The Securities and Exchange Commission (SEC) has finally issued its much-anticipated climate disclosure rules. As expected, it has received criticism both from climate activists disappointed by the removal of certain provisions contained in earlier drafts, and from members of the business community who cite regulatory over-reach and a veiled attempt to phase out fossil fuels. No one seems happy, no one seems devastated.
We support disclosures that help investors make decisions on financial risks and returns and believe that these new rules are broadly in line with that belief. We also believe that disclosure mandates should not be used as a mechanism to change corporate behavior (e.g., get companies to reduce emissions), but to provide relevant and reliable information so that investors can make informed capital allocation decisions. Adding our own good/bad characterization of the rule isn’t productive. In this post, we try to unpack some of the nuances of these regulations and their implications for investors and companies alike.
Materiality and the Investor's Lens
The newly minted rules hinge on a materiality provision that gives companies significant latitude in determining the relevance of Scope 1 and Scope 2 greenhouse gas (GHG) emissions for investor decision-making. This flexibility, while fostering a tailored approach to disclosure, may inadvertently muddy the waters for investors seeking consistency and comparability. Clarity and comparable reporting are foundational to integrating climate risks and opportunities into investment portfolios. It is important that the materiality threshold strikes a balance that serves both corporate and investor interests without sacrificing transparency or oversight. Investors will also have their own views on the thresholds for materiality, which we expect will vary widely given the criticisms of the rule as being both too stringent and not stringent enough. One practical outcome is likely to be that registrants will not be incented to claim lack of materiality if operating in a sector where GHG emissions are prima facie significant to investors or customers. We also anticipate that those companies with a process in place to measure GHG emissions data will be inclined to disclose, if only to reduce litigation risks should climate or carbon-related events result in material losses.
A Global Comparison: Balancing Act or Missed Opportunity?
The SEC’s rule, when viewed in a broader global context, is less stringent than its European and Californian counterparts. While much has been made of the additional costs of compliance, U.S.-based multinationals are already navigating more rigorous global requirements. Certain U.S. companies have to comply with the EU’s Corporate Sustainability Reporting Directive (CSRD) starting this year, and many more U.S. companies will follow over the next several years. While the harmonization of various regional disclosure rules would be welcomed by investors who focus on climate risk, the prospects for broad acceptance of a global reporting standard — such as the International Financial Reporting Standards (IFRS) S1 and S2 proposed by the International Sustainability Standards Board’s (ISSB) — seem bleak. That said, we believe the SEC rules ultimately support the baseline principles in other reporting regimes and will foster the production of meaningful and actionable climate-related financial information.
The Scope 3 Emissions Debate: A Broader Question of Market Role
The SEC’s decision to exclude mandatory Scope 3 emissions disclosure is emblematic of a broader conversation about the role of capital markets in driving sustainable change. Scope 3 emissions, which encapsulate the indirect emissions in a company’s value chain and end products, are often the most significant portion of a company’s carbon footprint. Their exclusion from mandatory reporting underscores a fundamental debate — what is the role of the capital markets in being proactive agents of societal and environmental change, and when or where are those responsibilities better carried out by policy-makers?
The push for Scope 3 disclosures, while contentious, signals a growing recognition of the systemic nature of climate risks and the pivotal role of capital markets in making those risks more visible and measurable. Given that, capital allocation and shareholder engagement alone will not result in a meaningful level of emissions reduction. Solving the climate crisis will only occur when science and policy are aligned, and market participants have the clarity and incentives to act.
What is Climate Risk Anyway?
A lot of people liberally use the phrase, “climate risk is investment risk”. But climate risk is multi-faceted, and the actions that companies take to address them vary by company. One benefit of the new disclosure rules, and the way they are written, is that the evolution of related risk management processes will provide management with not only more reliable data, but also with a better and broader disclosure narrative on the nature of such risks. Take for example first and second order impacts of climate risks. In some cases, first order impacts and associated analyses will be intuitive. An electric utility at risk of starting a wildfire won’t need to look far to begin considering potential costs. The first order implications of flood and drought risks to agricultural businesses should be analyzable. But what about a services company that doesn’t have a high location risk due to operational flexibility afforded by technology? Will they have second order risks that are material – e.g. their clients are concentrated in a certain geography or industry?
“What is needed is a mindset that recognizes the full scale of the climate risk, whilst maintaining the optimism that we can and will respond in a way to avoid and mitigate the worst risks from occurring.”
Gill Einhorn
Head, Innovation and Transformation
Centre for Nature and Climate,
World Economic Forum
If the analysis is done thoughtfully, then there is a good chance that the resulting disclosure won’t be legal boilerplate. Companies tend to be direct about risk and then talk about what they are going to do to manage it. That way, if the risk is realized, they can reduce the potential legal risks by pointing to their disclosures. Our hope is that the disclosure requirement forces a debate about the nature and breadth of climate risk on a company-by-company basis. If that happens, over time, investors can expect to gather more useful and holistic information, while companies will take action to reduce their exposure to climate risk, including managing GHG emissions.
Looking Forward: Embracing the Dual Mandates of Risk and Responsibility
Over the coming days, much will be made of the new SEC rules. Given the polarized state of our politics, it provides yet another flashpoint in the debate between ESG supporters and detractors. That aside, climate risk is a growing concern for investors. As severe weather events continue to cause destruction, and as the transition to a clean energy economy presses forward, investors will view both the physical and transition risks of climate worthy of their own distinct consideration. The new rules may cause an additional burden for companies that were taking little action on climate, but at the end of the day, investors were already pressing companies on carbon emissions and climate resiliency. Investors will continue to make their own assessments on the sufficiency of company commitments and actions. The new rules will help facilitate comparability and enhance reliability. So be happy.
Chris Ito
CEO
FFI Holdings