Benefits and Costs of Requiring Companies To Disclose Climate Risks
University of California, Santa Cruz
Investors are increasingly concerned about the risks to their investments posed by climate change and the transition towards more sustainable forms of production. However, evaluating a company’s exposure to these risks has been difficult — even as more companies voluntarily disclose their climate-related risk exposure. The Securities and Exchange Commission recently proposed new rules that would require publicly traded companies to disclose their climate-related risk in a standardized way that would be subject to audit. If adopted, the new rules would impose additional costs on SEC-reporting companies. But, they could also provide benefits to investors, the companies, and the economy as a whole.
Disclosure of climate-related risks is becoming more common but lacks reliability and uniformity.
- Companies face two main forms of risks associated with climate change: physical risks and transition risks. Physical risks can be acute, stemming from extreme weather events, such as increased frequency of fires, floods, and hurricanes; or chronic, such as those related to rising temperatures and sea level. Physical risks are likely to affect physical capital through potential property destruction as well as revenues through business interruption and productivity losses, especially in agriculture. Transition risks, on the other hand, are risks that arise from actions taken by governments, investors, or consumers, or from technological innovations that are designed to mitigate climate change but may lead to making certain equipment, processes, and assets obsolete (see here and here).
- Disclosure of climate-related risks is becoming more common but lacks reliability and uniformity. There are two main concerns with current voluntary disclosures – lack of comparability across institutions, and lack of audit (which results in concerns about “greenwashing,” or exaggerating sustainability improvements). Many companies around the world are voluntarily disclosing their exposure to climate risks through Task Force on Climate-Related Financial Disclosures (TCFD), or their membership in UN-sponsored Principles of Responsible Investment (PRI) or Principles of Responsible Banking (PRB) initiatives. These initiatives are a response to investors’ demand for such disclosures.
- Governments around the world are now working on standardizing climate-related disclosures. On March 21, 2022, the Securities and Exchange Commission (SEC) proposed new rules that would require publicly traded companies to disclose their climate-related financial risks. If adopted, the proposed rule changes would require publicly traded companies to disclose information about the governance and risk management processes for climate-related risks; how climate-related risks have affected or are likely to affect the strategy, business model, and outlook of the business; and the impact of severe weather events or the transition to cleaner energy on the businesses’ financial statements, among other things. In addition, the ruling would require disclosure of a company’s greenhouse gas emissions, as a metric to assess exposure to climate-related transition risks. (A larger amount of emissions generated means that companies rely more on fossil fuels and are therefore more financially exposed to changes in investor sentiment towards putting money in carbon-generating industries, the introduction of a carbon tax or other climate mitigation policies, or the likelihood that a cleaner technology will be developed rendering the business obsolete). The International Sustainability Standards Board (ISSB) and European Financial Reporting Advisory Group (EFRAG) are also proposing climate disclosure standards. In the very interconnected world the United States, as the largest financial market, has a lot of influence on what standards will be set going forward. Similar to other corporate regulation, global harmonization of climate reporting standards will reduce incentives for firms to relocate to other countries.
- Publicly traded companies are required to disclose their financial performance and governance details as well as their risks to the SEC. The SEC is a government organization, funded by the taxpayers, that oversees publicly traded companies as well as markets on which various assets and commodities are traded. Corporate disclosure requirements are in place so that any institutional or individual investor can access, for free, information about the company they invest or consider investing in. For example, if you want to learn about the risks and profitability of Apple, the largest U.S. company by stock market capitalization, you can simply go to the SEC website, search for Apple, and browse the reports. The proposed new rules would add an additional report to that list, to keep investors informed about climate-related risks of these companies.
