The following is the executive summary of a new report from the Climate Risk Disclosure Lab that highlights the need for a thorough, robust, and mandatory disclosure framework for climate-related information. The report exposes the failure of U.S. regulators to properly incorporate climate change into their mandates and assesses the threats that the vacuum of climate-related information poses to financial markets and the broader economy. The Climate Risk Disclosure Lab is a collaboration between the Global Financial Markets Center at Duke Law, Duke’s Nicholas Institute for Environmental Policy Solutions, and the National Whistleblower Center.
The climate crisis poses immense and immediate risks to financial systems around the world. If climate change were to cause sudden and widespread asset deflation across numerous sectors, as many experts worry, a painful global recession would almost inevitably follow. In contrast, if businesses, investors, asset managers, and others were to truly grapple with climate change reality and adjust business models to rapidly deploy renewable energy and other low-carbon technologies as well as strategies for making the world more resilient to climate-related shocks, they could help usher in an era of economic revitalization.
Climate change poses two types of risk to financial assets: “physical risk,” or the risk that companies will not be able to handle the physical impacts of climate-related events, and “transition risk,” the risk that companies will fail to prepare for the inevitable transition of the economy to one that relies on low-carbon energy sources. Climate-related events such as sea level rise, intensified wildfires and floods, and ocean acidification are already damaging public infrastructure and private property. Both types of damage have snowballing effects, diminishing property values, devaluing collateralized assets, and increasing insurance premiums while decreasing insurance coverage.
Transition risk is a major concern because many companies do not take seriously the enormity of efforts underway in both the public and private sectors to change policies, technologies, and business practices to combat climate change. These efforts lead inevitably to disinvestment in carbon-intensive assets, companies, and industries.
Companies that do not fully account for climate-related physical and transition risks will likely experience significant losses and many will be forced to liquidate. Conversely, as institutional investors are showing great eagerness to deploy capital toward sustainable technologies, and as policymakers around the world are looking for ways to catalyze the changes that their constituents are demanding, businesses that embrace the transition to a low-carbon economy will receive plenty of support.
Investors and financial markets increasingly demand the disclosure of material, climate-related risk information from public companies in order to adequately value their investments, price risk accurately, and efficiently facilitate the allocation of capital. The disclosure of climate-related risks is essential for market participants and financial regulators to ensure that public companies are managing and measuring climate-related risks. As a result, public companies and issuers face increasing pressure to identify, measure, and communicate climate change risks.
The most efficient way to ensure the accurate and timely dissemination of information is through a robust and mandatory disclosure framework. The Securities and Exchange Commission (“SEC”) requires public companies to disclose information related to their financial position and performance, future prospects, and material risks. These disclosure requirements allow investors to make accurate valuations, compare competing investment opportunities, and make confident and efficient capital allocations. Unfortunately, the existing SEC interpretative guidance has failed to produce comprehensive, comparable, and consistent climate-related disclosures by public companies.
This three-part Climate Risk Disclosure Lab report highlights the need for a mandatory and robust disclosure framework for climate-related risks. The report begins by discussing the importance of climate-related disclosure, and the risks that climate change pose to the economy. It then assesses how climate-related disclosures can benefit investors, issuers, and financial markets. Next, the report assesses how climate-related risks currently fit within existing SEC disclosure requirements. The report concludes by examining current best practices and recent proposals to establish a mandatory disclosure framework for climate-related risks.
There are currently four SEC requirements in Regulation S-K that potentially require firms to disclose climate-related information. First, Item 101 requires firms to disclose material costs relating to their business operations, including the costs of complying with environmental laws and regulations. Second, Item 103 requires firms to disclose most legal proceedings to which they or their subsidiaries are a party, unless the proceeding consists of ordinary routine litigation that is incidental to business. Item 103 has a specific environmental exception, designating certain environmental proceedings as being outside the scope of ordinary litigation. Third, Item 105 requires firms to disclose the most significant factors that make investments in their business speculative or risky. Item 105 requires disclosure of firm-specific information; for example, an airline must disclose that its planes are no longer in compliance with environmental standards, if bringing them into compliance would have a material financial impact on the firm. However, firms are not required to disclose, pursuant to Item 105, generic climate risks that could apply to any company. Finally, Item 303 is a broad and subjective disclosure requirement that generally requires management to disclose all known material events and uncertainties that may alter future operating results or financial conditions beyond what would otherwise be indicated by reported financial information. Item 303 requires, for example, disclosure from a brewery located in an area where natural water levels were falling if the brewery believed that water depletion would continue and that the inability to access natural water would have a material impact on its operations.
The report finds that these requirements have not led to sufficient, or consistent, assessment and communication of climate-related risks by public companies. The absence of a comprehensive mandatory framework for climate-related disclosures has led to the proliferation of multiple voluntary standards. The Task-Force on Climate-related Financial Disclosures (“TCFD”), the Sustainability Accounting Standards Board (“SASB”), the Global Reporting Initiative (“GRI”), the Principles for Responsible Investment (“PRI”), the Partnership for Carbon Accounting Financials (“PCAF”), and CDP have all developed standards and systems that aim to help firms and investors identify, measure, and communicate climate-related information and incorporate that information into their business practices.
Though these regimes and standards are useful in providing guidance to firms and investors, the wide range of voluntary practices and templates allows companies to omit unfavorable information and use their own scope and calculation methods when disclosing climate risks. This lack of consistency in disclosure standards and practices impedes the ability of firms to know what climate-related information must be disclosed, and it makes it impossible for investors to adequately understand the climate risks their investments are exposed to. This uncertainty makes it difficult for investors to compare firms and results in the mispricing of climate-related risks in financial markets.
A standard, robust, and mandatory disclosure framework would thus benefit investors and issuers alike. It would have broad market and social benefits, spurring greater productivity and creating more resilient economies. A mandatory framework would benefit investors by allowing easy company comparisons, promoting efficient capital allocation, decreasing search costs, making it easier to hold companies accountable, and protecting the reputation of institutional investors. Additionally, such a framework would benefit firms by minimizing shareholder and stakeholder information requests. It would also encourage firms to identify adaptation measures and emerging opportunities, and make it easier for firms to communicate that information to investors. Such a framework would lead to more confident long-term investments, a decrease in the cost of capital, and an increase in the competitiveness and reputation of firms that demonstrate their commitment to sustainable growth. Finally, a standard and robust disclosure framework for climate-related risks would encourage the private-sector to identify and implement sustainability practices, remove the risks associated with third-party analyses of companies’ climate change risks, and provide more accurate pricing in the market.
Lee Reiners is the Executive Director of the Global Financial Markets Center at Duke Law
Charlie Wowk is a J.D. candidate at Duke Law and a research assistant at the Global Financial Markets Center