Mandating Disclosure of Climate-Related Financial Risk

Alexander T. Song is a Legal Fellow at the Institute for Policy Integrity, NYU School of Law. This post is based on a recent paper, forthcoming in the NYU Journal of Legislation and Public Policy, authored by Mr. Song; Madison Condon, Associate Professor at Boston University School of Law and an Affiliated Scholar at the Institute for Policy Integrity; Sarah Ladin, Attorney at the Institute for Policy Integrity; Jack Lienke, Regulatory Policy Director of the Institute for Policy Integrity and adjunct professor at NYU School of Law; and Michael Panfil, Lead Counsel and Director of Climate Risk Strategies at Environmental Defense Fund, and lecturer at American University, Washington College of Law, and Howard University School of Law.

Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

Climate change will profoundly affect the institutions that undergird modern society and will challenge almost every industry and economic sector. Under certain warming scenarios, our best available estimates suggest that climate change will impose tens of trillions of dollars in economic costs over the next 80 years.

In this unprecedented environment, companies and their investors will need to mitigate their potential losses by preparing for the physical and transition risks associated with climate change. Physical risks include, for example, the costs of repairing damaged facilities after extreme weather events, as well as the increased insurance premiums for the facility following repair. Transition risks are associated with the actions society takes in response to those physical risks—actions like taxing carbon emissions, developing green technology, or increasing demand for sustainable goods and services.

While some of these physical and transition risks are increasingly foreseeable, many publicly traded companies still do not disclose sufficient information about the threats that climate change poses to their operations. Insufficient disclosure persists even though (1) the SEC’s Regulation S-K and Regulation S-X require corporations to disclose material financial information to their investors; (2) a 2010 SEC guidance document clarified that climate damages “can have a material effect on a registrant’s business and operations”; and (3) major investors—including behemoths like BlackRock and State Street Global Advisors—have confirmed that climate risks are material to their investment portfolios.

Despite these public and private sector calls for disclosure, studies consistently find that a broad swath of corporations continue to provide incomplete, insufficient, or boilerplate information on climate risk.

There are a number of reasons why corporations still do not provide good climate risk information to their investors, but the SEC has the tools at its disposal to change this status quo. When relevant information about a corporation is obscured or of low quality, investors cannot efficiently allocate capital, regulators cannot exercise effective oversight, and companies themselves cannot proactively manage foreseeable threats to their financial health. The importance of climate-related risk information cannot be understated. One survey found that ninety-three percent of institutional investors “view climate risk as an investment risk that has yet to be priced in by all the key financial markets globally.”

It’s not just individual companies that are under threat. As the new FSOC report has made clear, climate change threatens the entire financial system, and regulators will need to act quickly to mitigate these systemic risks. Experts have warned that continued complacency could lead to a “climate bubble” that, upon bursting, would send shockwaves throughout the economy, resulting in a new financial crisis.

New regulations are needed to bring the quality of climate risk disclosures level with other forms of risk disclosure commonly required of publicly traded companies. The SEC, as the primary regulator of American securities markets, should ensure that companies disclose their climate risk in a comparable, specific, and decision-useful manner. Comparable disclosures allow users, like investors and regulators, to understand how corporations compare in risk and performance. Specific disclosures provide information that is particular to the individual corporation and its financial outlook. And decision-useful disclosures allow investors to incorporate climate risk into their decision-making. Relevant decisions include whether and how much to invest, as well as ownership, engagement, and proxy voting-related decisions.

Improved disclosure addresses significant market vulnerabilities and may also provide indirect social benefits. Disclosure provides lenders and shareholders with information to compare risk exposure levels within and across industries, leading to more informed investment decisions. Regulators could more readily identify risk and monitor compliance. Companies themselves may also benefit, as many will be required to analyze and mitigate risks that are currently obscured or ignored. On the macro level, a climate risk regime can help ensure that asset prices reflect all relevant information about a company’s fundamental value, which can mitigate the risks of a climate bubble. Lastly, evidence suggests that climate risk disclosures result in reduced greenhouse gas emissions, which, in turn, provides health and welfare benefits to society by reducing air pollution, severe weather events, infectious disease, and risk to the global food supply.

For these reasons, we support the SEC’s plan to propose a rule requiring standardized climate risk disclosures. Doing so would further the Commission’s mandate to protect both investors and the public interest. Our forthcoming paper in the N.Y.U. Journal of Legislation and Public Policy provides several recommendations for how the SEC should build its institutional knowledge as it designs and enforces a climate risk disclosure regime.

First, the SEC should continue to build its expertise on climate risk through the staffing of climate change experts. It should also use the resources at its disposal to conduct economic analyses of climate impacts on financial markets and integrate those findings into its rulemaking and enforcement actions.

Second, the SEC should coordinate with other agencies to leverage their expertise on climate science and modeling, and to ensure consistency across distinct but overlapping regulatory regimes. Coordination with other agencies may be especially helpful as the SEC considers mandating climate scenario analysis. Other better-positioned agencies could help the SEC evaluate the underlying modeling techniques and assumptions that corporations may use.

Third, the SEC should continue its engagement with key stakeholders—including investors, climate experts, voluntary reporting organizations, and corporations. The SEC should solicit feedback and recommendations from those best positioned to understand how disclosure rules will unfold in practice.

Lastly, the SEC should draw best practices from existing frameworks and standards, which are the product of extensive research and are reflective of the needs of both users and preparers of disclosures. In particular, the Commission should look to the TCFD Framework, which recommends eleven disclosures that are applicable to all companies, and which has garnered broad support from investors, regulators, and corporations. For more granular, detailed reporting requirements, the SEC should look to the Value Reporting Foundation’s SASB Standards, which provides industry-specific disclosure recommendations across 77 different industries.

Climate change is ushering in a new set of challenges and opportunities for investors and corporations. Disclosure regulations must keep pace with these new threats, and current rules do not provide investors and other stakeholders with access to comparable, specific, and decision-useful climate risk information. A robust climate risk disclosure regime would facilitate efficient capital allocation, the development of effective risk mitigation strategies, and the reduction of systemic risk throughout the economy.

The complete paper is available for download here.

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