Is mandatory climate risk disclosure a done deal yet? Acting SEC Chair Allison Lee has taken almost every opportunity to emphasize the importance of the SEC's taking action to mandate climate risk disclosure. (See, for example, this NYT op-ed, her remarks at PLI entitled Playing the Long Game: The Intersection of Climate Change Risk and Financial Regulation and this statement, "Modernizing" Regulation S-K: Ignoring the Elephant in the Room.") And now, according to Reuters, Acting Corp Fin Director John Coates remarked during a conference on climate finance that the SEC "'should help lead' the creation of a disclosure system for environmental, social and governance (ESG) issues for corporations." But how to craft the new rules? With the new Administration in Washington, many of the think tanks and advocacy groups are making their voices heard on just that—crafting mandatory climate disclosure regulations. The reports of two are discussed below; there are definitely some common threads, such as the need for the SEC to onboard climate expertise and organize a platform or two for stakeholder input. Their recommendations may also provide some ideas for voluntary compliance and some insight into the direction the SEC may be going.
NYU and EDF: Mandating Disclosure of Climate-Related Financial Risk
This new report from the Institute for Policy Integrity at NYU and the Environmental Defense Fund advocates adoption by the SEC of a climate disclosure mandate. The report maintains that climate poses a grave risk to the U.S. economy, including corporations and investors, but "[u]nlike other financial risks,...climate risk is not routinely disclosed to the public." This deficiency continues notwithstanding regulatory guidance on the topic from the SEC, the development of voluntary disclosure frameworks and requests from investors for more consistent and comparable disclosure. (See this PubCo post.) According to the report, the "current patchwork approach" to climate risk disclosure has not led to the disclosure of information for investors, regulators and other interested stakeholders that is sufficiently "comparable, specific, and decision-useful." Moreover, the SEC's reliance on a principles-based "materiality" standard for disclosure "can be an 'elusive' concept in any context because of the discretion it affords to corporations in determining what information is material. There is no bright-line rule for what is material, and there are not degrees of materiality— information is either material or it is not. Along with a lack of information on corporations' materiality assessment processes, these aspects make it difficult to assess or second-guess materiality determinations. In the climate context, where the SEC has not historically staffed internal climate expertise, deference to a corporation's materiality determination may be magnified by the inability to rigorously assess those determinations."
The authors of the report won't find much opposition on that point from Lee. She has regularly lamented the "shortcomings of a principles-based materiality regime": in her view, it has not elicited the type of standardized disclosure that investors crave, nor has the SEC's disclosure review process been regularly employed to produce improved climate disclosure under the materiality standard: indeed, "in recent years there's been minimal comment on climate disclosure." Instead, in response to the investors' pressure campaigns, companies have provided some sustainability disclosure, often in separate reports, but, "these voluntary disclosures, while a welcome development, are no substitute for Commission action": in the absence of a mandatory standardized framework, the disclosures are variable and not comparable; the proliferation of frameworks and demands for various information puts undue pressure on companies; and the disclosures may not be reliable, lack independent verification and may not provide adequate remedies to investors. (See this PubCo post.)
The SEC, she has observed, "takes the position that it does not need to require or specify these types of disclosures because our principles-based disclosure regime is on the job and will produce any disclosures on these topics that are material. Investors are asked to trust that each individual company has gauged materiality on these complex issues with flawless precision and objectivity." But, by "some estimates, over 90% of U.S. equities by market capitalization are exposed to material financial impact from climate change. We are long past the point at which it can be credibly asserted that climate risk is not material. We also know today that investors are not getting this material information." (See this PubCo post.)
And in this NYT op-ed, she wrote that to conclude that SEC disclosure rules based on materiality already elicit sufficient information about climate is a misconception; otherwise Enforcement would take action. However, she observes, as
"a former S.E.C. enforcement lawyer who spent over a decade spotting failed and misleading disclosures, I can attest that enforcement of broad-based materiality requirements does not work with this kind of near-magical efficiency. That's why securities laws sometimes require very specific data and metrics on certain important matters like executive compensation. But, so far, not for climate risk. There are no specific requirements, and without that clarity how can companies be sure what is expected of them? As of now, there is little for us to enforce. The voluntary disclosure that companies have increasingly provided in recent years is still largely regarded as insufficient. It's not standardized, it's not consistent, it's not comparable, and it's not reliable. Voluntary disclosure is not getting the job done. And without better disclosure of climate risks, it's not just investors who stand to lose, but the entire economy."
