Accounting may not seem the most obvious arena for ambitious climate action, but a recent legal opinion highlights real opportunities for boards to drive sustainability through the company accounts. Nick Scott, Manager of the Law for Climate Action programme at the Centre for Climate Engagement, discusses the possible implications.
Corporate accounts are vital documents – they give shareholders a picture of a company’s financial health and can highlight key business risks and opportunities. They are also not just the domain of auditors. Directors must prepare and approve accounts and, in doing so, are legally required to ensure that the accounts give an accurate picture of their company’s financial position. Under section 393 of the UK’s Companies Act 2006, these accounts must be ‘true and fair’. Though many businesses now see sustainability as an important aim, it is often treated as separate from these financial fundamentals that underpin most business decision making. However, a new legal opinion authored by George Bompas KC and commissioned by Social Value International argues that sustainability can not only be relevant to company accounts, but that directors must consider sustainability in discharging their legal obligations.
The relationship between climate change and corporate performance is now fairly well understood, at least in a general sense, and the way that this interacts with directors’ duties garnered significant attention when ClientEarth took Shell’s board of directors to court in 2023. This new opinion centres on a more specific duty regarding corporate accounts, and provides useful guidance for boards looking to better integrate climate change in their financial decision making. The opinion clarifies how sustainability standards interact with broader accounting standards and directors’ duties, providing a framework through which boards can navigate both new and longstanding rules in the context of climate change. It also suggests that climate goals and strategies could be ‘constructive obligations’, which can be a tool to not only account for climate change, but incentivise action that addresses it. Finally, the opinion raises broader questions about the link between law, corporate governance, and climate change – how might a KC’s opinion actually impact directors, and how can these ideas be brought into practice?
The opinion in brief
The idea that environmental considerations are relevant to directors’ legal obligations is not new. Three Australian legal opinions,[1] the first issued in 2016, made the argument that directors must understand and address climate risks to discharge their fiduciary duties and duties of care. A similar position was endorsed by Lord Sales, former Justice of the UK’s Supreme Court, in 2019. We have now seen these ideas tested in UK courts, most notably in a high-profile derivative action[2] against Shell’s board of directors in 2023. Although ClientEarth’s claim was dismissed by the High Court, the court’s decision has been criticised by another former Supreme Court Justice, Lord Carnwath. These discussions centre on directors’ general duties, in particular to promote the success of the company and to act with reasonable care, skill and diligence articulated in sections 172 and 174 of the UK’s Companies Act 2006. In short, given the financial implications of climate risks – whether they be extreme weather events, laws introduced to reduce emissions, or societal attitudes shifting in the face of the crisis – failing to consider sustainability may also be a failure to act in a company’s best financial interests.
A different provision of the Companies Act, section 393, enshrines a more specific duty. Directors must not approve accounts unless “they give a true and fair view of the assets, liabilities, financial position and profit and loss”. Specific rules about what ‘true and fair’ means could never cover every circumstance a company might face, so courts have not been prescriptive about the concept’s definition. As with intersections between climate change and directors’ duties more broadly, climate is relevant to the ‘true and fair’ requirement to the extent that it might impact business’ broader commercial position. However, given section 393’s more specific application, it is easier to define general examples of these intersections.
If omitting key climate-related information from a financial statement would influence the decision making of existing and potential investors, creditors, or lenders , it is ‘material’ and should therefore be included. In the opinion, Bompas refers to educational material from the International Financial Reporting Standards (IFRS) noting that climate risks may reduce the useful lives of assets, which would need to be recognised as depreciation or impairment in financial statements.
It is important, according to Bompas, that directors “exert themselves” in interrogating these potential interactions, and not simply leave it to their executive team or sustainability specialists. This does not mean that directors must become leading experts in climate risk. It does, however, mean that they must consider whether these issues apply to their business, ask the right questions, and consult the right people.
Navigating sustainability standards
The legal standard set out in section 393 of the Companies Act is separate, but related, to accounting standards laid out by bodies such as the IFRS.[3] Bompas explains that compliance with accounting standards creates a presumption that accounts are true and fair. However, in some cases compliance might not be sufficient to discharge the true and fair duty. Even in cases where compliance with accounting standards would result in true and fair accounts, directors must always exercise their own independent judgement. In addition to general accounting standards, there are a growing number of specific climate-related reporting standards, including under the IFRS.[4] Sustainability reporting generally concerns narrative, rather than financial, reporting but it can identify aspects of a business that do require disclosure in the accounts. So, while directors’ core duty is found in section 393, ensuring that accounts are true and fair requires consideration of accounting rules and, increasingly, sustainability standards.
This links to a broader point – sustainability standards might seem overwhelming or burdensome, but they can bring clarity and structure to complex issues, guiding businesses towards sensible and well-informed decisions. There is often debate about whether companies should focus on integrating climate change in broader aspects of business or implementing targeted climate-related measures. In this case and others, different layers of requirements – varying in specificity and granularity – are not at odds, but instead support each other. Broad legal concepts and duties, such as that in section 393, give a basic reason for why climate change warrants consideration. More detailed rules, such as accounting standards, provide a framework for how sustainability issues can be addressed. Finally, specific requirements such as sustainability reporting highlights which climate-related issues which must be addressed under the previous two layers. The content of corporate accounts and sustainability reports is certainly complex, but this opinion provides a coherent view of how each framework relates to the other.
