, already established an explicit expectation that companies and their management need to be aware of their role in and responsibility vis-à-vis society. In fact, social and environmental factors are considered to be relevant for business success. [10] This is a clear commitment to sustainability principles.

The new version of the DCGK states that the board must take into account the social and environmental factors which influence the performance of the company, and the company’s impacts on people and the environment. Under the new DCGK, a company’s management board must systemically identify and assess social and environmental risks and opportunities for the company, and ensure that the company’s strategy gives appropriate consideration to social and environmental matters. The supervisory board is required to give supervision and advice on sustainability issues in particular, and should comprise members with sufficient skills and expertise in sustainability matters, which should be disclosed in a qualification matrix in the company’s Corporate Governance Statement. The new DCGK also requires one member of the audit committee to have expertise in auditing, and another to have expertise in accounting, which should include sustainability reporting and its auditing and assurance. The chair of the audit committee is required to have expertise in either accounting or auditing (and therefore, sustainability reporting to the relevant degree). Most recently, the German Supply Chain Act came into force. Since 1 January 2023, companies that have their head office, principal place of business, administrative headquarters or registered office in Germany or have a branch office in the country and usually employ at least 3,000 employees (1,000 from 2024) in the domestic market are subject to new and expanded duties of care. [11] They are required to implement risk management systems which monitor the companies’ entire supply chain particularly with regard to human rights and environmental risks. [12] This is accompanied by extended due diligence and reporting obligations which include an annual risk and effectiveness analysis.[13] Companies that fail to follow the imposed obligations can face fines of up to two percent of their annual revenues. [14] 

Against the backdrop of the anticipated Corporate Sustainability Due Diligence Directive (CSDD) at EU level, however, an amendment of this law is to be expected in order to create adherence to the stricter EU requirements.
 

Directors’ Duties and Climate Change

Germany is a civil law jurisdiction. Directors’ duties are codified in the Act on Limited Liability Companies (GmbHG) and the Stock Corporation Act (AktG), and fleshed out further in case law. The AktG provides for a dual board system with different duties and responsibilities for management and supervisory board members. Whereas the management board is responsible for the day-to-day business and the company’s strategic direction, the supervisory board is focused on controlling and monitoring the management board's decisions. Notwithstanding these different functions, pursuant to sections 93, 116 AktG, all board members owe the company a duty of care, duty of loyalty and duty of confidentiality, and must exercise their duties “for the benefit of the company”. [15] The duty of care requires the directors to “exercise the diligence of a prudent and conscientious manager”. [16] Notwithstanding the wide scope of directors’ duties under German law, according to the codified business judgement rule, a management board member does not breach his or her duties if, when making a business decision, the management board member could reasonably assume, on the basis of appropriate information, that he/she was acting in the best interests of the company. [17] The same rule applies, in principle, to supervisory board members. Accordingly, there is no breach of duty if the supervisory board member, when making a business decision, could reasonably assume that he/she was acting in the best interests of the company on the basis of appropriate information. In addition, it is the supervisory board members’ duty to diligently supervise and challenge the decisions made and proposed by the management board.

Applying these standards to directors’ duties regarding the risks resulting from climate change, BaFin has summarised in its guidance notice for regulated companies that the management board is responsible for the business and risk strategy, its implementation within the company, and its communication. Thus, as a first step, management board members are expected to understand climate risks and their potential impact on the company’s business. Further, management board members are responsible for fostering an effective risk culture and institutionalising processes and systems to control and oversee the impacts and implications of climate risks, applying a short, medium and long-term perspective. [18] This also applies accordingly to the supervisory board. In addition, although the NFRD and its implementation in German law are silent on directors’ duties, the disclosure obligations at least implicitly oblige the management board members to develop an understanding, and assess the impacts, of climate change on the business, incorporate the results in the entity’s strategic plans and scrutinise and challenge the company’s resilience to climate-related risks.

In Germany, there is currently a widely-observed litigation matter before the Higher Regional Court of Hamm (file no. I-5 U 15/17) based on a complaint brought by a Peruvian farmer against German energy provider RWE alleging damage due to the consequences of climate change caused by the defendant. The farmer is demanding that the defendant pay 0.47 percent of the cost of protective measures for his house and village. The farmer accuses the German company of being co-responsible for climate change through the greenhouse gas emissions it produces. The claimant believes that the consequences will cause a glacier in the Andes to melt, with meltwater threatening his house and village. In an oral hearing in November 2017, the judges considered a claim for compensation to be sufficiently pleaded as to move into the next procedural stage of evidence taking. This case is currently in the evidentiary phase. An on-site visit, in which judges, experts and other parties involved in the process were able to assess the situation in Peru for themselves, was carried out in May 2022. [19] The further outcome is largely dependent on the expert opinion currently underway. If, following trial, the Court were to determine that the defendant is liable to the claimant and if such decision was upheld by the German Federal Court of Justice on further appeal, the decision could have very far-reaching consequences for high-emission companies in Germany, as it could establish a route for claimants affected by climate change around the world to bring claims against German companies for their contributions to climate change.
 