The report suggests that the current regulatory regime has not been effective in eliciting appropriate climate disclosure. Although the SEC issued guidance on climate disclosure in 2010, two years later, the SEC reported to Congress that it had not seen a noticeable change in disclosure as a result, a conclusion supported by outside studies. And that state of affairs has generally continued, even in the face of the development of numerous voluntary frameworks and standards. A study conducted by SASB in 2017 found that most climate disclosure was inadequate boilerplate, and more recent reports have found that, while the quantity of disclosure may have increased in quantity, the information remains largely generic and unquantified. Even disclosure from companies that have sought to align with one of the frameworks has been inadequate: in "its 2020 Status Report, the TCFD found that only 17% of companies discussed their process for integrating climate change into risk management, and only 7% discussed resilience of strategy, two key recommended disclosures. The recommendation most reported was disclosure of risks and opportunities identified, yet only 41% of companies made that disclosure. And, while hundreds of corporations have signed on to the TCFD framework, less than 8% comply with the recommendation to provide climate risk information in their annual report."
Why this failure? The report attributes it, at least in part, to misalignment of incentives (short-term incentives relative to longer term climate effects), and cognitive biases and decision-making patterns that "might result in a systemic undervaluing of climate risk." these include the availability heuristic (discounting of low-probability "black swan" events that have not occurred in the past), optimism bias (individuals assuming that they themselves are less likely to experience the most negative consequences of an event) and prospect theory (individuals put less weight on outcomes that are uncertain). The report suggests that "insufficient reporting can be overcome through improved mandatory disclosure rules."
However, the report indicates, the SEC has "done little to prompt corporations to improve their climate risk disclosure," opposing petitions for rulemaking, focusing on principles-based rulemaking, "intervening to block investor proposals related to climate change" and failing to use the review process to elicit more disclosure. Since 2016, the report could identify only six comment letters with comments on climate risk disclosure.
According to the report, implementing mandatory climate disclosure requirements "so that they elicit comparable, specific, and decision-useful climate risk information would provide benefits to companies, investors, and the broader economy." For example, mandatory climate disclosures could compel companies to better analyze their exposures to climate risk and develop better strategies for climate risk management. With regard to benefits to investors, the report refers to studies showing mispricing of securities in various markets as a result of the absence of climate-related risk information. The report also cites a survey showing that 93% of institutional investors "view climate risk as an investment risk that has yet to be priced in by all the key financial markets globally." The authors also fear that widespread mispricing as a result of inadequate climate disclosure could lead "the economy towards a 'climate bubble'"; in that event, "sudden disruptions to asset prices could affect the health of the entire economy, as the shocks reverberate across the market." In addition, mandatory requirements would, in the authors' view, "reduce the prevalence (and the perceived prevalence) of 'greenwashing.'" Moreover, better climate risk disclosure may also have the effect of "furthering greenhouse gas mitigation efforts," benefiting society as a whole.
What should the SEC do? While better enforcement of the 2010 guidance would be useful, the authors do not believe that codification of the guidance or further guidance is the answer. Rather, the report recommends that the SEC "promulgate more detailed disclosure requirements that ensure investors receive comparable, specific, and decision-useful information."
To that end, the report recommends that the SEC:
"1. Develop greater institutional expertise on climate risk, improving its ability to set new standards and detect omissions of material information." The report recommends that the SEC engage advisors with expertise on climate risk to assist with rulemaking and conduct relevant research projects that could help the SEC set priorities and "make informed, evidence-based decisions as it establishes new policies and rules." DERA could be enlisted to conduct economic analyses of the impact of climate risk on financial markets, and its findings could be integrated into the SEC's policymaking, rulemaking and enforcement operations. The SEC could also leverage the valuable research conducted by outside organizations to identify its most effective disclosure regulations, anticipate trends and address new challenges. DERA could also develop data analytics to detect problems.
"2. Develop channels for stakeholder input through a concept release or creation of advisory committees." To craft appropriate metrics and disclosure requirements for different industries, the SEC will need to solicit feedback from relevant stakeholders. The report recommends issuance of a concept release to collect information and the formation of advisory committees composed of stakeholders and experts to advise on drafting regulations and enforcement.
In their joint dissenting statement on the recent amendments to MDA, Commissioner (now Acting Chair) Allison Lee and Commissioner Caroline Crenshaw advocated that the SEC establish "an internal task force and ESG Advisory Committee that is dedicated to building upon the recommendations of leading organizations, such as the Task Force on Climate-Related Financial Disclosures, and defining a clear plan to address sustainable investing." (See this PubCo post.)
