How Contracts Can Protect Businesses From Climate Risks

The climate crisis has undeniably climbed to the top of every business agenda, with nearly every company website boasting ambitious climate goals. To meet these goals, we are seeing companies adopt a range of strategies, from comprehensive transition plans and ambitious climate policies to green investments, AI-supported energy efficiency programs and offsetting schemes.

Despite these well-intentioned efforts, the stark reality is that most companies struggle to make meaningful strides in combating climate change, remaining exposed to all the risks that come with it. Market pressure, data challenges, knowledge gaps, resource limitations and fragmented regulations are only some of the obstacles that prevent companies from taking bold actions to address the risks they are facing and, in many cases, the risks their actions are exacerbating. As a result, besides a handful of “green” products and services, business as usual largely prevails.

Regina Villaruel

However, forward-thinking companies recognize that climate-related risks can significantly impact their long-term stability, from either physical or transition risks (such as a regulatory, or reputational risk), which can give rise to financial risks. And they understand that it is a risk which no organization is exempt from as all commercial activities are inherently connected to the environment in which they operate: our planet.

What action could they take to better manage their business? One example is the use of a legally binding obligation — set out in a contract — to deliver against climate targets.

Contracts Are the Pillars of Effective Risk Management

Contracts are the cornerstone of risk management for any reputable organization. They protect business interests and mitigate risks while transforming vague promises into concrete and binding commitments that give certainty to the parties. However, in contrast to payment terms or a limitation of liability clause, which are never overlooked, climate-related provisions are often surprisingly absent from most contracts.

Why aren't companies integrating climate risks into their contracts? It could be due to a combination of regulatory hesitation, lack of expertise or lack of awareness of the power of contracts. Whatever the reason, it’s clear that climate-aligned contracts are essential for ensuring the long-term profitability of businesses.

Contracts are inherently connected to the carbon emissions from the manufacture and delivery of the underlying products and services. They are therefore powerful levers for change which can remove a hidden barrier to decarbonization and help companies manage climate-related risks. They can operate through several mechanisms, such as:

• A company can include a clause in supply chain contracts allowing it to terminate agreements with suppliers if it can source goods or services with a lower carbon footprint.

• Loan agreements can feature interest rates that fluctuate based on a company's carbon footprint.

• Boards can adopt corporate governance standard templates to evaluate the climate impacts of significant transactions.

• Investors can require companies they fund to report on sustainability and carbon-reduction efforts, helping them assess climate-related risks.

Pre-contract documents — like due diligence questionnaires — also help identify and mitigate climate risks, further enabling companies to provide products and services that will lay the foundation for a sustainable economy.

Climate-aligned contracts also create opportunities to access new markets in green technologies, renewable energy, sustainable agriculture and green finance. Additionally, these contracts enhance reputational value and combat greenwashing accusations, demonstrating a genuine commitment to addressing climate change and helping attract top talents and customers.

Unlocking the Benefits of Climate-Aligned Contracts

Costly legal services are one reason for the slow take up of climate-aligned contracts. This hurdle can be removed by utilizing freely available climate-related clauses and resources available from organizations like the Chancery Lane Project (TCLP) which is a U.K.-based non-profit organization with a global reach.

TCLP open-source legal content — created through a peer-reviewed process using specialist lawyers from leading law firms — spans various legal areas and jurisdictions, offering businesses the tools to align their contracts with climate goals, at no cost to the firm.

The legal resources include an extensive library of climate clauses and glossary terms to be used directly in commercial contracts by companies ranging from banks to real estate companies to technology firms. For example, the clauses cover a range of topics from requiring suppliers to procure energy from renewable sources, to ensuring construction projects meet net-zero targets, to an agreement to reduce food waste in supply chains.

And in case you were wondering why the clauses all have people’s names: It’s because they are named after children of the lawyers who wrote or reviewed them.

There are also case studies and user-friendly "how-to" guides to help non-lawyers introduce climate contracting within their organizations. The case studies range from how to introduce climate provisions into contract discussions, to how to enforce and incentivize decarbonization.

Parting Thoughts

Contracts can be a powerful tool for driving positive change, enabling organizations to achieve their net-zero goals without compromising on their business objectives.

Accordingly, for businesses committed to a decarbonized economy, transitioning from voluntary actions to legally binding commitments in contracts is essential. To do this, every contract can embed climate considerations, benefiting both parties. Companies should be taking action now and aligning their standard contracts with climate standards for a sustainable — and lower risk — future.

Regina Villaruel is the Head of Finance and Capital Markets at The Chancery Lane Project. She trained as a lawyer at Shearman & Sterling LLP (Italy) in M&A and Capital Markets and has worked as in-house legal counsel for over a decade across different jurisdictions and industry sectors.