Central banks need to boost their efforts to understand the risks associated with climate litigation and develop sufficient supervisory tools to address the increasingly material issue, according to a report by the Network for Greening the Financial System (NGFS).
The body specifically called on its members to examine current and future trends to determine whether their jurisdictions are litigation “hot spots”, and to identify individual financial institutions with significant exposure to high-emitting sectors.
This could serve to “justify more specific supervisory activities” such as directly engaging with climate-vulnerable institutions to seek more information about their management of litigation risks and ensuring that the topic is being considered when determining how much regulatory capital needs to be set aside to absorb potential losses.
A list of possible supervisory approaches set out by the NGFS suggests that central banks consider the use of climate scenario exercises to examine litigation risks, establish market-wide definitions of climate litigation risks, and develop formal expectations on how the topic should be integrated into governance and risk management frameworks.
Litigation risk is normally a component of operational risk but “it may be argued that climate-related litigation risk warrants special consideration” due to the potential for significant financial payouts and the growing body of scientific knowledge that allows climate harms to be attributed to specific actors, said the NGFS.
It also noted that the potential for reputational risks meant that “climate litigation does not have to be successful for costs to materialise”.
The NGFS separately acknowledged the rise of efforts to stymie climate action via litigation in the US, or “non-climate aligned litigation”, but said that its “persistence… may be strongly tested in the future” as climate risks materialise.
The NGFS report was welcomed by European Central Bank board member and vice-chair Frank Elderson at the opening of an annual legal conference organised by the central bank.
Elderson said that if courts establish a legal obligation for corporates to proactively reduce their emissions it “would have major repercussions and would quite frankly be revolutionary” as such a duty is not currently being priced into planning and decision-making.
He also predicted that successes in climate litigation could encourage more lawsuits on other environmental areas such as nature and biodiversity.
Climate litigation has been on the radar of supervisors for some time, the NGFS identified it as a subset of physical/transition risks in 2021 and the FSB more recently advised G20 leaders that litigation could materialise “far in advance” of climate risks.
Despite this, the NGFS said that 93 percent of its members have not quantified the impact of climate litigation on regulated financial institutions, while 89 percent did not ask reporting institutions to identify losses relating to climate litigation as part of broader operational loss reporting.
The NGFS identified specific shortcomings around insurers, with most members saying they have not examined liability risks related to underwriting activities and have not considered the risks of insurers withdrawing climate litigation insurance for the financial sector.
The NGFS received survey responses from 47 central banks, out of a total of 127 members.
In addition to policy recommendations, the supervisory group published a follow-up report to a 2021 review of litigation trends, which it said was a response to the explosion of climate lawsuits recent years.
The NGFS warned that more than 70 percent of a total of 476 cases filed between 2021 and 2022 were brought against governments and public actors, including central banks and supervisors. However, it did not comment on the steps supervisors should take to prevent becoming the targets of climate lawsuits themselves.
It also predicted that climate-related disclosures would increasingly become the subject of litigation before courts or investigations by advertising regulators and other authorities, driven by the growing body of sustainability-related disclosure legislation.
Litigation risks could have knock-on effects at entity level and across the financial sector if not properly managed, said Julia Bingler, a fellow at the Council on Economic Policies.
“Litigation risks do not necessarily need to materialise – the presence of the risk itself might require firms to reserve substantial amounts of revenues to pay for future possible liabilities.
“If firms do not reserve the amount of capital that might be potentially required for litigation risks, they might face insolvency issues in case of successful litigation cases against them, with major second-round repercussions for investors and potentially entire financial markets.”
Bingler also echoed the NGFS warning of direct litigation risks for central banks, saying that financial supervisors could themselves the target of special litigation “if found that they do not adequately address financial risks in micro- and macro-prudential activities”.