Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Energy–Oil & Gas: March 2008
There has been a recent push by both public and private sectors to introduce new initiatives to combat and adapt to climate change; however, adapting to climate change involves more than simply changing a light bulb or buying a more fuel-efficient vehicle. Climate change is affecting the way in which we do business, particularly as industry braces for new environmental legislation, shareholders demand greater action on climate change, and more stringent disclosure standards are introduced. A heightened awareness of climate change issues is generating increased interest in how organizations manage their carbon footprint, which is leading to increased interest in the opportunities and risks associated with climate change.
Over the years, those involved in risk management have been looking at climate change models as a means to ascertain the business risks posed by abnormal weather patterns. But an entirely new area of risk management is emerging in connection with climate change, designed to assist carbon-conscious businesses and individuals seeking to ensure that the organizations in which they are investing, financing or acquiring are responsibly managing their carbon footprint. This area is climate change due diligence, which is increasingly becoming an essential part of liability and climate risk management. Considered to be an aspect of environmental due diligence, climate change due diligence involves a thorough evaluation of an organization's greenhouse gas (GHG) management process. The scope of climate change due diligence will depend on the nature and complexity of the transaction, but may generally address the following components of an organization's operations:
- evaluation of the organization's carbon footprint, which includes an accounting of the emissions generated by the organization's products and supply chain
- analysis of the organization's GHG inventories
- evaluation of the organization's mitigation strategies and analysis of its environmental management system as well as the integration of a GHG management system into business processes
- assessment of regulatory compliance
- consideration of an organization's participation in any voluntary carbon disclosure initiatives.
What is Due Diligence?
Due diligence generally refers to either the performance of an investigation of a business or person, or the performance of an act with a certain standard of care. In business transactions, the due diligence process varies for different types of companies and industries. Due diligence can cover any number of areas, including general corporate, financial, employment, tax or environmental.
Environmental due diligence emerged in the late 1970s and early 1980s as a tool to manage liabilities related to contaminated soil and groundwater. As awareness of environmental issues has increased over the years, environmental due diligence has evolved to include matters such as toxic substances, occupational health and safety, and product liability.
Broadly speaking, environmental due diligence is the process by which knowledge of the environmental and regulatory conditions affecting a project or organization is acquired, and applying such appropriate methods of mitigation to reduce environmental impacts during the construction, operation and decommissioning phases. These days, environmental due diligence is evolving further to capture matters relating to GHG emissions and carbon management. Climate change due diligence represents a new aspect of environmental due diligence and its purpose is to reduce the financial, regulatory and physical risks associated with climate change on business operations.
With heightened awareness of environmental issues, the term 'carbon footprint' is quickly becoming part of our daily vernacular. While the term carbon footprint has a number of definitions in the literature, the general idea is that a carbon footprint represents a measure of the total amount of carbon dioxide emissions that is directly and indirectly caused by an activity or is accumulated over the lifecycle of a product. More specifically, a carbon footprint can be considered the sum of two parts – the primary footprint and the secondary footprint.
The primary footprint is a measure of our direct emissions of CO2 and includes domestic energy consumption and transportation (e.g., car and plane).
The secondary footprint is a measure of the indirect CO2 emissions from the whole lifecycle of products we use i.e., from the production of raw materials associated with their manufacture to the disposal of the finished product.
The carbon footprint captures activities carried out by individuals, communities, companies, processes, or industry sectors and takes into account all direct and indirect emissions. The carbon footprint is similar to the idea of the ecological footprint, which represents the net impact of all the things bought, sold, and left behind in the course of daily life. Typically, an ecological footprint is measured in terms of global acres, which allows us to determine whether we are operating at, above, or below the average capacity of the Earth to renew resources and absorb waste. However, a carbon footprint is usually expressed in tonnes as this is a more accurate measure of emissions than an area-based indicator.
The accurate calculation of an organization's carbon footprint is important in ensuring that CO2 emissions are not undercounted or doublecounted, particularly where emission reductions will be used in carbon trading and carbon offsetting transactions. A careful review of an organization's methodology for calculating its carbon footprint will play a significant role in reducing the risks inherent in carbon trading and carbon offsetting, as well as ensure the credibility of carbon transactions.
Two major methodologies have been identified in Wiedmann and Minx, 2007: process analysis, and input-output analysis. Both methodologies seek to encompass the full lifecycle impacts of a product. Process analysis takes a "bottom-up" approach and has been developed to analyze the environmental impacts of individual products from cradle to grave. Environmental input-output analysis takes a "top-down" approach and takes into account all economic activities at a higher level. The input-output analysis is most effective for assessing the carbon footprints of industrial sectors, businesses, larger product groups or government, while process analysis is most effective for assessing the carbon footprint of a particular process or individual product.