"3. Coordinate regulatory actions across agencies with the use of interagency working groups." While the SEC can develop or provide expertise on some issues, such as climate-related financial risk, other agencies, such as the EPA and NOAA (the National Oceanic and Atmospheric Administration) have more expertise in other areas, such as expectations regarding the rapidity of climate change, and will need to coordinate with these and other agencies, perhaps through interagency working groups. For example, the report suggests the use of an IWG to provide better guidance on the conduct of climate scenario analyses, standardizing the scenarios that companies should consider, or mandating more complete disclosure of assumptions and results.
As discussed in this article from Bloomberg, the idea of the SEC's issuing mandatory climate disclosure requirements has come under fire from some Republicans—but not because of claims of excessive regulation as you might expect, but rather because the mandate "would go beyond the agency's expertise, according to the top Republican on the House Select Committee on the Climate Crisis. 'I think it is way, way out of their lane; it's the tail wagging the dog....I think there are other mechanisms to help identify what sort of metrics companies are operating under.'" According to the report, the Congressman said that "compelling the disclosures is best left to other regulators. 'I don't think the SEC has any business even remotely playing in this area,' the Republican said, adding that other agencies 'where you truly have the expertise' should be involved, including the departments of Energy and Interior and the Environmental Protection Agency." (Might he perhaps be thinking of the conflict minerals rules as an example of rulemaking outside the SEC's expertise?)
"4. Draw best practices from existing disclosure frameworks when crafting improved mandatory disclosure rules." The report advocates that, when determining standards and metrics for particular industries, the SEC leverage the TCFD framework and the SASB standards as reference points for regulation. These standards have been recognized as valuable resources and could decrease compliance costs for some companies. However, the report is not advocating wholesale codification of TCFD and SASB, but rather that the SEC look to those sources for best practices on climate risk disclosure, and optimize them by applying the SEC's own economic research and work performed by international counterparts, other sustainability reporting organizations and climate change experts. The report lays out the following process for iterative rulemaking:
"An improved climate risk disclosure regime should be comprised of industry-specific reporting requirements, and the SEC should consider building these reporting requirements through an iterative approach to sector-specific rulemaking or guidance. Under an iterative approach, the SEC would establish a disclosure regime that could be revised and expanded over time. This process could begin with an initial rulemaking that enacts improved reporting requirements that are (1) widely agreed upon to be decision-useful for investors, and (2) applicable across all industries. For example, the TCFD recommends that all companies engage in scenario analysis, which asks corporations to assess the resilience of their business strategies against a range of warming scenarios and the associated physical and transition risk. As the TCFD explains, scenario analysis is useful for investors and corporations across all industries because it 'clarifies the predictable and uncertain elements in different futures,' and encourages the development of alternative strategies that could bolster a corporation's resilience.... The SEC could then promulgate industry-specific requirements, similar to SASB's standards, and consider prioritizing disclosure rulemakings for industries that are most broadly exposed to climate risk—industries such as energy, agriculture, clothing, and real estate."
Center for American Progress: The SEC's Time To Act—A New Strategy for Advancing U.S. Corporate and Financial Sector Climate Disclosures
Like the report from NYU and the EDF, this new report from the Center for American Progress finds fault with the current climate disclosure regime and advocates that the SEC mandate a new set of standards. In this report, CAP identifies two key issues with current disclosure: the absence of comparability and consistency resulting from the proliferation of voluntary frameworks and standards and the lack of standardization of the "data, assumptions, and methodologies companies use to meet the standards, with much of this information being opaque." CAP contends that a mandatory, common set of standards is needed and that the task falls to the SEC. CAP maintains that, as opposed to voluntary standard setters, "government regulators are in the best position to select from existing frameworks and standards to create a common set of clear metrics." The SEC, CAP suggests, should "take a lesson" from the European Commission and "mandate a handful of specific core disclosures that are urgently needed to make progress on climate change." That mandate would provide some standardization while allowing time for the "valuable work" of aligning existing frameworks and standards. CAP also advocates that the SEC adopt an "all-of-agency approach," bringing climate expertise onto its staff and its advisory committees.
