This blog doesn’t typically write about the goings-on at the Commodity Futures Trading Commission, but here’s an exception—especially given that its recommendations encompass the SEC. In July, the CFTC voted to establish a Climate-Related Market Risk Subcommittee, which was asked to provide a report that would “identify and examine climate change-related financial and market risks.” The Subcommittee comprised over 30 financial market participants, including members from “financial markets, the banking and insurance sectors, as well as the agricultural and energy markets, data and intelligence service providers, the environmental and sustainability public policy sector, and academic disciplines focused on climate change, adaptation, public policy, and finance.” That Report was released yesterday. What does it conclude? 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 includes 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 (contrary to currently proposed controversial DOL regulations) and developing standardized classification systems for physical and transition risks. Importantly, the Report also concludes 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 recommends, as discussed further below, that the SEC update its 2010 guidance on climate risk disclosure and impose specific climate-related disclosure requirements on public companies. Will the Report make a difference?
Notwithstanding strenuous objections from the Democratic SEC commissioners, the SEC as a whole has regularly elected not to mandate any prescriptive disclosure requirements regarding climate change. For example, Commissioners Allison Lee and Caroline Crenshaw both dissented from the recent adoption of amendments to modernize the Reg S-K disclosure requirements related to the descriptions of business, legal proceedings and risk factors, in large part because of the silence of the new rules on climate risk. According to Lee, 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.” Crenshaw observed that the question of whether climate change risk is material is “no longer academic,” noting that the SEC’s “steps to modernize the securities laws should facilitate the efficient comparison of long-term sustainability in the face of present-day risks to issuers. But today’s failure to address climate change risk continues to hamper the efficient sorting and comparison of modern companies.” (See this PubCo post.)
Similarly, in May, the SEC’s Investor Advisory Committee observed that the issue of whether to mandate ESG disclosure, including climate, has been under consideration for about 50 years and advocated that it was time for the SEC to make a move. While recognizing the difficulties, the committee contended that “well-constructed, principles-based reporting that enables each Issuer, regardless of industry or business line, to set out its risks, strategies and opportunities in relation to material ESG factors should be no different than current disclosure of business risk, strategy and opportunity. ESG matters are part and parcel of the business of every Issuer and are unique to every Issuer.” (See this PubCo post.)
Nevertheless, SEC Chair Jay Clayton has persisted in his long-held view that the SEC’s approach to climate risk disclosure should be principles-based. In a 2019 interview in Directors & Boards (see this PubCo post), Clayton made clear that when it comes to mounting calls for rulemaking that standardizes ESG disclosure, Clayton was less than enthusiastic: “My view is that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies. Such a step would be inconsistent with our mandate, would be a departure from our long-standing commitment to a materiality-based disclosure regime, and could effectively substitute the SEC’s judgment for the company’s judgment on operational matters.”
In a January 2020 statement regarding proposed amendments to modernize MD&A, Clayton identified five interrelated threshold issues in crafting and evaluating climate-related disclosure mandates and guidance that underpin his conclusion above and can be expected to guide his thinking in the future:
- the complex, uncertain, multi-national/jurisdictional and dynamic landscape that surrounds climate issues;
- for “both issuers and investors, capital allocation decisions based on, or materially influenced by, climate-related factors are substantially forward-looking and likely involve estimates and assumptions regarding, again, complex and uncertain matters that are both issuer- and industry-specific, as well as regional, national and multi-national/jurisdictional, in nature”;
- under the disclosure system, issuers generally provide verifiable and largely historic issuer-specific information, and forward-looking disclosure that is required or provided voluntarily is typically afforded safe-harbor protection;
- as a standard setter, Clayton is mindful that he should not substitute his “operational and capital allocation judgments for those of issuers and investors” and that he (and other standard setters) must “stay within the bounds of their regulatory mandate”; and
- in coordinating with other domestic or international regulators, the need to keep in mind that the U.S. regulatory regime “stands apart” from the perspectives of investor protection, liability and enforcement and that “facially analogous disclosure mandates should not be expected to equate to uniform effects across jurisdictions.” (See this PubCo post.)
The Report first makes clear that the physical and transition risks of climate change “affect capital markets writ large. The Sustainability Accounting Standards Board (SASB) finds that industries totaling 93 percent of U.S. market capitalization are materially exposed to climate risk (SASB, 2016). As firms, investors and other capital market actors seek to make informed decisions in the face of these risks, demand is growing among market stakeholders for comprehensive disclosure evaluating climate-related risks and uncertainties.”