The effective accounting and management of carbon requires unambiguous, verifiable specifications to ensure credibility in GHG quantifications and that a tonne of carbon can be consistently calculated. To that end, an internationally agreed upon standard for measuring, reporting and verifying GHG emissions was introduced by the International Organization for Standardization (ISO) in 2006 and is referred to as ISO 14064.
ISO 14064 consists of three standards, which provide guidance at the organizational and project levels, as well as for validation and verification. The first part of ISO 14064 – ISO 14064-1:2006 – specifies the requirements for designing and developing GHG inventories at the organizational level. The second part – ISO 14064-2:2006 – sets out the requirements for quantifying, monitoring and reporting emission reductions and removal enhancements from GHG projects. The third part – ISO 14064-3:2006 – provides the requirements and guidance for conducting GHG information validation and verification. Each part can be used independently or as an integrated set of tools to meet the various needs of GHG accounting and verification.
The other widely-used standard in preparing GHG inventories is the Greenhouse Gas Protocol: A Corporate Accounting and Reporting Standard (the Protocol), which was developed by the World Resources Institute and the World Business Council for Sustainable Development. It provides the accounting framework for many GHG programs around the world, including the California Climate Action Registry and the EU Emissions Trading Scheme, as well as GHG inventories prepared by individual companies.
The Protocol consists of two separate, but linked, standards: (i) Corporate Accounting and Reporting Standards, which sets out the methodologies for business and other organizations to inventory and report all of the GHG emissions they produce; and (ii) Project Accounting Protocol and Guidelines, which supports the calculation of reductions in GHG emissions from specific GHG-reduction projects.
The use of a common standard gives greater credibility to GHG quantifications, and supports the compatibility of rules across sectors. In ensuring the credibility of claims made in respect of GHG emission reductions, the risk of running afoul of regulatory requirements or other contractual obligations may be reduced. However, parties should be aware that the calculation of GHG inventories may be affected by some degree of uncertainty given the availability of sufficient data and the nature of the techniques used to process them. Over time, this uncertainty may be minimized as more precise methods of calculating GHG inventories are developed. In the meantime, it may be prudent to factor in uncertainty into any analysis in order to ensure a more robust accounting system. Other matters to consider include whether any enforcement actions have been taken against the organization, if sufficient training is available to the organization's employees to ensure accurate reporting, and the accreditation of third party verifiers.
GHG Mitigation Strategies and EMS
Every organization has some processes, products or services that generate either direct or indirect emissions from a variety of sources. GHG mitigation generally refers to efforts to stabilize or reduce greenhouse gas concentrations in the atmosphere. GHG mitigation strategies can be developed across a wide range of regions, industries and organizations. Mitigation strategies can take many forms from reduction of tillage intensity in the agricultural sector to implementing carbon sequestration technologies in the energy sector or investing in energy infrastructure in developing countries.
The focus of this article is mitigation strategies at the organizational level, which can include programs to increase energy efficiency, reduce waste and improve transportation practices. Such mitigation strategies are often embedded in an environmental management system, or EMS, which is a set of processes and practices developed by an organization to reduce its impact on the environment and to increase its operating efficiency. The implementation of an EMS is associated with a range of benefits, including:
- cost savings through the reduction of waste and more efficient use of natural resources
- reduction in insurance costs by demonstrating better risk management
- improved overall performance and efficiency
- improved internal communications and morale, often leading to sound environmental solutions suggested by staff
- a more positive public perception of the organization.
The development and implementation of an EMS is essentially a voluntary initiative and the most important element of an EMS is the commitment by the organization of sufficient staff and resources to implement and run such a program. In reviewing the effectiveness of an EMS, the following matters should be considered.
Environmental Policy. A statement of what an organization intends to achieve from an EMS.
Environmental Impact Identification. Identification and documentation of the actual and potential environmental impacts of an organization's operations, often achieved through environmental audits.
Objectives and Targets. To ensure continuous improvement, targets should be regularly reviewed.
Consultation. Consultation with staff and stakeholders should be undertaken before, during and after the establishment of an EMS.
Operational and Emergency Procedures. All procedures should be reviewed to ensure they are compatible with the organization's environmental objectives and targets.
Environmental Management Plan. Such a plan details the methods and procedures which an organization will use to meet its objectives and targets.