Directors’ Disclosure Obligations and Climate Change

The German government has implemented the NFRD, which provides for disclosure obligations in a non-financial statement. [20] These disclosures regard, inter alia, the implications of climate change for the company, including potential damage caused by the company to society through its emissions, and those experienced by the company due to physical impacts, regulatory change, technological disruption etc.; and they require the company to disclose its strategy to address them by means of the CSR Directive Implementation Act of March 2017. [21] Pursuant to the regulations in sections 289b subsequent of the Commercial Code (HGB), companies with more than 500 employees are obliged to include a non-financial statement in their management report. Within this non-financial statement, the company must address at least the following aspects: environmental issues (including greenhouse gas emissions, water consumption, air pollution, use of renewable and non-renewable energy), employee concerns, social concerns, human rights and its efforts to combat corruption and bribery. [22] Further, with regard to these aspects, the non-financial statement must provide information necessary for an understanding of the company’s development and performance, its position and the effect of its activities on the aspects referred to above. [23] If the company does not adopt any measures to address one or more of these aspects, it must explain and justify this clearly in the non-financial statement. [24] Although the implementation of the NFRD generally involves a disclosure obligation for directors regarding climate change risks and impacts, as an explicit exception, the company may, in the non-financial statement, omit any information on future developments or matters under negotiation if the directors, in their exercise of sound business judgment, determine that the information is likely to cause significant damage to the company. [25]

As an additional ramification, the implementation of the NFRD has led to an amendment in the definition of the supervisory board’s responsibilities, insofar as it gives supervisory board members the option of instructing an external party to conduct a content review of the non-financial statement. [26]

In November 2022, the European Commission adopted the Corporate Sustainability Reporting Directive (CSRD), which expands the scope of the companies which are required to make sustainability disclosures, and includes more stringent and harmonised reporting obligations, including plans to align the business model and strategy in line with the temperature-limitation goals of the Paris Agreement, and reporting on a ‘double materiality’ basis. Sustainability information disclosed pursuant to the CSRD will be required to be disclosed as part of the management report and will be subject to assurance. The first companies required to report under the CSRD (those which are already subject to the NFRD) will be required to make their first CSRD disclosures in 2025, in respect of FY2024. The CSRD has not yet been transposed into national law. 

Under the HGB, breaches of the disclosure obligations concerning the non-financial statement are sanctioned in different ways. Misrepresentation or non-disclosure of the company’s relations are subject to criminal punishment, including potential prison sentences of up to three years for board members. [27] Moreover, omitting or incompletely preparing a non-financial statement constitutes an administrative offence, resulting in possible fines of up to EUR 10 million. [28] In the event of errors in the non-financial statement, the management board members are also considered to be in violation of their obligations under section 93 AktG, which may result in liability for damages towards the company.
 

Practical Implications for Directors

Given that German regulators have become increasingly emphatic regarding the need for companies and their directors to adopt climate resilience measures in business practices and disclosure, and in particular the above-noted BaFin guidance to its supervised companies; the German Federal Government’s GHG emissions reductions targets, and the implementation of the EU’s CSRD, well-counselled boards will:

Revisit existing and build future business models

Directors and supervisory board members should conduct strategy discussions and manage the necessary transformation of business models, reflecting also geopolitical risks. On the way to net-zero, directors should in particular assess the carbon footprint under Scopes 1 to 3 under the Greenhouse Gas Protocol. Beyond that, it is necessary for the management and supervisory boards to adequately consider both the risks and opportunities of all relevant ESG aspects. 

Further, directors should put on the agenda for the board within 3 or 6 months a process to start developing a climate transition roadmap to 2050 with transparent carbon neutrality or reduction targets, with clear interim targets to 2040, 2030, and within the current rolling multi-year strategic plan, and periodically thereafter report back to the board.

In addition, directors should delegate to the appropriate committee(s) of the board, such as risk, audit, legal and governance, scenarios/strategy, nominations/remuneration, or sustainability/corporate responsibility, the task of translating the long-term strategy into a clear decision-making process for each aspect that is relevant to each committee.

Comply with disclosure requirements

Directors and supervisory board members need to gain an understanding of, and directors need to manage legal issues related to relevant (new) non-financial reporting standards. The supervisory board, in turn, has to monitor the directors’ strategy and decisions as part of its supervisory function. This requires sufficient knowledge of the underlying regulation and legal issues and risks.

Further, directors need to discuss with disclosure counsel, to develop an external engagement and communications plan and to oversee rigorous disclosure and accounting.

Review supply chains

Directors should review supply chains to identify potential risks of business disruption due to the impacts of climate change and other business and geopolitical factors. New due diligence obligations will need to be fulfilled under the new German Supply Chain Act as well as further incoming regulation in Europe. Again, the supervisory board has to monitor proper fulfilment of directors’ responsibilities.

Implement compliance measures

Directors should implement compliance measures and apply best crisis management practices in the event of a breach, including communication with regulators and third parties. Directors must consider legal requirements and recommendations regarding climate risks for all new projects and activities. Due diligence frameworks and policies and procedures related to employees, assets, operations and transactions must be developed and reviewed. Directors need to be trained on legal issues related to climate risks.

