This is the first in a series of blog posts that highlights the proposed climate disclosure rule from the US Securities and Exchange Commission (SEC). For this first installment of our special series, experts address the question: Why do investors need or want the SEC climate disclosure rule?
Editor’s note on May 12, 2022 – On May 9, the SEC announced an extension to the comment period for its proposed climate disclosure rule. The new comment period will end on June 17, 2022. This article has been updated to reflect the revised duration of the comment period.
On March 21, 2022, the US Securities and Exchange Commission (SEC) released a proposal for rules on climate-related disclosures that apply to publicly traded companies. Among other stipulations, the proposal requires companies to disclose the following information:
- their greenhouse gas emissions footprint, their plans to achieve goals (if any) for reducing greenhouse gas emissions, and how they will use carbon offsets to help achieve their emissions goals
- how their board of directors governs climate-related risks and how their management identifies, assesses, and manages these risks
- the climate-related risks they’ve identified, which “have or are likely to have” a material impact on business in the short, medium, or long term, and how those risks affect their business model and strategy
- when climate-related risks would have an impact on line items in consolidated financial statements
The proposed rule is vast and detailed—500 pages long, with over 800 specific questions posed to solicit input. To shed light on some of these issues, we have asked a diverse group of experts to share their views on a set of questions that we believe are of particularly broad interest. These selected issues range from why investors need a disclosure rule in the first place to the particulars of exactly what types of emissions will be reported under the rule. We will publish these questions and responses from experts over the next few weeks, in the lead-up to the end of the public comment period on June 17, 2022.
Special Series: The SEC Climate Disclosure Rule
In light of a recently proposed climate disclosure rule from the US Securities and Exchange Commission (SEC), we ask experts to weigh in on what the rule entails and its implications. Browse the blog series by clicking through these articles:
- Introduction to the Series: Why Do Investors Need or Want the SEC Climate Disclosure Rule?
- Indirect Emissions Disclosures Are Important but Tricky
- Even with Moves toward Transparency, Corporate Climate Pledges and Carbon Offsets Will Be Complicated
- Will the SEC’s Proposed Climate Disclosure Rule Come Up against Legal and Economic Challenges?
- International Context of the Proposed Climate Disclosure Rule from the US Securities and Exchange Commission
Experts address the question: Why do investors need or want the SEC climate disclosure rule?
For more than a decade, companies voluntarily have reported climate-related information in response to investor demand. Previously, the SEC has emphasized that such disclosure might be part of a company’s required reporting of business activities, risk factors, and management discussions. Until now, no further guidance has detailed what specifically needed to be reported, where the information would be reported, and any stipulations about information quality.
So, why do investors need or want an SEC climate disclosure rule?
Shivaram Rajgopal, Columbia University
Let me begin answering this question as a user of financial statements. I am involved in a research project in which we are trying to understand whether net-zero pledges of US oil companies are credible. I do not think that adequate disclosures are currently in place—both in terms of quality and relevant quantity—for us to answer that question satisfactorily.
The underlying data are scattered across press releases, 10-K financial reports, sustainability reports, and company websites. Tremendous variation characterizes every aspect of a path to that promise of net-zero emissions, the reporting, and the associated verifiability of a given path. On top of that, companies follow diverse frameworks, such as those proposed by the Task Force on Climate-Related Financial Disclosures, the Sustainability Accounting Standards Board, and the Global Reporting Initiative. To add to the confusion, at least three (but many more) rating agencies, such as the Institutional Shareholder Services group of companies, Morgan Stanley Capital International, and Sustainalytics, rank different aspects of a company’s environmental, social, and governance (ESG) footprint with varying degrees of success.
I would point out that rigor, consistency, comparability, and verifiability of these disclosures will be necessary. Otherwise, these companies cannot be held accountable for the promises they make in terms of carbon reduction.
Shivaram Rajgopal, Columbia University
As a user and investor, I would point out that rigor, consistency, comparability, and verifiability of these disclosures will be necessary. Otherwise, these companies cannot be held accountable for the promises they make in terms of carbon reduction. This concern is even more acute for ESG funds with prospectuses that claim to hold stocks that are climate friendly, given that ESG funds rarely discuss the process they use to do what they say they do. The old cliché “you cannot manage what you cannot measure (and disclose)” motivates the investor need for the SEC’s disclosure rule.
