FINANCE E Q U I TA B L E G R O W T H , F I N A N C E & I N S T I T U T I O N S N OT E S Climate Change and Sinking Corporates: Mitigating the Risks Authors: Antonia Menezes and Akvile Gropper © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be construed or considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202- 522-2625; e-mail: pubrights@worldbank.org. Cover photo: © Checubus / Shutterstock Images. Used with the permission of Checubus / Shutterstock Images. Further permission required for reuse. Cover design and layout: Clarity Global Strategic Communications / www.clarityglobal.net >>> Contents 1. Introduction 5 2. The Effects of Climate Change on Firms’ Solvency 7 3. Do Insolvency and Restructuring Frameworks Have a Role to Play in Mitigating the Risks? 11 4. Conclusions 14 >>> Acknowledgements Antonia Menezes is a Senior Financial Sector Specialist with the Insolvency & Debt Resolution Team of the World Bank Group based in Washington, DC. Akvile Gropper is a Consultant with the Insolvency & Debt Resolution Team of the World Bank Group based in Barcelona, Spain. We are grateful to Dr. Eugenio Vaccari (Senior Lecturer, Royal Holloway, University of London), Steven T. Kargman (Kargman Associates), Fiona Elizabeth Stewart (Lead Financial Sector Specialist with the Long-term Finance Team, Finance, Competitiveness, and Innovation Global Practice, World Bank Group), and François Lesage (Consultant, Finance, Competitiveness, and Innovation Global Practice, World Bank Group) for their review and insightful comments on this article. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 4 1. FINANCE >>> Introduction It is now broadly recognized that climate change is a complex global challenge that requires urgent, comprehensive mitigation and adaptation solutions. As described in the World Bank Group’s 2021–2025 Climate Change Action Plan,1 integrating climate action and economic development objectives is a priority that should be addressed collectively through public and private sector interventions, including policy and regulatory reforms and private sector invest- ments. This is critical given the reciprocal relationship between the effects of climate change on economic activity and the effects of economic activity on climate. The negative effects of climate change on economic activity are particularly pronounced in emerging markets and developing economies (EMDEs) due to their geographical locations, including the vulnerabilities of their ecosystems to physical climate risks,2 and due to EMDEs relatively limited fiscal space for mitigating the impacts of natural disasters.3 For example, the recent disastrous floods in Pakistan caused loss of life of over 1,700 people and affected 33 million people.4 The economic damage was also significant: the floods destroyed or damaged physical assets in agriculture, industry, and the service sectors (equivalent to 4.8 percent of FY22 GDP) and caused significant losses in GDP (projected to be around 2.2 percent in FY22, with agriculture accounting for the largest decline).5 The projected recovery and reconstruction needs are 1.6 times the budgeted national development expenditure for FY23.6 1. World Bank Group (2021), World Bank Group Climate Change Action Plan 2021–2025: Supporting Green, Resilient, and Inclusive Development (Washington, DC: World Bank); available at https://openknowledge.worldbank.org/handle/10986/35799 (last accessed on September 7, 2022). 2. According to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC), Africa, Asia, Central and South America, Small Islands, and the Arctic are particularly vulnerable to rising temperatures and extreme climate hazards, such as heatwaves, floods, droughts, and cyclones. See IPCC (2022), Climate Change 2022: Impacts, Adaptation, and Vulnerability, Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change IPCC (Cambridge University Press: Cambridge, UK, and New York, NY, doi:10.1017/9781009325844). Similarly, according to a special report on climate change physical risks by Fitch Ratings, countries in Asia and Latin America generally come out as most exposed to natural hazards, while countries in northern and central Europe are generally least exposed. See Ed Parker and Kathleen Chen (2021), “Climate Change Physical Risks Are a Growing Threat to Sovereigns,” Special Report by Fitch Ratings (November 23). 3. International Monetary Fund (2020), “Climate Change: Physical Risks and Equity Prices,” Ch. 5 in Global Financial Stability Report (Washington, DC: International Monetary Fund, April 2020); available at https://www.imf.org/en/Publications/GFSR/Issues/2020/04/14/global-financial-stability-report-april-2020#Chapter5. The report states that as a result of the 10 largest climatic disasters during years 1970–2018, EMDEs incurred damages in the range of 2.9 percent of GDP to 10.1 percent of GDP, whereas advanced economies incurred damages in the range of 1.0 percent of GDP to 3.2 percent of GDP. See also United Nations (2020), “Climate Change; Exacerbating Poverty and Inequality,” Ch. 3 in World Social Report 2020 (New York, NY: United Nations); available at https://www.un.org/development/desa/dspd/ wp-content/uploads/sites/22/2020/02/World-Social-Report-2020-Chapter-3.pdf. 4. Government of Pakistan, Asian Development Bank, European Union, United Nations Development Programme, and World Bank (2022), “Pakistan Floods 2022: Post-Disas- ter Needs Assessment” (World Bank, Washington, DC; October); available at https://thedocs.worldbank.org/en/doc/4a0114eb7d1cecbbbf2f65c5ce0789db-0310012022/. 5. Ibid. 6. Ibid. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 5 This article explores the reciprocal relationship between climate change and economic activity through the lens of business insolvency—in particular, the effects of climate change on corporate solvency and the potential role that in- solvency and restructuring frameworks can play in addressing climate-related risks and contributing to mitigating the effects of climate change. We will refer to the case of Pacific Gas & Electric Corporation in the US to illustrate how corporate insolvencies could be addressed through insolvency and re- structuring processes that promote climate change mitigation and adaptation. Although Pacific Gas & Electric presents a US case, similar restructurings of firms with higher exposure to climate risks could be replicated in other countries, including in EMDEs, assuming the necessary enabling environment for corporate restructurings is in place. It should also be noted that the role of restructuring frame- works in this context may be more relevant and impactful when applied to large firms (and particularly those in carbon-intensive sectors) than to small and medium enterprises (SMEs). This is because financially distressed SMEs are less likely to access formal restructuring procedures, including post-filing and post-commencement financing, and are generally more likely to be liquidated.7 Nevertheless, further inquiry into possible solutions that incorporate sustainability aspects into the SME restructuring processes would be highly valuable given the importance of SMEs to global economic development. Aside from insolvency and restructuring frameworks, other remedies for SMEs, such as advisory services for climate action and risk mitigation, targeted climate financing for SMEs, and insurance against climate-related risks, remain critical.8 7. See, for example, M. Adalet McGowan and D. Andrews (2018), “Design of Insolvency Regimes across Countries,” OECD Economics Department Working Papers No. 1504 (OECD Publishing, Paris), and A. F. Martinez and M. Uttamchandani (2017), “Report on the Treatment of MSME Insolvency” (World Bank Group, Washington, DC). 8. See, for example, Emmanuelle Ganne, Zakaria Imessaoudene, and Kathryn Lundquist (2022), “Small Business and Climate Change,” Research Note 3, Economic Research and Statistics Division, WTO (World Trade Organization, Geneva, Switzerland); available at https://www.wto.org/english/tratop_e/msmes_e/ersd_research_ note3_small_business_and_climate_change.pdf. The note discusses why MSMEs will be critical to achieving global decarbonization targets and the key challenges MSMEs face on their path to decarbonization and managing climate risks, including lack of knowledge on how to reduce carbon emissions and lack of access to financial assistance and incentives. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 6 2. FINANCE >>> The Effects of Climate Change on Firms’ Solvency Companies that fail to take account and remedial actions for climate risks are more likely to become financially distressed. A growing body of empirical evidence confirms the positive relationship between firms’ exposure to transition risks (such as new carbon regulations) and physical risks related to climate change and those firms’ corporate default risk. For example, a study of 458 companies listed on the Bloomberg Barclays Aggregate Corporate Index, observed from 2007 to 2017, found that these companies’ greater carbon footprint and intensity is associated with their increased corporate default risk following the introduction of a new climate regulation, such as the 2015 Paris Agreement.9 Other comparable studies using samples of European and US listed nonfinancial firms reached similar conclusions.10 The Carbon Tracker Initiative, an independent financial think tank, predicted that even under the Sustain- able Development Scenario (SDS),11 33 of the world’s 60 largest listed companies—more than half—would see at least 50 percent of their business-as-usual12 investments on unsanctioned (i.e., pre-final investment decision) projects become financially stranded.13 SMEs, which form a large segment of businesses in most countries, are especially vulnerable to economic shocks due to their scarce resources and significant funding gaps.14 SME failures due to climate risks, often physical risks, can cause significant disruptions of production and supply chains. For example, severe floods in Thailand in 2011 affected more than 14,500 companies worldwide that relied on Thai SME suppliers.15 9. G. Capasso, G. Gianfrate, and M. Spinelli (2020), “Climate Change and Credit Risk,” Journal of Cleaner Production 266, 121634; available at https://climateimpact. edhec.edu/publications/climate-change-and-credit-risk. 10. See, for example, Carbone, Giuzio, Kapadia, Krämer, Nyholm, and Vozian (2022), “The Low-Carbon Transition, Climate Commitments and Firm Credit Risk,” Sveriges Riksbank Working Paper No. 409 (Sveriges Riksbank, Stockholm, Sweden; January), available at http://hdl.handle.net/10419/251307; and Cristina Gutiérrez-López, Paula Castro, and Maria Teresa Tascon (2022), “How Can Firms’ Transition to a Low-Carbon Economy Affect the Distance to Default?,” Research in International Business and Finance 101722 (July 25), ISSN 0275-5319, available at SSRN https://ssrn.com/abstract=4171611. 11. This indicates the International Energy Agency (IEA) scenario of achieving net zero emissions by 2070. 12. In the study, the business-as-usual proxy is consistent with the IEA State Policies Scenario (STEPS), which projected about 2.7°C warming above pre-industrial levels on the basis of current policies. 