Currently, there are a number of disclosure frameworks, such as the SASB (see this PubCo post) and the Task Force on Climate-related Financial Disclosures (TCFD). (See this PubCo post.) But with the multiplicity of frameworks, investors and other market participants have recognized the need for alignment and consistency among standard setters and “called for ‘decision useful’ climate risk disclosure.”
Although the number of disclosing companies has increased and the quality of disclosure has improved, the Report says,
“the information disclosed falls significantly short of what capital market actors need to adequately integrate climate risk into their decision-making…[T]he slow rate of growth in the number of firms and other market participants disclosing under the current disclosure regime, which relies to a large extent on voluntary disclosures by companies and other market participants, is not sufficient to meet investor needs, given the urgency of mitigating and adapting to climate change. The TCFD’s most recent status report included a review of reporting by more than 1,100 companies from 2016 to 2018, and found that, while disclosure rates were increasing, surveyed companies only made, on average, 3.6 of the 11 total TCFD recommended disclosures…. An analysis of Russell 3000 companies found that 30 percent discussed climate change as a risk in their 10-K filings, but only 3 percent of companies discussed climate risks in the MD&A section of those filings….”
While more large companies are providing some climate-related disclosure, it varies significantly from company to company, “presenting a challenge for investors and others seeking to understand exposure to and management of climate risks.” The lack of completeness and comparability is not only a challenge for investors, according to the Report, it also impedes the ability of companies to benchmark their performance against their peers.
Interest by investors, particularly large institutional investors, in sustainability disclosure has accelerated. Sustainability—especially as viewed through the lens of economic impact—has become a central concern among investment managers and others. For example, in his annual letter to CEOs, BlackRock CEO Laurence Fink said that he believes climate change risk will now lead to “a profound reassessment of risk and asset values. And because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself. In the near future—and sooner than most anticipate—there will be a significant reallocation of capital.” Investors, he said, are now “recognizing that climate risk is investment risk,” making climate change the topic that clients raise most often with BlackRock. (See this PubCo post.)
That view was reinforced by this report from consultant Russell Reynolds Associates on 2020 corporate governance trends, observing that, “[f]or the first time, in 2020, we see the focus on the ‘E’ and the ‘S’ of environment, social and governance (ESG) as the leading trend globally, including in the United States, where it traditionally has not received as much attention by boards.” For example, State Street Global Advisors, one of the largest asset managers, has just announced that, in 2022, it plans to start voting against the boards of big companies that have underperformed relative to their peers on ESG standards, particularly financially material sustainability issues, and cannot explain how they plan to improve. (See this PubCo post.)
However, many investors find the proliferation of frameworks and resulting disclosure to be an impediment to consistency and comparability. For example, in a recent article, BlackRock contended that, to facilitate its own goal of putting sustainability at the center of its investment strategy, corporate issuers must provide more clarity and comparability in their ESG reporting, which will require harmonization and convergence of reporting frameworks, metrics and scoring methodologies. According to the article, the need for alignment and consolidation of standards is particularly acute in the U.S., which “has stood somewhat apart from other jurisdictions, taking a less prescriptive approach to ESG disclosure, opting instead for a principles-based approach centered on the [SEC’s] traditional materiality standard.” BlackRock advocates that policy makers play a role in promoting better and more comparable ESG disclosure practices by aligning around common disclosure frameworks.
According to this study from consulting firm McKinsey, although there has been an increase in sustainability reporting, investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. In the survey, an overwhelming 75% of investors said there should be only one standard, and 82% of investors said companies should be legally required to issue sustainability reports. Surprisingly, 66% of executives agreed. (See this PubCo post.)
Similarly, in comments at a meeting of the SEC’s Investor Advisory Committee, a number of institutional investors advocated for more standardization and disclosure of more decision-useful information. A State Street representative indicated that availability of high quality information that was financially material, consistently disclosed and comparable across companies was one of their biggest challenges. And, State Street observed, companies need guidance on how to measure and disclose ESG information in a standardized way. Another representative of a large asset manager, Neuberger Berman, noted at the same meeting that, with more standardized information and dialogue, they would be better able to perform analyses and reach more qualitative conclusions. Currently, he contended, evaluating the information is an imprecise task because of the “patchy” and inconsistent nature of the disclosure among companies. There is insufficient quality, decision-useful data, exacerbated by corporate greenwashing. In his view, companies are typically unwilling to share more information because their competitors are not disclosing it and it’s not legally required, which the SEC could address. Another participant observed that, even though there are a number of frameworks, they are not regularly used or, if used, companies may respond selectively or fail to include quantitative data. One panelist observed that there is insufficient transparency into how companies determine which ESG issues are material for their financial performance. (See this PubCo post.)
