It’s Time the SEC Enforced its Climate Disclosure Rules

In the United States, companies are required to disclose material financial information about their exposure to climate risks. However, the Securities and Exchange Commission has not followed up with enforcement. 

Three realizations finally awakened the financial world to the risks of global warming: (1) that if a climate catastrophe is to be avoided, a large percentage of existing fossil fuel reserves cannot be burned, making the companies that own them considerably less valuable; (2) that falling demand for coal could reduce coal company profitability even to the point of bankruptcy; and (3) that increasingly frequent extreme weather events threaten not only insurance companies but also real estate investors, municipal bondholders and other asset holders.

The vulnerable assets matter not only to the companies that own them but also to their debt and equity investors, the portfolios in which these financial assets are held, the companies that hold or manage these portfolios and even the financial obligations of countries whose national economies might be significantly affected.

The Limits of Voluntary Approaches

Financial market participants and overseers recognize that these climate-related risks are not well understood. Climate issues were previously regarded, if at all, in the context of firms’ corporate social responsibility reporting. Firms were called upon to report on their fossil fuel use or carbon emissions, along with other indicators of environmental performance and management. There still are dozens of different reporting frameworks proposed by numerous organizations, which companies can adopt or choose to ignore. Efforts by such organizations to unify reporting frameworks, such as those by the Sustainability Accounting Standards Board and the Carbon Disclosure Standards Board, have had limited success. 

This voluntary approach to climate risk disclosure has been of little use to investors because of inconsistencies, non-comparability across companies and sectors, and the lack of explicit quantitative financial information. Consequently, most mainstream investors and asset managers say that such non-financial information plays no role in their investment decisions.

Towards Better Disclosure

Some financial firms have tried to fill the disclosure gap with their own analyses. Major banking groups, ratings agencies and investment advisory firms have issued reports, some based on “bottom-up” analyses starting with individual firms and asset classes, other using scenario-based macro-economic models. A good example of combining these approaches is the Carbon Risk Valuation Tool developed by Bloomberg New Energy Finance. To assess individual energy companies’ climate risk, it combines policy scenarios with detailed company-level data on oil and gas reserves and their extraction costs. Although this tool is useful, Bloomberg acknowledges that the lack of specific company data limits its accuracy.

These organizations emphasize that their analyses are no substitute for better financial disclosure by the firms exposed to climate risks and are pushing for mandatory reporting. For example, a Mercer Advisory Services report, Investing in a Time of Climate Change, recommends that investors “encourage mandatory company reporting on climate risk and related metrics; …  encourage disclosure of climate/carbon exposure; …ask companies with large carbon footprints for GHG-reduction plans (mitigation); … ask companies with large exposure to weather or resource risks for climate risk management plans (adaptation).”

There is increasing pressure on organizations to start providing to external stakeholders the kinds of information that they use for internal management purposes. Hundreds of firms that now apply an internal proxy “price on carbon” to guide investments decisions are being urged to disclose the results of such analyses. Nonetheless, a recent report by the International Federation of Accountants found that, today, most disclosure still tends to be compliance-oriented, qualitative and focused on historical financial statements.

Concerned that poorly understood climate risks could lead to financial market shocks, international officials have called for better disclosure. In a 2016 staff paper, the International Monetary Fund (IMF) wrote:

In financial markets, increased disclosure of firms’ carbon footprints, prudential requirements for the insurance sector, and appropriate stress testing for climate risks will help ensure financial stability during the transition to a low-carbon economy. Analyses of how firms’ asset values could be impacted by de-carbonization are needed to efficiently allocate investments across carbon-intensive and other sectors.

The IMF pledged that its staff will work with member countries and other partners to support initiatives encouraging consistent climate-related disclosures, prudential requirements and stress testing.

The Financial Stability Board of the G20 countries has created an international Task Force on Climate-related Financial Disclosure, headed by Michael Bloomberg, who stated: “It’s critical that industries and investors understand the risks posed by climate change, but currently there is too little transparency about those risks.” In 2014, the UN Environment Program initiated a large research program on Energy Transition Risk, which has produced a number of reports calling for more disclosure and risk analysis. These efforts have been backed by numerous national overseers: for example, by the Bank of England and by China’s State Council and Central Bank, among others. Also in May 2015, the French government passed a law making climate risk reporting mandatory for institutional investors and commissioning a climate stress test at the finance sector level. Many other countries also have laws requiring disclosure of environmental risks.

In the United States, disclosure and transparency form the foundation of securities regulation. Beyond strict accounting standards, the law requires firms to disclose any known risks or uncertainties that might have future material financial effects and any material information needed to prevent statements from misleading investors. Any information is material if a reasonable investor would consider it significant in making investment decisions.

Why the Securities and Exchange Commission Should Step Up Enforcement

For decades, the Securities and Exchange Commission (SEC) was urged, unsuccessfully, by investor groups and others, to apply these disclosure rules to material financial risks stemming from environmental exposures. The SEC has resisted what it sees as “disclosure overload,” lacking adequate internal resources and facing hardening political divisions about climate change. In 2007 former New York Attorney General Andrew Cuomo and others forced the issue by petitioning the SEC to require climate disclosures and suing several electric utilities operating in New York for misleading investors. In 2010 this action tipped the SEC into promulgating an Interpretive Release reminding companies that they must disclose material financial information about their exposure to climate risks, whether physical, regulatory or marketplace.

However, the SEC has not followed up with enforcement. Of the tens of thousands of comment letters it has issued questioning companies’ financial statements, only a handful have concerned environmental or climate disclosures. Consequently, most companies are still responding with compliance-based, qualitative acknowledgements of potential risk and have taken refuge in future uncertainties to avoid more explicit quantitative statements of potential financial impacts, even when the company had intensively studied potential impacts under plausible future scenarios.

For example, the annual 10-K reports issued by Arch Coal and Alpha Natural Resources at the end of 2014—two companies that declared bankruptcy in the following year—provided little guidance to investors of their serious exposure to climate risk. Alpha maintained that they were unable to estimate the financial impact of clean energy legislation or the Obama Administration’s regulation of greenhouse gas emissions. Arch Coal reassured investors that coal was estimated to remain the dominant fuel for power generation and that, though subject to regulatory risks and competition from gas and renewables, it thought coal to be competitively priced.

In November 2015 Peabody Energy, another coal company, settled a lawsuit brought by the New York Attorney General that accused the company of misleading investors by not disclosing internal studies that showed substantially material financial impacts from climate change regulations. It agreed to make more complete disclosures.

Also in 2015, Robert Rubin, former chairman of Goldman Sachs and former Secretary of the Treasury, stated: “Investors should demand that companies disclose the impact that climate change could have of their business and assets, the value of their assets that could be stranded by  climate change, and the costs they may someday incur to address their carbon emissions. … I believe that such disclosures should be considered material and mandated by the SEC, not just requested by investors.”

In May of 2015 a coalition of 35 senators and congressmen wrote to the Chair of the SEC requesting information regarding the specific steps that the SEC has taken to ensure compliance with its climate disclosure directive and what steps it intends to take in the future. Several investor groups have also written to the SEC requesting action.

This is an issue on which Wall Street and Main Street can unite. Adequate financial disclosure would not only protect investors and help allocate capital efficiently, but would also put pressure corporations to manage their exposure to climate risks more prudently. The SEC should step up to its responsibilities.