Bringing climate commitments to life as constructive obligations
Many directors already know that climate change is a business risk, but identifying the problem is only the first step towards solving it. Through constructive obligations, accounting can provide a concrete structure and real incentives to help businesses address climate risk. Constructive obligations arise when a company, through public plans or past practice, makes a third party expect that it will fulfil a responsibility. Investors, employees, customers and the public at large may all have legitimate expectations based on a company’s communicated sustainability policies, so can climate commitments be constructive obligations?
Bompas notes that certain undertakings – for example to buy carbon offsets to meet a specific target, or to tie executive remuneration to climate goals – may meet the definition of constructive obligations. Rethinking Capital, a think tank which aims to use accounting to drive sustainability goals, argues that broader corporate net zero transition commitments should be construed as constructive obligations under current IFRS rules.
Constructive obligations are given force when they must be recognised as provisions within accounts, in which case companies must dedicate funds to fulfilling them. Obligations must be recognised as provisions if they have arisen from a past ‘obligating event’ which left no realistic alternative to fulfilling the obligation, and if they will lead to a likely payment of funds which can be reliably estimated. This more specific category of constructive obligations may still apply to many corporate climate commitments. For example, if a business has an ongoing commitment to apply an internal carbon price to their emissions which is paid towards specific environmental projects or initiatives, this obligation may be demonstrable through past practice, and it may be possible to determine a reliable estimate of the funds required to fulfil the commitment. Even if a climate commitment does not meet the criteria to be recognised as a provision, it may still be material to the company’s accounts and could be recognised in a note to the financial statements.
This creates a potential path to action for businesses and their auditors. First, corporate climate policies can be analysed to see whether they may have created constructive obligations. Next, those obligations can be tested against the criteria required to be recognised as a provision. Obligations which meet these criteria would be recognised, and those which do not could be mentioned in a note to the accounts if material. Finally, businesses can monitor debates about the links between sustainability and corporate accounts to understand whether they may need to recognise further climate commitments and prepare for this possibility if appropriate.
Businesses that decide to structure and recognise their commitments in this way would create firm incentives for climate action, giving greater certainty to both internal and external stakeholders and accounting for long-term financial risks stemming from climate change. One concern may be that other businesses choose to make commitments either less specific to avoid being construed as constructive obligations, or less ambitious to reduce the burden of these potential obligations. However, investors, customers and even employees are applying greater degrees of scrutiny to corporate net zero targets. Businesses that scale back their targets may find it harder to attract investment than similar businesses with concrete net zero strategies. Nonetheless, these possibilities feed into broader concerns about unintended side-effects of legal routes to addressing climate change.[5]
What happens next?
But why does a legal opinion like this actually matter to directors? After all, boards might usually only interact with barristers through a couple of layers of lawyers , and while the opinion is from an authoritative source, it is not the decision of a court. Similar opinions show a path to impact. Three years after Australian barristers issued the ‘Hutley Opinion’ on directors’ duties and climate change, their views had been supported by a former UK Supreme Court judge and a wide range of academics, lawyers, and NGOs.[6] Four years later, ClientEarth took Shell’s board of directors to court on similar principles. Bompas’ opinion may not have direct effect, but indicates that others, including potential litigants, may adopt a similar interpretation of the law. It also provides momentum to organisations advocating in this area – including Social Value International itself, which is using the opinion to determine practical steps for businesses looking to address climate change in their accounts.
Of course, there are still barriers to widespread integration of sustainability into accounts. Many companies may not feel downsides from business-as-usual (yet) and are likely concerned about potential first mover disadvantages. This may change these ideas are socialised with boards, accountants, lawyers, investors and standards-setters. Ambitious businesses can already take comfort in knowing that they canintegrate climate change into their accounts, whereas laggards could suffer if growing recognition of these links means that they mustchange their accounting practices. While this momentum builds, the opinion and surrounding advocacy may be enough to at least start a conversation in the boardroom, and working with lawyers and accountants will be vital to implementing an effective strategy. However dull it is portrayed in stereotypes, accounting provides exciting opportunities for proactive boards looking to reach net zero, and risks to those that fail to align with the net zero transition and become resilient to climate change’s business impacts.
With thanks to Jeremy Nicholls from Social Value International for his input and comments on a draft version of this piece.
[1] Although these opinions relate to Australian corporate law rather than UK company law, similar principles mean that it is informative of UK law as well.
[2] A derivative action involves a shareholder bringing a claim on behalf of the company, in this case ClientEarth was a minor shareholder in Shell so could seek permission for a claim against the company’s board of directors.
[3] Bompas’ opinion and this article mainly address the IFRS, but many companies report under UK GAAP (Generally Accepted Accounting Principles).
[4] Current IFRS sustainability standards include IFRS S1 (General Requirements for Disclosure of Sustainability-related Financial Information) and S2 (Climate-related Disclosures).
[5] One similar issue is the concept of ‘greenhushing’, where companies intentionally keep quiet about their climate strategy out of fear of being targeted for greenwashing.
[6] For example, the Commonwealth Climate and Law Initiative has carried out a large amount of research in this area.
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