Directors should delegate climate risk identification and evaluation to a clearly-identified team in management which reports directly to the CEO and board.

Supervisory board must supervise proper fulfilment of the directors’ responsibilities.

Examine insurance coverage 

Directors should review insurance coverage issues in relation to climate-related risks.

Monitor the regulatory and legal environment

Directors and the supervisory board should monitor the regulatory and legal environment and respond to any changes.

Avoid reputational damage

Directors must communicate an ESG strategy, take steps to review it and avoid reputation damage, in particular through greenwashing. Past communication also needs to be scrutinised.

If you would like to discuss this update, please contact Henning Schaloske or Christoph Pies, co-lead of our German ESG and Climate Change practice, from our Düsseldorf office.
 

[1] Gesetz zur Einführung eines Bundes-Klimaschutzgesetzes und zur Änderung weiterer Vorschriften vom 12. Dezember 2019 (the Climate Protection Act); www.bgbl.de/xaver/bgbl/start.xav?startbk=Bundesanzeiger_BGBl#__bgbl__%2F%2F*%5B%40attr_id%3D%27bgbl119s2513.pdf%27%5D__1605199445200

[2] BVerfG, Beschluss des Ersten Senats vom 24. März 2021 - 1 BvR 2656/18 -, Rn. 1-270; www.bverfg.de/e/rs20210324_1bvr265618.html

[3] Gesetz zur Einführung eines Bundes-Klimaschutzgesetzes und zur Änderung weiterer Vorschriften vom 12. Dezember 2019, berücksichtigt die Änderung(en) des Gesetzes durch Artikel 1 des Gesetzes vom 17. August 2021 (BGBl. I S. 3905) (the Climate Protection Act) (as amended). www.gesetze-im-internet.de/englisch_ksg/englisch_ksg.html

[4] BaFin, ‘BaFin’s Sustainable Finance Conference: Financial markets and climate change’ (June 2019) www.bafin.de/SharedDocs/Veroeffentlichungen/EN/Fachartikel/2019/fa_bj_1905_Tagung_nachhaltige_Finanzwirtschaft_en.html

[5] BaFin, Guidance Notice on Dealing with Sustainability Risks (January 2020); www.bafin.de/SharedDocs/Downloads/EN/Merkblatt/dl_mb_Nachhaltigkeitsrisiken_en.pdf;jsessionid=CAFA36097D7125E6241B7D08B04596ED.2_cid500?__blob=publicationFile&v=5>

[6] BaFin, Konsultation 06/2022 - Entwurf der MaRisk in der Fassung vom 26. September 2022; www.bafin.de/SharedDocs/Downloads/DE/Konsultation/2022/dl_kon_06_22_MaRisk.html?nn=9021442

[7] Sustainable Finance Committee, Shifting the Trillions: A sustainable financial system for the great transformation (March 2022); https://sustainable-finance-beirat.de/wp-content/uploads/2021/03/210319_SustainableFinanceCommiteeRecommendations.pdf

[8] Regierungskommission Deutscher Corporate Governance Kodex, German Corporate Governance Code (27 June 2022); https://dcgk.de/en/press/details/new-code-published-in-the-federal-gazette.html

[9] Regierungskommission Deutscher Corporate Governance Kodex, German Corporate Governance Code (28 April 2022); www.dcgk.de//files/dcgk/usercontent/en/download/code/220627_German_Corporate_Governance_Code_2022.pdf

[10] Ibid.

[11] German Supply Chain Act, Section 1

[12] Ibid, Sections 3-10

[13] Ibid

[14] Ibid, Section 24 para. 3

[15] Sections 93 para.1, 116 para.1 AktG

[16] Ibid

[17] Ibid, s. 93 para.1

[18] BaFin, Guidance Notice on Dealing with Sustainability Risks (January 2020); www.bafin.de/SharedDocs/Downloads/EN/Merkblatt/dl_mb_Nachhaltigkeitsrisiken_en.pdf;jsessionid=CAFA36097D7125E6241B7D08B04596ED.2_cid500?__blob=publicationFile&v=5

[19] Press release by the Higher Regional Court of Hamm, 17 June 2022; www.olg-hamm.nrw.de/behoerde/presse/pressemitteilung_archiv/archiv/2022_Pressearchiv/19_22_PE_Beweisaufnahme-in-Peru-im-Rechtsstreit-Lliuya-___-RWE/index.php

[20] Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014; https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014L0095&from=EN

[21] Gesetz zur Stärkung der nichtfinanziellen Berichterstattung der Unternehmen in ihren Lage- und Konzernlageberichten (CSR-Richtlinie-Umsetzungsgesetz) vom 11. April 2017

[22] Section 289c para. 2 HGB

[23] Ibid, s. 289c

[24] Ibid, s. 289c para. 4

[25] Ibid, s. 289e para. 1

[26] Section 111 para.1 AktG

[27] Ibid, s. 331

[28] Ibid, s. 334