Specifically, CAP recommends that the SEC start with the following steps:
1. Require public company climate-related disclosures and transition analysis
CAP identifies the following as "basic initial disclosures and analysis that the SEC should require of all public companies in the United States:
Disclose direct and indirect greenhouse gas emissions. The SEC should require public companies to disclose their Scope 1, 2 and 3 emissions in accordance with the Greenhouse Gas Protocol, including negative emissions—meaning "the increase in future emissions resulting, for example, from deforestation activities"—across the firm's supply chain. Scope 1 emissions are "direct emissions, such as fuel the company burns to heat its buildings and run its vehicles," Scope 2 emissions are "indirect emissions from electricity the company consumes" and Scope 3 emissions are "other indirect emissions from up and down the value chain, such as outsourced activities and emissions that occur in materials or products before the company acquires them and after it sells them." Although determining Scope 1 and 2 emissions may not be difficult according to CAP—the TCFD reported that 26% of the largest companies it surveyed disclosed these data in 2019—Scope 3 will likely be a challenge. CAP argues that disclosure of Scope 1 and 2 emissions "is vital for enabling boards and management to set and be held accountable to GHG emission reduction targets." With regard to Scope 3, the SEC should establish specific standards for energy sector companies (see below for the financial sector), but for other companies, CAP acknowledges that establishing an appropriate disclosure regime could take a while, given the complexity of company supply chains, and could be "phased in beginning with—or limited to—industries where data are available and companies are of significant size."
Disclose climate-related risks. CAP suggests that the SEC should provide further guidance, following up on its 2010 guidance, indicating that the SEC expects climate-related risk disclosure to at least be compliant with the TCFD (although compliance with additional frameworks should encouraged) and further indicating that it plans to identify specific additional metrics. CAP encourages the SEC to do more to facilitate alignment of standards and initiate rulemaking to require disclosures of itemized metrics, comparable across companies, that could include the following:
- "Water stress: Scientists have identified regions of the world that are expected to have high or extremely high baseline water stress in the coming years. Firms should disclose assets and facilities they have committed to owning or operating in each of those regions over the next three, five, 10, and 20 years.
- Natural disasters: Other areas have high or extremely high potential for storms, floods, or fire within the next three, five, or 10 years. Companies should disclose assets and facilities committed in those regions.
- Energy consumption: Even as the United States adopts clean forms of energy production, it will be critical for individuals and businesses to reduce their energy consumption. Companies should disclose their total energy consumption, broken out by energy source and type.
- Agricultural production: Drought, water scarcity, heat, and pestilence are expected to threaten existing agricultural production, including forestry, in the coming years. Companies engaged in or dependent on agricultural production should disclose whether that production is implicated by these threats and provide details regarding risks arising from approaches to land use in the relevant vicinity, including deforestation activities.
- Water insecurity: In many areas where climate change affects water supplies, social tensions are expected to arise. Companies that offer water-intensive services and products should disclose the aspects of their services and products that could be affected by water insecurity issues.
- Heat stress: As average global temperatures rise, scientists predict that many areas will be at high risk of heat stress for humans. Production or services located in those areas of the world should be disclosed, along with ensuing vulnerabilities to labor supply and the company's approach to worker rights across the supply chain.
- Diseases: Scientists have identified areas of the world where climate change will increase the number and types of diseases that pose threats to human health. Companies should disclose whether and to what extent their business could be affected by these threats, including the governmental capacities in the relevant jurisdictions and the contributions and risks of the company to the fiscal capacities of the relevant jurisdictions.
- Political unrest and migration: The effects of climate change will exacerbate already existing political unrest and migration around the world. Companies should disclose underlying human rights risks across the supply chain and the potential for additional climate-related political instability and migration in their areas of operation.
- Overburdened communities: Many communities of color and low-income communities are or will be disproportionately affected by climate change and other harms caused by the cumulative impact of toxic pollutants. Using environmental justice data from the Environmental Protection Agency (EPA), firms should identify and disclose their operations in environmentally vulnerable communities and disclose whether and how they engage with those communities and work to reduce the firm's pollution and environmental impact on them."
To make progress on climate disclosures, however, will require the SEC to "ramp up [its] capacity to convene experts and develop data and methodology protocols for calculating required disclosure metrics." As the SEC expands its list of metrics, it may elect to tailor them to address industry sectors, much like SASB (see this PubCo post).
Require transition plans, target and sectoral adjustment strategies. CAP recommends that the SEC require disclosure in MD&A of "board and management strategy regarding targets and performance for the firm's decarbonization and GHG reduction efforts," including a "company transition plan that includes interim targets to accomplish a transition to net-zero GHG emissions in accordance with the relevant international commitment, but no later than 2050.... Additionally, to the extent that a successful transition—especially with respect to Scope 3 emissions—depends on sectoral adjustment up or down the supply chain, disclosure should include strategies for supporting, and any obstacles to engaging in, the necessary sectoral adjustments and ongoing compliance once those strategies are in place."