Let us now turn to what critics are saying about the proposed rule and my high-level reactions:
Critique 1: Carbon disclosures are not correlated with cash flows or stock returns of firms. Proxy proposals that push firms to report more on climate rarely muster majorities. Doesn’t this mean that the proposed SEC disclosures are useless? The SEC disclosures will not be useless if the required information allows investors to make better decisions. Disclosures of carbon emissions that are improved in quality, standardized, and required may end up correlating with cash flows and stock returns, even if disclosures that are unregulated and voluntary do not. Firms have no incentive to be accountable for their emissions (and cannot be rewarded by the market) if the emissions are not consistently measured—which is precisely what the SEC’s new proposal aims to start doing. Emissions are a negative externality imposed by companies on society, for which those companies usually are not asked to pay—for now. We would not expect to see correlations with stock returns until investors have consistent information and invest according to a belief in stronger future policies. Regarding majority votes, shareholders might well vote to require all companies to disclose their climate risks—essentially creating a level playing field—even if shareholders would not vote for individual companies to make the same disclosures. This phenomenon is akin to a prisoner’s dilemma, in which the best outcome is for both players to cooperate, even though each has an incentive not to cooperate.
Critique 2: These disclosures are too costly. I have sympathy for this argument. I believe the SEC’s estimates of compliance costs are understated. Providing additional detail and external validation of cost estimates will help the SEC address these objections better.
Critique 3: Firms voluntarily report climate data, if material, anyway. This statement is partially true; however, voluntary disclosure is patchy, and there is a need to ensure consistency among the diverse standards already in use. Most importantly, moving the disclosures into the 10-K financial reporting process would strengthen the SEC’s ability to police any empty promises associated with climate pledges and emissions disclosures.
To be sure, disclosure per se will not solve climate change. However, disclosure is a necessary condition to quantify climate risk at the level of individual firms and across the value chain, and to lay the foundation for a future carbon tax.
Barbara Buchner and Nicole Pinko, Climate Policy Initiative
Climate change impacts—both transitional and physical—already are affecting the US economy. Companies and investors need a unified approach for measuring and disclosing these impacts and risks. With a growing number of publicly traded companies clamoring for guidance, the proposed SEC climate disclosure rule is far overdue. This rule is in the best interest of investors because it will improve the consistency of disclosures and data, which will allow investors to clearly evaluate climate risks in their portfolios.
With a growing number of publicly traded companies clamoring for guidance, the proposed SEC climate disclosure rule is far overdue. This rule is in the best interest of investors because it will improve the consistency of disclosures and data, which will allow investors to clearly evaluate climate risks in their portfolios.
Barbara Buchner and Nicole Pinko, Climate Policy Initiative
As society undertakes this work, our fundamental goal should be ensuring that our total effort equals the sum of its parts. And to meet this goal, we need to bear in mind the following things:
Disclosure is in the best interest of investors. Climate risks—both transitional risks to company finances and physical risks to company operations—pose significant potential harm to portfolios. A clear view of where and how an investor’s portfolio is exposed to climate risks, and an understanding of how companies plan to address climate risks, will carry vital information for identifying potential market volatility and the creation of a balanced and resilient portfolio. Additionally, as financial institutions take stock of how the emissions that result from their investments and lending (known as their financed emissions) align with their internal climate goals, they are paying more attention to how the companies they do business with intend to address climate risks and reduce emissions—and at times parting ways with companies that don’t have a credible transition plan. Without a uniform, regulated disclosure scheme, retail investors will lack access to the critical information about risks that larger shareholders can obtain.
Disclosures and data must be improved across the whole of the global public and private sectors. US businesses and their investors cannot possibly manage risks during a major economic transition without knowing where global emissions and climate action stand today. The current landscape of voluntary disclosures, and the lack of standardization on greenhouse gas emissions measurements, means that the information currently being disclosed is not comparable across companies—even in the same industry or sector. The lack of consistency also leaves the United States increasingly behind other major capital markets and financial centers, which are moving forward with uniform, regulated schemes that not only address climate change but also attract capital from the increasing number of financial institutions and asset owners that are aligning their investment decisions with the Paris Agreement. The SEC’s proposed climate disclosure rule is a big push in the right direction on disclosure and data.
Scale and speed require a more uniform approach to climate disclosure. Financial institutions have a very short time frame in which to realign trillions of dollars of capital with global climate goals. Yet, the public and private sectors do not have a commonly accepted definition of “climate finance.” The proposed SEC disclosure rule, along with the recently proposed International Sustainability Standards Board rule and the Task Force on Climate-Related Financial Disclosures, create a framework that will put financial institutions on a more certain path toward developing a common language around definitions, tracking, accounting, and valuation of climate-aligned finance and investment, which will accelerate the deployment of climate investment where that investment will be most effective. In this context, the proposed SEC disclosure rule can accelerate efforts to better coordinate across the silos of the public and private sectors and the many existing initiatives and disclosure regimes—by fostering the integrity of climate data, commitments, and transition plans.