- Producing additional disclosures will impose costs on SEC-reporting companies, but there are also benefits. As with any regulation, companies that are subject to it will incur additional costs which need to be evaluated by comparison with their benefits. Since the proposed SEC rules are based on TCFD methodologies, they would impose little additional disclosure burden on companies that already disclose their risks and would also ensure that companies that will have to start disclosing their climate risks will rely on the same methodology for comparability. Companies can benefit from the disclosure requirement. Climate-related financial risks are real, as was recently illustrated by the bankruptcy of PG&E due to the higher frequency of large wildfires in California. Any company needs to be evaluating its exposures to such risks as a part of its best practices in risk management. Detailed disclosure rules provide the blueprint for measuring such risks and will likely lower the cost of obtaining professional services in evaluating such risks. For example, in the early years of PRI and TCFD, the United Nations Environment Programme Finance Initiative (UNEP-FI) commissioned a climate risk evaluation methodology from Oliver Wyman and Mercer, which is now available for free as a white paper. Disclosure of future climate-related risks will lead to the incorporation of these risks into asset prices, therefore reducing the probability of a large sudden asset repricing and related financial stability problems, should important climate mitigation measures take effect. For example, when the Sarbanes-Oxley Act (SOX) increased reporting burden for firms going public in order to increase transparency and accuracy of their asset valuation, it reduced uncertainty and volatility of stock prices for newly public firms, and reduced risk-taking by public firms. Disclosure requirements have important benefits when compared to voluntary disclosures. Introducing detailed rules will help investors through uniformity of reporting, easy access to disclosures, and assurance of the reliability of said disclosures because of the required audit. Companies that are currently not reporting their climate risks might appear to investors to have something to hide. If such companies have lower climate-related risks than investors are expecting, they might benefit from disclosing their risks. Finally, climate-related risk disclosures will provide incentives to companies to reduce their own impact on climate change.
- Greenhouse gas emissions disclosures included in the proposed rules may affect non-SEC reporting firms. Emissions disclosures can be defined in three scopes: Scope 1 emissions are direct emissions generated by the firm, such as CO2 from their heating furnace or methane from a factory farm. Scope 2 emissions are those produced by the power generation for the electricity used by the firm. Scope 3 emissions are those embedded into intermediate goods the firm buys or in products the firm sells. For example, a car manufacturer making internal combustion cars may have zero Scope 1 emissions in its production process, and use only solar and wind power, leading to zero Scope 2 emissions, but the consumers buying cars will produce Scope 3 emissions when they drive the cars. When financial companies invest in greenhouse gas-heavy firms, this would count towards their Scope 3 emissions and will expose these companies to climate-related risks. Because large companies may be supplied by small and medium companies, the suppliers are concerned that they may face an undue burden if they have to report their emissions to their customers or even lose their business partnerships if they are unable to do so. This is a valid concern. The SEC took one step toward alleviating it by including a “safe harbor” exception for Scope 3 reporting, which means that it will not penalize companies for calculating Scope 3 emissions incorrectly. This provision makes it possible for SEC-reporting firms to not require exact emissions from their small suppliers, but assign industry average emissions to all their small suppliers instead, or use a different simplified methodology.
- The additional regulatory burden may discourage some firms from going public or may incentivize some public firms to go private. When companies decide to go public, they factor the costs of regulatory compliance, which is much higher for public firms, into such decisions. If the costs of reporting climate-related risks are high, some firms might choose to stay private and some public firms might decide to go private. Any additional regulation may have such effects, as was the case after the passage of the Sarbanes-Oxley Act. This might be undesirable if we believe that public firms are more transparent, more efficient, better governed and have better access to financial capital when they have investment opportunities. As with any regulation, efforts need to be taken to minimize the reporting burden. It remains to be seen whether private investors, such as private equity funds, will also require an evaluation of climate-related risks, which would reduce the benefits of staying or going private to avoid reporting these risks to the SEC. PRI has published a guide on climate change for private equity funds, while leading accounting consulting companies, such as Deloitte, and Ernst and Young are already publishing white papers and offering climate risk consulting services to their private equity customers. This suggests that reporting climate-related risks is likely to become a requirement for obtaining any investment, public or private.
What this Means:
Proposed SEC rules are consistent with already adopted practices and will benefit investors by providing important information for their decisions. They will also benefit the economy by reducing the probability of transition risk turning into a financial crisis. Finally, they will benefit the world by incentivizing companies to reduce their climate-related risks through investment in climate change mitigation and adaptation technologies. These benefits come with additional reporting costs for the companies and may even incentivize some companies to go private or spill-over on smaller firms. However, to the extent that climate-related risk management is becoming necessary for all firms, these additional costs might be unavoidable.