13. A. Dalman and M. Coffin (2021), “Adapt to Survive” (Carbon Tracker Initiative, London); available at https://carbontracker.org/reports/adapt-to-survive/ (last accessed on September 7, 2022). Stranded assets are investments that become unviable because of changes in operating environments, in policy, or in market conditions (for example, fossil fuel infrastructure that will no longer be used). Stranded assets are usually written down as operating losses, but they may also be considered environmental obligations. 14. See, for example, A. F. Martinez and M. Uttamchandani (2017), “Report on the Treatment of MSME Insolvency” (World Bank Group, Washington, DC). 15. Eric Savitz (2011), “Long After the Floods Recede, Supply Chains Feel the Pain,” Forbes (December 1, 2011), available at https://www.forbes.com/sites/ciocen- tral/2011/12/01/long-after-the-floods-recede-supply-chains-feel-the-pain/?sh=4732f1d55327 (last accessed on December 5, 2022); Shubham Pathak and Jorge Chica Olmo (2021), “Analysing Spatial Interdependence among the 2011 Thailand Flood-Affected Small and Medium Enterprises for Reduction of Disaster Recovery Time Period,” Geoenviron Disasters 8, no. 8, available at https://doi.org/10.1186/s40677-021-00180-4 (last accessed on December 5, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 7 International financial institutions and financial oversight or- As reported by the United Nations’ Intergovernmental Panel ganizations recognize climate change as a source of financial on Climate Change (IPCC), countries and regions that rely on risk that can be transmitted to the financial system through climate-exposed sectors (such as tourism, agriculture, fishing, impacts on corporates.16 They project that the physical risks of and outdoor labor productivity) are particularly affected by climate change (for example, wildfires, rise in temperatures, the ongoing rise in sea levels, changes in rain patterns and flooding) and the risks related to the transition to a lower- temperatures, and the increasing intensity of natural disas- carbon economy (including regulatory, policy, and market ters.22 For example, in the Caribbean region, one of the most changes; reputational and litigation risks; and other complex climate-vulnerable regions in the world, the asset damages risks) can cause large-scale defaults on loans and widespread caused by natural hazards such as earthquakes, hurricanes, fire sales of assets by corporates with high climate risk expo- tsunamis, and floods are estimated at $12.6 billion per year.23 sures.17 Studies confirm that large-scale natural disasters can trigger an increase in total non-performing loans (NPLs) in the With regard to the physical risks, a firm-level analysis by the most affected geographic areas, with a higher impact on the European Central Bank (ECB) estimated that in a scenario nonfinancial corporate loan portfolio.18 lacking an orderly transition,24 a significant share of firms’ physical capital could be destroyed, and their profitability Insurance can reduce the financial impact of climate-related would deteriorate markedly.25 In an orderly transition, again physical hazards to corporates, households, and banks. The according to the ECB report, defaults may rise temporarily, future effectiveness, affordability, and availability of climate but “this initial impact would be more than offset by much risk insurance, however, may depend considerably on climate lower costs from physical shocks.”26 The ECB assessed that change scenarios19 and insurance market development.20 30 percent of euro-area banking system credit exposures to nonfinancial corporations are subject to high or increasing risk Physical risks to firms’ activity due to at least one physical risk driver. Furthermore, two-thirds of these exposures are secured by physical collateral, which The Basel Committee on Banking Supervision defines climate- may itself be subject to physical risks.27 related physical risks as economic and financial losses result- ing from the increasing severity and frequency of (1) extreme Transition risks to firms’ activity weather events (for example, heatwaves, floods, wildfires, storms); (2) longer-term gradual shifts of the climate (chronic The Basel Committee on Banking Supervision defines risks, such as rising sea levels and average temperatures); climate-related transition risks as “risks related to the process and (3) indirect effects of climate change, such as loss of eco- of adjustment towards a low-carbon economy.”28 According to system services (for example, water shortages or degradation the Committee, the drivers of transition risks include changes of soil quality or marine ecology).21 in public sector policies, legislation, and regulation as well as market changes (such as technological developments and changing customer preferences).29 16. See, for example, Bank for International Settlements (2021), “Climate-Related Risk Drivers and Their Transmission Channels” (April); Financial Stability Board (2020), “The Implications of Climate Change for Financial Stability” (November); European Central Bank (2021), “Climate-Related Risk and Financial Stability” (July); or Financial Stability Oversight Council (2021), Report on Climate-Related Financial Risk. 17. See note 16. 18. Pietro Calice and Faruk Miguel (2021), “Climate-Related and Environmental Risks for the Banking Sector in Latin America and the Caribbean: A Preliminary Assess- ment,” Policy Research Working Paper No. 9694, World Bank, Washington, DC; https://openknowledge.worldbank.org/handle/10986/35764. 