The Era of Legal Accountability

As featured in ESG Investor

Disputes in European courts are beckoning a new dawn in corporate climate reporting, according to FRA Partner Gerben Schreurs.

Over the last five years, multinational corporations have come under increased public scrutiny over their impact on the environment. Stakeholders, ranging from local NGOs to national politicians, are turning a sharper eye on companies’ financial practices and environmental commitments. Against this backdrop, companies no longer just worry about the reputational repercussions of any potential missteps, but legal and regulatory ones.

Whilst environment reporting obligations and legislation are still maturing in practice and enforcement, recent legal battles like those involving French and Dutch energy companies TotalEnergies and Royal Dutch Shell, and Dutch banking giant ING, highlight the immediate litigation risks for companies.

Concerns over adequacy of traditional accounting

In France, TotalEnergies is currently facing legal action from its activist shareholder group Métamorphose over its measurement of Scope 3 emissions – the result of activities from assets not owned or controlled by the reporting organisation.  The case points to a wider debate over whether traditional accounting is adequate for the specificities of climate impact reporting.

This was first brought to the fore in 2021 when a Dutch court ordered Royal Dutch Shell to speed up plans to cut its global greenhouse gas emissions by 45% in line with global climate targets by 2030. It set a legal precedent that companies could be held accountable for their Scope 3 emissions and also marked the first time any court in the world had imposed a duty of care on a company to help fight climate change. Another point of significance was the failure of Shell’s defence which set new expectations for financial accounting and reporting, compelling companies to re-assess their valuation methodologies and disclose their climate-related risks and future costs accurately.

In addition to its measurement of Scope 3 emissions, TotalEnergies is finding itself under attack from Metamorphose for its dividend distribution, which the NGO claims is partially made up of fictitious dividends. It asserts that the company has erroneously been modelling future carbon credits expenditure with a stable price per ton, when instead the price should increase as a rising number of companies buy such credits under growing pressure to reach environmental targets.

This gap in long term promises versus present-day accounting practice must be reconciled by senior management if they are to credibly defend good intentions in court. TotalEnergies v Metamorphose exemplifies stakeholders’ evolving expectations of corporations, and their willingness to hold corporations to account in court.

Banks facing increased legal scrutiny

To add to the existing litigation faced by oil majors, banking group ING is now under threat of legal action from environmental group Friends of the Earth Netherlands over an alleged breach of legal obligations – or ‘duty of care’ – by contributing to dangerous climate change through its financing of fossil fuel companies.

The NGO is demanding that the bank reduce emissions, mandate a climate transition plan for corporate clients and cease funding of fossil fuel companies lacking comprehensive phase-out strategies.

This is a test case for the banking industry; if it’s won, it would effectively force every systemically significant company to drastically curb their emissions or be in breach of Dutch law.

Financial reporting under increased strain

Despite the absence of a single standard on climate-related issues under the International Financial Reporting Standards (IFRS), stakeholders, and now courts of law, still expect companies to qualitatively explain how these matters are considered in financial statements. In this fluid context, how can auditors and financial boards benchmark good practice?

Some big regulators are attempting to address this. In Europe, for example, the UK’s Financial Reporting Council (FRC) and the European Securities and Markets Authority (ESMA) have proposed legislation on climate-related topics. Those that are specifically targeted include the impairment of assets, provisions, financial instruments, and the fair value measurements that include climate-related risk factors or the accounting of carbon credits and renewable energy certificates.

Best practice in technical accounting is also at risk in the absence of concrete rules. For example, when it comes to credit risk, climate change-related risks impact factors such as the probability of default, loss given defaults, or concentrations. Such rules are in their early days, creating a legal grey area which companies must navigate.

Litigation’s role in shaping standards

The recent legal battles involving TotalEnergies, Royal Dutch Shell and ING portend further litigation by stakeholders in future against companies to ensure their business practices align with climate commitments. The goalpost has shifted from reducing direct emissions to taking responsibility for Scope 3 emissions.

Financial and climate accounting are important evidence-based resources for authorities and shareholders to determine if companies are making good on their commitments. Proper carbon measurements and updated financial practices must become central to ensure legal compliance. Companies will be pressured to accurately account for climate-related risks and disclose them in their financial statements. Overvalued assets due to the omission of environmental costs may face corrections.

In future, companies must be more proactive when it comes to addressing environmental commitments, ensuring that their operations align with global standards and can withstand legal scrutiny. The era of legal accountability in the corporate world is only just beginning, and litigation will play a pivotal role in shaping standards in the future.