The Report observes that, in addition to the materiality-based disclosure requirements of Reg S-K, in 2010, the SEC issued “guidance to remind companies of their obligations under existing federal securities laws and regulations to consider climate change and its consequences as they prepare disclosure documents.” That guidance, the Report concludes, “has not had a significant impact on actual climate risk disclosures by companies because of its lack of specificity and uneven application.” A 2018 GAO report “found that ‘climate-related disclosures in some companies’ filings use boilerplate language, which is not specific to the company, and information is unquantified,’ thereby limiting the utility of the information to investors.” Despite increasingly sophisticated expectations for disclosure, the SEC has not updated the guidance since 2010.
Citing academic research in support, the Report concludes that “[t]he quality of climate disclosure in the United States by issuers largely remains inadequate for the needs of investors.” In part, the Report attributes the inadequacy to current interpretations of the concept of “materiality,” which often limits
“required disclosure to short- and medium-term risks, and firms may have assumed that climate risks are relevant only over longer time horizons. However, different firms and industries may have different time horizons over which climate risks are deemed material, taking into account factors like the economic life of assets, the percentage of valuation that can be attributed to future growth, the nature of climate-related risk exposure, and corporate strategy. Physical risk exposure of a company or industry may fall somewhere between near-term acute shocks and long-term chronic stresses. These factors should be evaluated when determining which climate risks—including medium- to long-term transition risks—are material and should be included in SEC filings. Moreover, even in the case of long-term physical and transition risks, investors have asked the SEC to consider the perspective of shareholders investing for the long-term benefit of their beneficiaries.”
Primarily because of the “significant ambiguity about when climate change rises to the threshold of materiality, particularly for medium- and long-term risks,” the existing disclosure regime cannot fill “the reporting gaps.” Large pension funds and asset managers have urged the SEC to consider making clear that “materiality” comprehends long-term value creation and sustainability, the Report maintains.
To achieve comparability in disclosure, the Report advises, companies must have “clear rules about what metrics companies should consider.” The Report suggests that rules for climate risk disclosure proposed or considered by a number of foreign financial regulators “could act as models to be adapted for the U.S. context.” [That should go over big at the SEC. Remnember that Clayton believes the U.S. regulatory regime “stands apart.”] “Given the inadequacy of the current climate risk disclosures,” the Report advocates, “U.S. regulators should build on their global counterparts’ models and issue rules for climate risk disclosures. They should monitor the rules for effectiveness. Such action by regulators would be directly responsive to market demand for enhanced climate disclosure.”
The Report makes a number of recommendations to improve disclosure, which should be implemented in consultation with various stakeholders. Creating a U.S. climate disclosure regime, the Report advises, including a “mandatory, standardized disclosure framework for material climate risks, including guidance about what should be disclosed that is closely aligned with developing international consensus, would improve the utility and cost-effectiveness of disclosures.” Because our understanding of climate risk is evolving, so should regulatory approaches evolve and remain open to refinement in line with emerging best practices.
First, when developing rules or guidance, the SEC (and other financial regulators) should consider the following principles for effective climate risk disclosure:
●“Disclosures should represent relevant information.
● Disclosures should be specific and complete.
● Disclosures should be clear, balanced, and understandable.
● Disclosures should be consistent over time.
● Disclosures should be comparable among companies within a sector, industry, or portfolio.
● Disclosures should be reliable, verifiable, and objective.
● Disclosures should be based on current consensus science (and updated as the science evolves) and the best available projections regarding climate change impacts.
● Disclosures should be provided on a timely basis.”
Second, “climate risk disclosure should cover material risks for various time horizons.” The SEC “should clarify the definition of materiality for disclosing medium- and long-term climate risks, including through quantitative and qualitative factors, as appropriate. Financial filings should include disclosure of any material financial risks from climate change in a consistent but non-boilerplate manner, as well as a qualitative description of how firms assess and monitor for potential changes in climate risks that may become material.”