19. Bank for International Settlements (2021), “Climate-Related Risk Drivers and Their Transmission Channels,” (Bank for International Settlements, Basel, Switzerland, April 2021). 20. Insurance markets are generally underdeveloped in EMDEs. See Stephane Hallegatte, Fabian Lipinsky, Paola Morales, Hiroko Oura, Nicola Ranger, Martijn Gert Jan Regelink, and Henk Jan Reinders (2022), “Bank Stress Testing of Physical Risks under Climate Change Macro Scenarios: Typhoon Risks to the Philippines” IMF Working Paper, WP/22/163, International Monetary Fund, Washington, DC (August 2022). 21. Bank for International Settlements (2021), “Climate-Related Risk Drivers and Their Transmission Channels” (Bank for International Settlements, Basel, Switzerland, April 2021). 22. Summary for Policy-Makers (SPM) of the Sixth Assessment Report (AR6) of the IPCC (2022); available at https://www.ipcc.ch/report/ar6/wg2/ (last accessed on September 30, 2022). 23. This is based on the modeled estimates of disaster losses by the United Nations (UN) Global Assessment Report on Disaster Reduction (UNISDR), cited in Julie Rozenberg, Nyanya Browne, Sophie De Vries Robbé, Melanie Kappes, Woori Lee, and Abha Prasad (2021), 360° Resilience: A Guide to Prepare the Caribbean for a New Generation of Shocks (Washington, DC: World Bank; © World Bank); https://openknowledge.worldbank.org/handle/10986/36405. 24. The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) developed two scenarios of disorderly transition: the first involves policy delays and complacency in mitigating climate change; the second involves lack of uniform policy approaches among countries, which would create inefficiencies. See Financial Stability Oversight Council (2021), Report on Climate-Related Financial Risk (Financial Stability Oversight Council, Washington, DC); available at https://home. treasury.gov/system/files/261/FSOC-Climate-Report.pdf (last accessed on September 7, 2022). 25. European Central Bank (2021), “Climate-Related Risks to Financial Stability,” Financial Stability Review (European Central Bank, Frankfurt, Germany; May 2021); available at https://www.ecb.europa.eu/pub/financial-stability/fsr/special/html/ecb.fsrart202105_02~d05518fc6b.en.html (last accessed on September 7, 2022). 26. Ibid. 27. Ibid. 28. Bank for International Settlements (2021), “Climate-Related Risk Drivers and Their Transmission Channels” (Bank for International Settlements, Basel, Switzerland; April 2021). 29. Ibid. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 8 Evidence suggests that businesses that fail to address legacy responsibility disclosures (which include environmental ac- issues and to adapt to the regulatory and market changes counting, among other social impacts) and the firms’ risk of related to the transition toward a low-carbon economy are bankruptcy.35 It concluded that of 613 listed firms, firms with more likely to file for bankruptcy than firms with “green perfor- higher performance in corporate social responsibility disclo- mance.” For example, a study using a panel of 179 large US sures had a reduced risk of bankruptcy (in the year of the firms included in the Newsweek Green Rankings30 between study and in subsequent years) compared to listed firms of 2010 and 2017 and a generalized method of moments esti- similar size, sector, and time of listing that did not disclose mation found that firms with higher “green performance” (one social responsibility information.36 indicator of which was greenhouse gas emissions) were at lower risk of bankruptcy.31 The study also confirmed its hy- Over the past several years, various recommendations for re- potheses that the link between “green performance” and firm porting on climate-related financial risks have been developed survival in the long term is stronger for firms (1) with stronger at the global, regional, and national levels.37 Although to date market power (because market power may offset the addi- no uniform reporting standards exist for fully assessing the tional costs of green practices) and (2) in highly competitive financial risks, investors and market participants are increas- markets (because corporate environmentalism is associated ingly expected to factor climate risk into their decision-making. with positive market-based reputation).32 For example, investors are increasingly calling on directors and auditors to always consider material climate risks when Similarly, a study of US public firms between 1991 and 2012 preparing and auditing financial statements.38 The International found that firms’ engagement in corporate environmental Sustainability Standards Board (ISSB) is currently developing responsibility generally lowers their bankruptcy risk because of two global standards—one on climate-related disclosures and increased trust and reputation among stakeholders.33 This effect another on general sustainability-related disclosures.39 The of corporate environmentalism can be attributed to improved proposed standards, when finalized, would form a compre- risk management, greater market appeal to customers, and hensive global baseline of sustainability-related disclosures reduced information asymmetries between firms and inves- for the capital markets.40 tors. By comparing results across industries, the study further found that in sectors less sensitive to the environment, such as In July 2021, the Financial Stability Board (FSB) surveyed services, results may be contrary: in these sectors, bankruptcy climate-related disclosure practices in 24 jurisdictions that risk may be increased due to the investments required to