The SEC’s proposed climate disclosure rule is critical to investors who are managing transitional risks and physical risks, and critical for the global pursuit of ambitious climate policy. Investors are an essential pillar in scaling up climate finance, through blended finance with development finance institutions, direct investment in climate-friendly mitigation and adaptation projects, and support for efforts to reduce global emissions. The proposed rule will allow investors to make better decisions regarding climate risks in their portfolios and provide insights about investment opportunities in low-carbon solutions.
Bob Litterman, Kepos Capital
The weather has changed. It’s warmer on average, of course—but more significantly, the likelihood of extreme weather events has increased dramatically in recent years. We now often hear expressions such as, “This was a 100-year flood,” or “This is the worst drought in 1,200 years.”
While such expressions seem to refer to frequencies of occurrence, they are today best understood as descriptions of the magnitude of an event. Moreover, there’s something special about rare events which were expected to happen less than once in a lifetime. We are not prepared for them. These natural disasters often are catastrophic because homes, infrastructure, cities, and regions are just not built to withstand events of this magnitude—yet the climate models that reflect the physics of climate change show that these devastating climate-related events already have been occurring much more frequently. Historical statistics are no longer sufficient. Extreme storms, severe hurricanes, hailstorms, extreme wind, heat and cold, drought and floods, wildfires, and storm surge made worse by sea level rise all are increasing in magnitude because of the impacts of climate change. Losses from climate-related events are increasing rapidly as the energy in the climatic system increases.
This rule clearly is necessary, as climate-related risks have become, in many cases, a material risk to a lender or equity holder.
Bob Litterman, Kepos Capital
Clearly, legal contracts containing payments that may be affected by extreme weather perils must be revised. For example, the risks of wildfires destroying homes in many parts of California, where I live, are much greater today than they were even in the recent past. Because the risks are higher, financial markets must reflect this reality.
In addition to increased insurance rates, credit ratings of municipal bonds in exposed locations will need to account for the increased likelihood that the loans will default because the tax base will be destroyed. This increased likelihood of loan defaults is true as well for corporate borrowers that are exposed to climate-related risks.
An entire industry is rapidly developing to estimate these physical risks of climate change and to provide guidance for mitigation and requirements for resilient infrastructure. In that context, the SEC recently issued a proposed rule for the disclosure of climate-related risks by corporations. This rule clearly is necessary, as climate-related risks have become, in many cases, a material risk to a lender or equity holder.
I had the honor of chairing a climate-related market risk subcommittee of the Commodity Futures Trading Commission Market Risk Advisory Committee, which in 2020 published a road map called “Managing Climate-Related Risks in the US Financial System.” The report was not controversial. The 34 members of the subcommittee, along with the institutions they represented, unanimously endorsed its recommendations. These stakeholders include many corporations, insurers, investors, asset owners, academics, and environmental organizations.
Ours were high-level recommendations, and the SEC proposal on disclosure goes into much more detail—but on all the key issues, they are consistent. For example, one of the more difficult areas that required compromise within the subcommittee of the Commodity Futures Trading Commission relates to the disclosure of Scope 3 emissions, those indirect upstream and downstream emissions created across the value chain. We agreed that, “As reliable transition risk metrics and consistent methodologies for Scope 3 emissions are developed, financial regulators should require their disclosure, to the extent that they are material.” While more specific, the SEC proposal includes a similar compromise. Corporations will be required to disclose Scope 3 emissions if such emissions are material to investors or if the company had made a commitment that included reference to Scope 3 emissions—but this type of disclosure is phased in, safe harbor provisions apply to the disclosures, and smaller companies are exempt.
This is significant progress.
Note, however, that time is running out. The first and most urgent recommendation of the Commodity Futures Trading Commission subcommittee has not yet been fulfilled. Our subcommittee unanimously agreed: “It is essential that the United States establish a price on carbon. This is the single most important step to manage climate risk.”
It has to happen soon. It’s time to slam on the brakes.
For more information on this series and the topics covered, contact Marc Hafstead, the director of RFF’s Climate Finance and Financial Risk Initiative.
Browse the articles in this blog series about the SEC’s proposed climate disclosure rule.
