Climate-related litigation is an emerging and growing source of risk, but the supervisory framework for addressing this is only at an “early stage of development”, says this report by the Network for Greening the Financial System (NGFS).
The report examines the risk climate litigation poses for financial institutions, reviews current supervisory practices, and sets out potential options for micro-prudential supervision. It was published with an accompanying document exploring key trends in climate litigation.
According to the authors, it is challenging to reliably estimate the rate of increase in litigation risk due to its uncertain and non-linear trajectory. “Legal tipping points” – caused by rapid changes in case law, public sentiment towards litigation, international treaties, and legislation – can cause large, non-linear and unpredictable losses.
The report introduces preliminary principles for quantifying climate litigation risks (CLR). It states that while CLR is best considered as a subset of transition and physical risk, it can materialise in advance of both forms of risk and is a “transversal risk”.
Transversal impacts intersect across several risk categories, including credit, operational, market, liquidity, insurance and reputational risks. The report mentions research which shows that litigation could impact a firm’s value, creditworthiness and financing costs.
The authors encourage supervisors “adopt a risk-based approach” to mitigate direct costs such as damages, fines, legal and administrative fees, as well as indirect costs which include insurance pay-outs, credit losses and adverse business impacts.
The authors stress the need for universally accepted definitions of CLR and clear guidelines for integrating this aspect into governance and risk management frameworks, which their survey of 47 NGFS members found most are currently not doing.
Overall, the report finds that supervisors address litigation risk under operational and enterprise risk management frameworks, often as part of general litigation risk, and so may assume it is already being addressed.
However, the report says that CLR may warrant “special consideration” and calls for additional supervisory tools. Yet only 7% of NGFS members surveyed currently quantify the financial impact of CLR on financial institutions.
The report presents a toolbox of supervisory options with a range of intensity. They recommend initial risk assessment at jurisdictional and entity levels to determine the appropriate level of intervention.
Jurisdictional analysis should scrutinise current and future patterns to assess which regulated entities are most susceptible to legal action. Entity-level analysis should pinpoint financial institutions with substantial involvement in high-emitting industries.
Depending on the extent of exposure, supervisors can decide if more in-depth analysis is needed. On the lower end, the report proposes thematic supervisory activities, such as raising awareness, incorporating CLR into governance structures and risk management frameworks, and encouraging credible disclosures. Credible disclosures can mitigate direct litigation risks by anticipating key expectations of potential litigants.
When there is more material exposure, supervisors could consider targeted supervisory activities such as incorporating CLR into prudential reviews, conducting scenario analysis, and encouraging integration of CLR into capital adequacy assessments.
This page was last updated December 4, 2023
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