The U.S. Securities and Exchange Commission approved a proposed rule this week that would require public companies to report on climate-related risks. The rule will provide investors with much-needed information that will help them make better decisions. Far from being an unnecessary burden on businesses, as some have suggested, it will concentrate the attention of many public companies on how they are going to manage their climate risks between now and midcentury.
What Is in the Proposed Rule?
The proposed rule would require climate-related disclosures from all public companies registered with the SEC. Much of the attention has focused on the required disclosure of a company's greenhouse gas emissions, but the proposal goes further than that. It requires companies to report on how climate-related risks may affect their financial condition over the short, medium, and long term; whether climate risks may affect their strategy or business model; and how they are governing climate-related risks. For companies that have adopted transition plans and climate-related targets, the proposal requires them to shed light on the substance of the plan and the progress in achieving targets.
Why Is It Needed?
Because climate change is a major planetary crisis that must be urgently addressed--a code red for humanity. That should go without saying, but unfortunately, it doesn't. Climate change is happening now, and scientists are certain that its negative effects will multiply if global warming surpasses 1.5 degrees Celsius, which is likely in the next few decades unless more-significant measures are taken to reduce greenhouse gas emissions. Climate change is a fact of life for us all.
For investors, therefore, climate risk is a fact of life. For investors to better understand climate risk and make informed decisions, we need reliable, comparable, and decision-useful information from public companies, which is the purpose of the proposed rule. Currently, some firms report on their emissions, some have transition plans, some discuss the risks and opportunities they face from climate change and threats to their business models. But certainly not all do so, and the information they provide is often hard for investors to use as they weigh their investment options.
To be sure, investors will vary in the weight they give climate risk in their investment decisions, but for the foreseeable future--let's call it the next three decades--it's hard to imagine the investor who will be successful by ignoring climate risk altogether.
What Is Climate Risk?
Climate risk is the material risk a company faces from climate change and its activities related to climate change. These could be short-, medium-, or long-term risks. It's helpful to think of them in terms of "transition risks" and "physical risks."
Transition risk is about greenhouse gas emissions for which a company is responsible and the costs of transitioning away from the use of fossil fuels over the next three decades or so. Some companies will be able to manage the transition more easily than others; some may actually benefit from the transition because their products and services may be of greater value in a low-carbon economy. For others--the fossil-fuels industry in particular--the energy transition poses a significant threat to their business models.
Physical risks include the impact of increasing incidents of extreme weather, like floods, hurricanes, and tornadoes, and of the longer-term chronic effects of global warming, like higher temperatures, rising sea levels, wildfires, and drought. These physical manifestations of climate change can affect a company's own operations, its supply chain, its distribution, the health of its workforce, and the stability of its customer base. As with transition risk, some companies and industries are more vulnerable to physical climate risks than others depending on the location of their activities throughout their value chain and of their customers, as well as their management of these risks.
Is This Only About ESG?
Absolutely not. The proposed rule will benefit all investors in the same way: by giving them more reliable, comparable, and decision-useful information about climate-related risks from every public company in the United States. For those who already give significant weight to climate risk in their investment decisions--and most environmental, social, and governance-conscious investors are in that group--the proposed rule will make life easier by reducing the time and resources they currently spend on making sense of the piecemeal information currently available. Indeed, the complexity of evaluating climate risk in the absence of required disclosure could be keeping many investors from fully considering it in their decisions.
How Will This Affect Mutual Funds and Fund Investors?
The proposed rule requires public companies, not mutual funds, to report on their climate-related risks and emissions. It is possible that subsequent rulemaking on climate risk could address mutual funds, but I think that's unlikely.
Nonetheless, mutual fund managers will benefit from the proposed rule by having at their disposal better information about climate risk when they make their investment decisions. Again, this applies to all fund managers--not just ESG fund managers.
Even passive managers will benefit from having access to better information about climate risks. Large passive asset managers like BlackRock and State Street have ramped up their stewardship activities related to climate risk on the theory that the only way they can add long-term value for their fundholders in an otherwise predetermined indexed portfolio is through direct engagement and proxy voting.
One unintended benefit of the proposed rule could be that it will prod mutual fund managers to disclose to fund investors how they are accounting for climate risks in their portfolios. Check out your funds' websites today and see how long it takes you to find this information--if it even exists. Given the magnitude of this issue, it seems irresponsible to me that funds do not routinely provide investors with a full description of how they are accounting for climate risks. With this rule in effect, perhaps they will.
Who Supports the Proposed Rule?
While media reporting may cast environmental groups and climate activists as the main supporters of the proposal, it's important to note that investors strongly support it. In fact, if investors did not support the idea of mandatory climate-risk disclosure, it's unlikely this proposal would have seen the light of day. In a statement made this week, SEC Chair Gary Gensler said asset managers with $130 trillion in assets under management had requested that companies disclose their climate risks.
It also appears to be a popular idea among the general public. In a recent poll, 87% of Americans agreed that the federal government should require large companies to publicly disclose climate risks.
Who Opposes the Rule?
Some conservative, business, and fossil-fuel trade organizations. All of them are in the camp of what Michael E. Mann calls "climate inactivists": organizations that have dropped their outright denials that climate change is real in recent years but still oppose any policy action to combat it.
In this case, they argue existing SEC guidance on materiality disclosures is sufficient and no further rule is needed. They're referring to interpretive guidance issued in 2010 that reminds companies to report on climate risk if they believe it is material to their business. The SEC estimates that only about a third of the corporate annual reports it recently reviewed contained climate disclosures.
Opponents also argue that requiring reporting of greenhouse gas emissions by companies that don't consider their emissions to rise to the level of a material risk is an unnecessary burden on public companies and not within the SEC's jurisdiction. This is especially the case, they say, for Scope 3 emissions, which are difficult-to-measure emissions that come from a company's supply chain and those that emanate from the use of their products. But the proposal requires only the largest companies to report on Scope 3 emissions and allows them to decide whether that information would be material to investors.
It's important to note that none of the opposition that I know of comes from within the investment industry. That's because asset managers and wealth managers understand that smart investing takes account of all relevant risk factors, and that clearly requires an evaluation of climate-related risks.
What Happens Now?
The proposed rule now enters a public comment period of up to 60 days. Anyone can comment, and all will be made public. The SEC will then consider public comments before finalizing the rule, which would go into effect starting in 2024. Given that the proposed rule runs 500 pages, there are undoubtedly elements of it that will be changed or dropped as a result of public comment.
But the bottom line is that the SEC has responded to investor demand for more and better information about climate-related risks, and that will enable investors to make more-informed decisions.
One final thought: the proposed rule is not only good for investors but also good for public companies. It will focus their attention on assessing climate risk, lowering emissions, and articulating the relevance of their business case as we make the inevitable transition to a low-carbon economy.