2. Devote special attention to the disclosure of financed emissions by the financial sector
The U.S. financial sector, comprising banks, insurance companies and asset managers and owners, finances carbon emissions. CAP contends that the financial sector "has the capacity and sophistication to disclose and mitigate climate risks, including by accounting for the carbon emissions embedded in its portfolios of loans, insurance policies, and investment funds and by aligning those with the net-zero 2050 target." These Scope 3 emissions "contribute substantially to the systemic risk of climate change faced by the financial sector. Thus, climate risk disclosure for the financial sector must especially focus on disclosing the contributions that financial firms themselves are making to climate change by financing, underwriting, or insuring carbon emissions and the strategies these firms are adopting to reduce those contributions."
CAP suggests that financed emissions can be calculated using EPA data on the amount of greenhouse gases emitted by certain high-emitting industry sectors and estimating the financed emissions based on the percentage of each of these industries represented in a financial firm's portfolios. Financial firms can also obtain emissions information through due diligence in the course of their financing transactions and through their client relationships more generally.
CAP recommends that the SEC prioritize disclosure requirements for "the forms of finance that have the potential to substantially influence the level of emissions," and then extend this mandate to publicly traded financial firms, including bank holding companies, insurance companies and asset managers, as well as mutual funds and others. For public financial firms, financed emissions should be disclosed in the business section, along with "negative emissions, or the increase in future emissions that results when carbon-absorbing forests are cleared." The SEC should also, CAP advises, "require additional details, such as the maturity of investments in high-carbon sectors, the value and number of investments in new projects in high-carbon sectors, and details of investments in deforestation activities....Disclosure of financed emissions would enhance and complement the transition plans, targeting, and sectoral adjustments that would be required to be disclosed for publicly listed firms."
The NYT reported that, at a recent DealBook conference, new Treasury Secretary Janet Yellen "said that dealing with climate change is part of a broader mandate for the Treasury." According to the NYT, she said that there was a "new movement now toward stress testing of financial institutions" for climate risks such as "physical risks and also risks due to price changes, stranded assets and the like." For example, severe weather events triggered by climate change, such as flooding and wildfires, could affect the assets that underlying bank loans. The Treasury may be able to facilitate climate stress tests conducted on financial institutions by the Fed. She added, the NYT reported, "[i]t's not envisioned that these tests would have the same status in terms of limiting payouts and capital requirements, but I think they would be revealing to both regulators and to the firms themselves." According to the WSJ, Yellen indicated that she plans to "create a hub within the Treasury to review the tax policy incentives and financial stability risks related to climate change and will appoint a senior official to lead the review."
3. Take an all-of-agency approach to climate
CAP also observes that the SEC has a wide field of responsibility such as investment advisers, brokers and exchanges, which present other potential avenues for addressing climate risks. CAP suggests that the SEC "require investment advisers to disclose to their clients their processes for integrating climate risks into their analysis and investment guidance. The commission should also examine the methodologies that credit rating agencies use to develop their ratings and take steps to require them to incorporate climate factors. In addition, the SEC should work with the Public Company Accounting Oversight Board (PCAOB) to fully incorporate climate into its audit regulatory functions, over which the SEC has statutory oversight responsibility. This should include developing expectations for assurance and completeness of information that could be disclosed in relation to or affected by climate risk." Third-party audits or validation may help ensure reliability. Climate issues could also be considered as potential critical audit matters, CAP suggests. CAP also recommends that the SEC "reinforce climate and ESG incorporation more broadly within corporate disclosure and financial market operations through its whistleblower and enforcement priorities."
A 2020 CFTC Report concluded that "[c]limate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy," calling for U.S. financial regulators to "move urgently and decisively to measure, understand, and address these risks." The Report included 53 recommendations, such as putting an "economy-wide price on carbon," developing a strategy for integrating climate risks into the monitoring and oversight functions of financial regulators, allowing 401(k) retirement plans to use ESG factors in making investments and developing standardized classification systems for physical and transition risks. Importantly, the Report also concluded that current disclosure by U.S. companies is inadequate—in no small part because of what might be a cramped interpretation of the concept of "materiality"—and recommended that the SEC update its 2010 guidance on climate risk disclosure and impose specific climate-related disclosure requirements on public companies. (See this PubCo post.)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.