Documentation. All objectives, targets, policies, responsibilities and procedures should be documented along with information on environmental performance.
Responsibilities and Reporting Structure. To ensure the effective implementation of an EMS, responsibilities should be properly allocated to staff and management.
Training. Proper training should be provided to staff to enable them to become familiar with the EMS and the organization's overall environmental policy and objectives.
Review Audits and Monitoring Compliance. Review audits should be undertaken on a regular basis to monitor progress towards EMS objectives and to refine operational procedures to meet this goal. In addition, regular environmental monitoring may be required in order to ensure regulatory and other requirements are being met.
Regulatory ComplianceThe review of an organization's regulatory compliance is one of the cornerstones of environmental due diligence. The scope of compliance assessment will depend on the nature of the transaction, but can include:
- searches of public registries to ensure that no enforcement or non-compliance actions have been taken against the organization
- litigation searches in the relevant jurisdictions to determine whether any actions have been commenced against the organization
- a review of all environmental permits and approvals, as well as applicable internal documentation, to ensure that the organization is operating within the terms of such permits or approvals
- a review of environmental assessment reports to identify any areas of concern.
With climate change due diligence, uncertainty is introduced into the equation because the elements of a climate change due diligence review will be dependent on future legislation. Regulatory frameworks for managing GHG emissions do not yet exist in many jurisdictions and, in jurisdictions where regulations governing GHG emissions do exist, they are often piecemeal in nature and may involve several pieces of legislation. As governments around the world come to grips with the need for regulatory tools to address climate change, we will likely see the implementation of binding standards and targets. The only certainty appears to be the imminent arrival of climate change regulations, the nature and scope of which will be shaped by political forces. Greater regulatory certainty will mean a decreased risk of liability for non-compliance.
In the absence of regulatory guidance, consideration of the following additional issues may be helpful in verifying an organization's compliance record in respect of climate change-related matters:
- a review of the appropriate legislative framework impacting GHG emissions, such as air quality regulations or industry-specific legislation for emissions (e.g., for large emitters, electricity industry, etc.)
- a review of the organization's capital expenditure commitments to comply with foreseeable future legislative requirements
- if the organization is involved in a carbon offset project, confirmation that the project exists and that any emission reduction credits generated by such a project are recognized by the appropriate authority
- a review of material contracts to identify ownership and/or allocation of emission reduction credits
- a review of any third party verification documents relating to quantification and verification of emission reduction credits
- if the organization participates in any emissions trading system, a review of the documents relating to the verification and registration (if applicable) of emission reduction credits.
An increasing number of organizations are under pressure to disclose any current or anticipated risks of climate change in connection with their business operations. In particular, shareholders, non-governmental organizations and regulators are seeking greater disclosure by organizations to evaluate the impacts of climate change on their businesses. In the absence of clear regulatory standards, organizations are taking on a leadership role by engaging in voluntary disclosure initiatives. One of the biggest disclosure projects is the Carbon Disclosure Project (CDP), which is an independent, not-for-profit organization aimed at creating a lasting relationship between shareholders and corporations regarding the impact of climate change on shareholder value and commercial operations. The stated goal of the CDP is "to facilitate a dialogue, supported by quality information, from which a rational response to climate change will emerge." To date, the CDP has 315 signatory investors with assets valued at $41 trillion. Furthermore, the CDP holds the largest registry of corporate GHG emissions data in the world and its reports provide detailed analyses of how the largest companies in the world are responding to the climate change issue.
Voluntary initiatives are looked upon favourably and climate change risk analysis is gaining profile among investors, insurers and rating agencies. In assessing the degree of disclosure exercised by an organization, the following should be considered:
- whether the organization has established corporate policies and governance structures with respect to climate change
- evaluation of the physical risks of climate change to existing and planned corporate facilities or operations
- evaluation of the financial risks arising from current and proposed GHG legislation
- tracking current and forecasted benchmarks in respect of GHG emissions
- whether the organization has factored costs and risks associated with climate change into business plans and investment decisions
- evaluation of other publicly available information on the organization such as sustainability reports.
The area of climate change due diligence is a fast-evolving one. As can be seen above, a thorough assessment of the risks associated with climate change involves a review of many elements of an organization, from its business processes and internal management systems, to its relations with shareholders and the public. As climate change risk analysis becomes more commonplace, there will be an expectation that organizations implement "best practices" for managing climate change risks, even in the absence of a clear regulatory framework. Organizations that are reluctant to actively manage these risks may find themselves in a vulnerable position, potentially putting the organization's finances and reputation on the line.
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