imple- are members of FSB.41 Of the surveyed jurisdictions, both ment environmentally friendly strategies combined with the developed economies and EMDEs had requirements, lesser likelihood of a pay-off for such investments.34 guidance, or expectations in place for firms’ climate-related disclosure practices. These findings showed progress since The findings of several other studies, including from developing the earlier survey in March 2021 when most EMDEs were still economies, reinforce the supposition that reducing informa- at a planning stage.42 Among the challenges reported by the tion asymmetries about the social, ethical, and environmental countries were some that related to the EMDEs’ low levels impact of firms’ activities can reduce their bankruptcy risk. For of financial sector maturity and to the predominance among example, one study, using two different regression models, some EMDEs’ listed corporates of SMEs lacking in data and analyzed the link between Vietnamese firms’ corporate social resources.43 These challenges may also negatively affect 30. A Newsweek project that ranks the 500 largest publicly traded companies in the United States (the US 500) and the 500 largest publicly traded companies globally (the Global 500) on overall environmental performance; see https://www.newsweek.com/greenrankings. 31. S. Aziz, M. Rahman, D. Hussain, and D. K. Nguyen (2021), “Does Corporate Environmentalism Affect Corporate Insolvency Risk? The Role of Market Power and Competitive Intensity,” Ecological Economics (Elsevier) 189: 107–82. 32. Ibid. 33. L. Cai, J. Cui, and H. Jo (2016), “Corporate Environmental Responsibility and Firm Risk,” Journal of Business Ethics 139 (3). 34. Ibid. 35. S. L. Nguyen, C. D. Pham, A. H. Nguyen, and H. T. Dinh (2020), “Impact of Corporate Social Responsibility Disclosures on Bankruptcy Risk of Vietnamese Firms,” Journal of Asian Finance, Economics and Business 7, no. 5 (April 2020). 36. Ibid. 37. Financial Stability Oversight Council (2021), Report on Climate-Related Financial Risk. Some of the most relevant recommendations and standards to date include the proposed global standards for Disclosure of Sustainability-related Financial Information and Climate-related Disclosures by the International Sustainability Standards Board (ISSB); recommendations of the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD); Regulation (EU) 2019/2088 of the European Parliament; and the Council’s November 27, 2019, recommendations on sustainability-related disclosures in the financial services sector. See https://eur-lex. europa.eu/legal-content/EN/TXT/?uri=CELEX%3A02019R2088-20200712 (last accessed on September 7, 2022). 38. Institute of Chartered Accountants in England and Wales (2021), Insights (October 26, 2021); see https://www.icaew.com/insights/viewpoints-on-the-news/2021/nov- 2021/little-evidence-of-climate-risk-effects-in-financial-statements (last accessed on September 7, 2022). 39. See the International Financial Reporting Standards (IFRS) Foundation webpage at https://www.ifrs.org/projects/work-plan/climate-related-disclosures/. 40. Ibid. 41. Financial Stability Board (2022), “Progress Report on Climate Related Disclosures of October 2022” (Financial Stability Board, Basel, Switzerland; October 13, 2022); available at https://www.fsb.org/2022/10/progress-report-on-climate-related-disclosures/ (last accessed on December 5, 2022). 42. Ibid. 43. Ibid. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 9 the prospects for restructuring. Identifying needs specific Physical and transitional climate change risks can be entwined, to EMDEs and SMEs and building the necessary capacity both being a source of litigation risk for corporates. In some remains a priority in developing economies. cases, damages were sought from companies for their alleged contribution to climate change harms (Luciano Lliuya v. RWE),46 Litigation risk as a subcategory of physical and in others, companies faced large liability claims under the and transition risks strict liability doctrine for damage that was, at least in part, caused or amplified by the effects of climate change (In re Climate change litigation, including claims against corporates PG&E Corporation and Pacific Gas and Electric Company).47 for climate damage or alleging noncompliance with climate reg- Below we discuss the PG&E litigation in more detail because ulations or failure to adapt, have grown considerably over the although this major California utility company was exposed to past several years.44 While fossil fuel companies are usually the liability claims for wildfires in 2017 and 2018 that led it to file primary target of climate change litigation actions against cor- for bankruptcy, the case resulted in a restructuring plan that porates, cases against corporates in the food and agriculture, included specific commitments to sustainability and achieve- transport, plastics, and finance sectors are also on the rise.45 ment of the state’s climate goals. The Bankruptcy of the Pacific Gas & Electric Corporation (PG&E) The Pacific Gas & Electric Corporation (PG&E)48 case The company pleaded guilty to involuntary manslaughter illustrates a corporate bankruptcy that, although driven for the deaths in the Camp Fire and, as part of its Chapter by a combination of factors, was due primarily to PG&E’s 11 reorganization, committed to paying $25.5 billion in set- failure to forestall the wildfire sparked by its faulty tlements with fire victims, insurers, and local government equipment and then spread disastrously under the dry agencies. Also under PG&E’s reorganization