Winter is coming: contracting for climate change
Published on: 06/04/2021
“Winter is coming” went the line from the hit TV show Game of Thrones, and like the hoard of White Walkers coming to destroy humanity, so is climate change. I once wondered whether GoT was allegorical: while the humans of Westeros fought and politicked and squabbled, the real danger was brewing beyond the Wall, in the same way that we might view the last few decades of revolution, war, economic crisis and political turmoil (and Covid?) as a sideshow compared the existential threat posed by global warming. It feels like we are in the penultimate series of GoT now: the Wall is well and truly breached and we’re all well aware of the dangers climate change poses (save for a few doubters, and we know how they ended up in GoT).
Climate change could severely impact the global economy and the supply chains on which we rely. Heatwaves, wildfires, floods and storms can disrupt supply chains and inflict economic damage on businesses around the world. The Covid-19 pandemic has revealed both the weaknesses of global supply chains and the ill-preparedness of the world's governments to manage the economic impacts of acute events. A state can build resilience by regular disaster monitoring and response planning, but supply chains are complex and intertwined and multinational corporations cannot rely on uniform and harmonised government action across the world to deal with the threat of climate change. A prudent business should strive to build resilience from within.
Contracts are a powerful tool available to any business to protect against the risks posed by climate change – especially since, unlike Covid-19, climate change risks are already known to and experienced by us. These risks are chronic, long-term and foreseeable; and just like any risk, their impacts can be mitigated by appropriate contractual provisions. It just requires a change of mindset from corporates – or, I should perhaps say, their legal advisors.
Let's begin where every contract begins – with pre-contractual negotiations. For a supplier looking to secure a new supply contract to openly discuss risks that climate change poses to their businesses, they must be confident that the discussion about these risks will remain confidential. Standard non-disclosure/ confidentiality agreements (NDA) can be amended to specifically refer to the need to disclose any climate change-related risks associated with the contract. At the same time, the customer's net zero goals or other ESG commitments may be outlined in NDAs to ensure that these concepts are introduced in the transaction from the very outset, which also reduces a scope for misalignment once the negotiations are concluded.
Heads of Terms (HoTs) can also be adapted to identify and provide for climate change risks. Although they are non-binding as such, HoTs often lay the groundwork for subsequent contractual negotiations and the eventual deal. Like NDAs, climate change clauses can be incorporated into HoTs to ensure that the parties’ net zero goals and decarbonisation strategies become a material consideration at the negotiation table. These clauses can open a discussion about carbon-neutral ways of fulfilling the contract at hand, or perhaps carbon offsetting schemes if the contractual performance concerns industries which are difficult to decarbonise (aviation and shipping spring to mind).
During contractual negotiations parties can further minimise their exposure to climate change risks by inserting clauses which set out their desired carbon performance, accompanied by regular monitoring and reporting. These clauses are especially important for those companies that have set net zero targets, since a failure to align their contracts with their public pronouncements may expose them to greenwashing lawsuits – as well as negative publicity and shareholder anger. Several types of contractual provision could be used, such as:
- Environmental and climate warranties, such as a warranty that the contracting party has undertaken and reported on its own carbon footprint;
- Net zero performance target and a roadmap how to achieve it (for example by switching transportation from traditional vehicles to EVs/hydrogen-powered vehicles or reducing wasteful by-products of the party's operations);
- Regular monitoring and reporting obligations in order to assess the on-going progress towards net zero as per the agreed roadmap, which may be accompanied by regular audit rights of the other party (these obligations and rights may be made mutual);
- If commercially viable, a contractual mechanism that will ensure that a failure to progress towards a net zero target on the timescale agreed will be accompanied by a reasonable remediation or offsetting fee to motivate compliance.
These terms will ensure that a company retains full control over carbon emissions throughout its contractual framework, and will encourage more and more ambitious performance by its contractors. They also provide transparency as to the overall carbon footprint of its business (thus aiding reporting obligations).
Climate risk sharing can also be catered for. Parties to a contract often agree to abandon their contractual rights and obligations if an event outside of their control or foresight frustrates the contractual performance (force majeure clauses). However, this can result in environmental consequences, such as dumping of stock which got “stuck” halfway in transit. Parties can agree on how they will cooperate if a climate change-related event results in interruptions and delays in contractual performance. For example they can agree to undertake a contractual risk assessment in which they will balance the financial and commercial losses caused by delay with climate change and environmental impacts, and the benefits of maintaining a commercial relationship as opposed to having to negotiate a new one.
Termination clauses are often ill-suited to address climate change risks. Supply contracts are commonly negotiated to last for several years so that the parties get returns on the time and money invested into negotiating them in the first place. However, as a result of this standard practice, many companies become locked in high-carbon contracts, while the continuous advances in technology and science make competitors' contracts more sustainable.
Parties can still benefit from technological advances made throughout the contractual term by including a clause providing that they can request the other party to step up originally-agreed carbon reduction targets in certain circumstances. A customer in a strong negotiating position may even propose a termination right conditional on them identifying an alternative supplier with better suitability and environmental objectives, perhaps subject to affording the existing supplier an opportunity to match the alternative supplier's offer within an agreed period of time. To further incentivise green competition among the suppliers, a consumer may commit to renew its contract for another term if certain agreed carbon-reduction goals have been met.
Finally – and something I’ll be looking at more closely at LIDW - contracts sometimes terminate less amicably, and a dispute arises. Even though dispute resolution clauses are often given little thought in negotiation/drafting, carbon reductions can be promoted even at this contentious stage of the commercial relationship. Disputes often involve a range of carbon-intensive practices, from excessive use of paper to extensive international travel (be it of witnesses, arbitrators, or the parties and their representatives). Specific dispute resolution clauses can be inserted into contracts to, for instance, agree that any paperwork exchanges in the dispute will be in electronic form only, while the use of paper bundles will be conditioned on recycling and offsetting obligations (by way of tree-planting for instance). Parties can also agree to attend virtual proceedings by default, and offset any inevitable emissions generated, for instance, when witnesses from countries with poor network coverage have to attend hearings in person. Even simply considering which arbitral organisation’s rules are “greenest” can assist.
Winter is coming. But corporates can prepare for climate change risk and mitigate its effects by considering a range of appropriate provisions in pre-contractual negotiations and in their contracts themselves. Those who prepare now will surely weather the storm better than those who ignore the warning signs…
This blog was written by Richard Power, Partner at Clyde & Co, a founding member of LIDW.