Third, the SEC and other regulators should consider “additional, appropriate avenues” for disclosure of climate risks that are substantive but not quite material over different timeframes outside of SEC filings. Disclosure regarding greenhouse gas reduction targets and strategies that companies devise out to the year 2035 or 2050 “may be appropriate to facilitate robust efforts toward this positive trend.”
Fourth, in light of the substantial costs involved in reporting climate risk information, the SEC should consider whether less burdensome regulation should be applied to smaller companies.
Fifth, the SEC should consider rulemaking where relevant. In addition, the SEC should update its 2010 guidance to achieve greater consistency and ensure its implementation. The update could provide advice on the following:
● “Information that is needed from all companies in order to enable financial regulators to assess the systemic risks posed by climate change. Federal financial market regulators should work closely with prudential regulators to develop these rules.
● Industry-specific climate risk information. Rules should build from existing standards that provide industry-specific climate disclosure recommendations, for example, those developed by the TCFD, SASB, CDSB, the Physical Risks of Climate Change (P-ROCC) framework, and the Global Real Estate Sustainability Benchmark (GRESB) standards for real estate and infrastructure. Because these standards are already sophisticated, regulators do not need to create their own standards or metrics from scratch. Regulators should encourage stakeholders to partner with these standard-setting bodies to further develop, standardize, implement, and validate these metrics over time. Regulators should also acknowledge, in any rulemaking, that climate disclosure standards continue to evolve, and it could provide issuers flexibility, where appropriate, to adopt these evolving standards.
● Governance, risk management and scenario planning information that demonstrates how well companies are situated for a clean energy transition. Federal financial market regulators should work closely with prudential regulators to develop these rules…. Regarding governance and risk management disclosure, regulators should consider the TCFD’s recommendations and the Committee of Sponsoring Organizations of the Treadway Commission/World Business Council for Sustainable Development (COSO/WBCSD) guidance, applying enterprise risk management to environmental, social and governance-related risks.”
Sixth, the SEC and other regulators should “require listed companies to disclose Scope 1 and 2 emissions. As reliable transition risk metrics and consistent methodologies for Scope 3 emissions are developed, financial regulators should require their disclosure, to the extent they are material.”
Seventh, with respect to derivatives, financial regulators “should examine the extent to which climate impacts are addressed in disclosures required of the entities they regulate and consider guidance and rulemaking if disclosure improvements are needed.”
Eighth, accounting standards regulators should, once climate risk disclosure standards are “well advanced,” map the applicability of accounting standards to climate-related disclosure and subsequently issue guidance on disclosure, as appropriate, providing more clarity about how climate risks may be integrated into financial statements.
The Report contends that climate risk disclosure provides a number of benefits to issuers, helping them
“to identify, assess, manage, and adapt to the effects of climate change on operations, supply chains and customer demand; (ii) to relay risk and opportunity information to capital providers, investors, derivatives customers and counterparties, markets, and regulators; and, (iii) to learn from competitors about climate-related strategy and risk management best practices. Peer group disclosures create an information platform where companies can learn from each other and, as a result, increase their organizational and network resilience.”
Investors will also benefit from “a more refined measure of the long-term cost of capital, as well as risks to firms, margins, cash flow and valuations,” as well as the assurance that climate risks are taken seriously. The absence of disclosure could lead to a reduction in market confidence, adversely affecting the company. Communities will benefit by better understanding “how companies in their localities are preparing for climate risks and opportunities that could impact the local economy, labor force, and tax base.”
In light of the SEC’s long-standing commitment to regulation that is principles-based and not prescriptive, time will tell whether this Report induces the SEC to take any further action. It’s hard to imagine the current SEC mandating, as recommended, that public companies disclose Scope 1 and 2 emissions or even that companies provide disclosure under one or more of the existing frameworks—that ship appears to have sailed with most recent Reg S-K amendments. More conceivable is that the SEC might update its 2010 guidance, perhaps even expounding further on the timeframe for “materiality” as suggested. Although fairly recent references to the 2010 guidance may well reflect some level of comfort with its adequacy (see this PubCo post), notably, in a webcast interview in June with non-profit FCLT Global (see this PubCo post), Clayton indicated that, instead of prescriptive requirements, he would view the type of guidance that the Corp Fin staff issued in connection with COVID-19 disclosure as a good model for sustainability disclosure guidance. (See this PubCo post and this PubCo post.) Whether the SEC issues new guidance on climate remains to be seen.