plan, conditions caused by droughts in California. certain unsecured creditors classified as “unimpaired” were paid in full for their claims unrelated to the fire. The On January 29, 2019, PG&E, a California-based utility company’s emergence from Chapter 11, approved by both corporation, filed a voluntary Chapter 11 petition in the US the California Public Utility Commission (CPUC) and the Bankruptcy Court for the Northern District of California. Federal District Bankruptcy Court, was financed through The company, which was solvent at the time of filing, (1) the issuance of new debt (approximately $28 billion) cited potential liabilities exceeding $30 billion stemming and reinstatement of the pre-petition debt (approximately from major wildfires sparked by its faulty equipment and $10 billion), and (2) the issuance of common stock and then devastatingly amplified by conditions resulting from other equity-linked instruments (approximately $9 billion). Northern California’s prolonged droughts. Because the On July 1, 2020, PG&E emerged from Chapter 11 after legal doctrine of “inverse condemnation” is applicable in completing its restructuring process and implementing California, electric utilities there are strictly liable for any its Plan of Reorganization, which was confirmed by the damages caused by their activity or equipment, regardless bankruptcy court on June 20, 2020. of fault or foreseeability. One of the blazes, the 2018 Camp Fire, killed 84 people and destroyed the town of Paradise. 44. Joana Setzer and Catherine Higham (2022), Global Trends in Climate Change Litigation: 2022 Snapshot (London: Grantham Research Institute on Climate Change and the Environment and Centre for Climate Change Economics and Policy, London School of Economics and Political Science); available at https://www.lse.ac.uk/ granthaminstitute/wp-content/uploads/2022/08/Global-trends-in-climate-change-litigation-2022-snapshot.pdf (last accessed on December 5, 2022). 45. Ibid. 46. Grantham Research Institute on Climate Change and the Environment, Climate Change Laws of the World (database), available at https://climate-laws.org/geographies/ germany/litigation_cases/luciano-lliuya-v-rwe. 47. In re PG&E Corporation and Pacific Gas and Electric Company, Case No. 19-30088-DM (the “Main Case Docket”). The summary of case facts is based on information provided on the Kroll Restructuring Administration website, available at https://restructuring.ra.kroll.com/pge/ (last accessed on September 7, 2022). 48. See In re PG&E Corporation and Pacific Gas and Electric Company, Case No. 19-30088-DM, or the summary of case facts at the Kroll Restructuring Administration website, https://restructuring.ra.kroll.com/pge/. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 10 3. FINANCE >>> Do Insolvency and Restructuring Frameworks Have a Role to Play in Mitigating the Risks? As part of a business management strategy, climate change risk as a financial risk can be minimized by implementing corporate environmental strategies and reporting, as suggested above. As also noted earlier, insurance against climate-related risks can be another important risk mitigant. New tools to assist businesses in assessing their vulnerabilities to climate risks are being developed.49 When it comes to managing climate risks, overlooking environmental risks may result in businesses becoming financially distressed. The question then arises: what role do insolvency and restructuring frameworks play in averting some of these insolvencies and promoting climate change mitigation and adaptation? We think it would be worthwhile to further explore two areas in which insolvency and restructuring frameworks could have an impact. First, restructuring practices could more proactively promote climate and sustainability commitments. Second, the treatment of environmental obligations and stranded assets in insolvency laws would benefit from further research to explore the mecha- nisms that could be used to mitigate the polluting activity of distressed businesses. 49. For example, see the UK Climate Impacts Programme’s BACLIAT vulnerability assessment at https://www.ukcip.org.uk/wizard/future-climate-vulnerability/bacliat/ (last accessed on September 7, 2022). See also the OECD Due Diligence Guidance for Responsible Business Conduct, available at https://www.oecd.org/investment/due-diligence-guidance-for-responsi- ble-business-conduct.htm (last accessed on September 7, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 11 Promoting environmental sustainability through formal Embedding climate change mitigation and adaptation goals restructuring processes is not a completely novel idea. Envi- in restructuring processes requires multidisciplinary skills and ronmental, social, and governance standards (ESG) can be expertise on the part of both the restructuring professionals integrated into distressed asset investing and restructurings and the investors. When weighing the options of restructuring by incorporating ESG into business plans and operations, or reorganization, insolvency and restructuring professionals reporting requirements, board composition, the executive must be familiar with the fast-changing regulatory and policy compensation structure, and financial modeling.50 Climate environment aimed at reducing carbon emissions; any techno- and sustainability requirements could possibly justify (with logical developments that may affect firms’ competitiveness; appropriate safeguards, such as judicial scrutiny) deviations the firms’ reputational risks and risks of litigation for climate- from the absolute priority rule on distribution of assets51 in related damages; and the cost and availability of insurance.56 solvent debtor cases. In such cases, shareholders and junior creditors would be allowed to retain some interest in the dis- The insolvency law could also provide additional incentives tressed company only if they demonstrated the achievement or enhanced protections if the new financing enhances the of these requirements. (The specific climate change mitigation climate action of the company being restructured. The advan- requirements would have to be identified.) It should be noted tages and benefits of such policies should be further explored, that deviations from the absolute priority rule are not com- along with the modes of implementation. monplace but, in some instances, they have been justified; examples include cases “under the new value doctrine” in US The treatment of environmental claims and obligations in Chapter 11 reorganization 52 or based on the recent European insolvency is another issue that we find relevant because (1) Union Directive on Restructuring and Insolvency (2019).53 many carbon-emitters are at risk of ending up with stranded assets that often carry environmental obligations (clean-up or other end-of-life obligations), and (2) climate litigation against The Reorganization of the Pacific Gas & companies, as a subset of environmental litigation, is on the Electric Corporation (PG&E) rise. Hence, it may be worthwhile exploring whether and how the treatment of climate-related environmental claims and ob- In the PG&E bankruptcy case (introduced above), ligations in insolvency laws influences lenders’ and investors’ part of the Chapter 11 process established a post- decisions from the climate sustainability perspective. bankruptcy agenda through which PG&E committed to modifying its governance structure, implementing greater safety measures, and achieving California’s state climate goals.54 The reorganization agreement included linking executive compensation to wildfire safety and prevention goals and realigning the corporate governance culture with long-term sustain- ability.55 50. B. Mirchandani (2021), “Distressed Credit and the ESG Opportunity,” Forbes, August 5, 2021, available at https://www.forbes.com/sites/bhaktimirchandani/2021/08/05/ distressed-credit-and-the-esg-opportunity/?sh=627912d128bc (last accessed on September 7, 2022); see also Mayer Brown (2021), “How ESG May Affect Refinancings and Restructurings of COVID-Era Debt” (April), available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2021/04/how-esg-may-af- fect-refinancings-and-restructurings-of-covidera-debt_apr21.pdf (last accessed on September 7, 2022). 51. Although subject to differences between jurisdictions, the absolute priority rule (APR) is essentially a rule that the claims of creditors in a dissenting class are to be paid in full if a more junior class is to receive a distribution or retain an interest. See World Bank (2022), A Toolkit for Corporate Workouts (Washington, DC: World Bank); https://openknowledge.worldbank.org/handle/10986/36838. 52. In Case v. Los Angeles Lumber Products Co., 308 U.S. 106, 60 S.Ct. 1, 84 L.Ed. 110 (1939), the U.S. Supreme Court made an exception to the APR—“the new value” exception. It meant that equity holders could participate in a plan of reorganization if they paid a fair value for that continued interest. In Bank of America National Trust and Savings Association v. 203 N. LaSalle Street Partnership, 526 U.S. 434 (1999), the Supreme Court implicitly recognized the continuing validity of “the new value” exception. 53. Directive (EU) 2019/1023 of the European Parliament and of the Council of 20 June 2019 on preventive restructuring frameworks, discharge of debt and disqualifications, and measures to increase the efficiency of procedures concerning restructuring, insolvency, and discharge of debt and amending Directive (EU) 2017/1132. The Directive’s Article 11(1)(c) allows member states to introduce, as an alternative to APR, a rule that under a restructuring plan dissenting voting classes would not have to be paid in full before junior classes receive anything but would have to be treated more favorably than any junior class. 54. California Public Utilities Commission, Press Release, May 28, 2020 (Docket #: I.19-09-016), available at https://docs.cpuc.ca.gov/PublishedDocs/Published/G000/ M338/K725/338725560.PDF (last accessed on September 7, 2022); see also United States Bankruptcy Court of Northern District of California Order Confirming Debtors’ and Shareholder Proponents’ Joint Chapter 11 Plan of Reorganization (dated June 19, 2020), Bankruptcy Case No. 19-30088-DM, available at https://restructuring. ra.kroll.com/pge/ (last accessed on September 7, 2022). 55. California Public Utilities Commission, Press Release, May 28, 2020 (Docket #: I.19-09-016), and United States Bankruptcy Court of Northern District of California Order Confirming Debtors’ and Shareholder Proponents’ Joint Chapter 11 Plan of Reorganization, Bankruptcy Case No. 19-30088-DM. 56. J. Sarra (2019), “Insolvency Risk and Climate,” Annual Review of Insolvency Law, University of British Columbia, pp. 279–341; available at https://law-ccli-2019.sites. olt.ubc.ca/files/2020/02/Janis-Sarra-Insolvency-Risk-and-Climate.2019.pdf (last accessed on September 7, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 12 Currently no universal policy exists regarding the priority In the United States, under Chapter 11 of the US Bankruptcy of environmental claims and obligations or the ability to Code, environmental claims can be exempt from the Code’s discharge them in insolvency. Some jurisdictions, however, automatic stay provision, and the debtor must comply with have taken an extra step and established the super-priority environmental laws prior to filing its plan of reorganization or “super-responsibility” of environmental obligations enforced and, if it remains in possession, subsequently.62 by environmental regulators. For example, a recent decision of the Supreme Court of Canada in the Orphan Well Associa- Because insolvency frameworks determine the treatment of tion v. Grant Thornton Ltd. case (2019) determined that the environmental obligations and claims, their preferential treat- bankruptcy estate’s environmental obligations were not finan- ment may have a negative impact on the cost and availability cial claims or claims provable in bankruptcy and that the bank- of credit to businesses with greater environmental—including ruptcy estate must fulfill environmental obligations in priority climate—risks and, likewise, a positive impact on businesses to any other claims, including those of the secured creditors.57 with “green performance.” So far, we have not found empirical The environmental obligations included stranded assets such evidence to prove or rebut this assumption, but we believe it as oil wells that needed to be plugged and capped, surface would be of value to investigate this further as it could provide structures to be dismantled, and land requiring restoration. important guidance to policy makers working to develop in- Even though the cost of environmental liabilities attached to solvency laws and to decide whether to give any preferential the stranded assets exceeded the estate’s realizable value, treatment to environmental obligations and claims. the Supreme Court of Canada confirmed that the trustee could not disclaim unproductive company assets that contin- ued to pose environmental and safety hazards. The Alberta Energy Regulator did not seek to hold the trustee liable for environmental obligations beyond keeping the assets in the bankruptcy estate.58 In an article published in the Journal of Sustainability Research, Tuula Linna points out that treating the environmental obliga- tions of insolvent companies as ordinary monetary claims provable in bankruptcy affects the choice between restructur- ing and liquidation, favoring liquidation.59 This is because in liquidation the costs of addressing environmental obligations are diluted among the creditors according to the pari passu rule, whereas in restructuring the debtor company bears that responsibility.60 The author suggests that the “super respon- sibility” principle, similar to that adopted in the Orphan Well case, does not lead to that kind of bias.61 57. Orphan Well Association v. Grant Thornton Ltd., 2019 SCC 5, [2019] 1 S.C.R. 150. The case summary is available on the website of the Supreme Court of Canada at https://scc-csc.lexum.com/scc-csc/scc-csc/en/item/17474/index.do (last accessed on September 7, 2022). 58. Ibid at 53. 59. T. Linna (2020), “Business Sustainability and Insolvency Proceedings—The EU Perspective,” Journal of Sustainability Research, Hapres (April). 60. Ibid. 61. Ibid. 62. See In re Commonwealth Oil Refining Co., 805 F.2d 1175 (5th Cir. 1986); available at https://casetext.com/case/matter-of-commonwealth-oil-refining-co (last accessed on September 7, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 13 4. FINANCE >>> Conclusions The causal relationship between economic activity and climate change is no longer news. The bankruptcy and subsequent restructuring of the Pacific Gas & Electric Corporation was a wake-up call reminding us of the other side of the coin: the physical and transition risks of climate change that put companies at risk of bankruptcy. At the global scale, as demonstrated by empirical research, these risks are mounting and pose a threat to financial stability. Comprehensive solutions (such as climate finance, reporting, and technological innovations), although outside the scope of this article, are necessary. Here, we attempt only to look through the prism of corporate insolvency and restructuring law and practice to identify opportunities to contribute to the climate change mitigation and adaptation agenda. Using this specific lens, we see the greatest opportunities lying in two domains: (1) Corporate restructuring practice and law. Restructurings of insolvent or nearly insolvent busi- nesses could be designed to attain greater alignment with climate change mitigation and adapta- tion strategies. Key to this change could be preparing restructuring and insolvency practitioners to be mindful of climate change concerns and potential climate change mitigation measures when fashioning restructuring plans, developing incentives for new financing that advances climate action, and potentially allowing deviations from the absolute priority rule on distribution of assets. (2) Treatment of environmental claims in insolvency law. Further research on the treatment of environmental obligations and stranded assets in insolvency laws would be beneficial in identify- ing mechanisms that could be used to mitigate the polluting activity of distressed businesses. All things considered, the objectives of climate change mitigation and adaptation and the objec- tives of commercial insolvency systems are not irreconcilable. Increasing numbers of links will be forged between financial viability and environmental sustainability as we face the intensifying pressures of the climate crisis. EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTE <<< 14