SEC’s Proposed Climate Risk Rule Helps All Investors

The United States Securities and Exchange Commission this week approved a proposed rule 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 business, as some have suggested, it will focus the attention of many public companies on how they will manage their climate risks by mid-century.

What is in the proposed rule?

The proposed rule would be require climate-related disclosures from all public companies registered with the SEC. Much of the attention has focused on mandating disclosure of a company’s greenhouse gas emissions, but the proposal goes further than that. It obliges companies to report on how climate-related risks may affect their financial situation in the short, medium and long term; whether climate risks may affect their strategy or business model; and how they manage 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 made in meeting the targets.

Why is it necessary?

Because climate change is a major planetary crisis that needs to be addressed urgently…a code red for humanity. This should go without saying, but unfortunately it does not. Climate change is happening, and scientists are sure its negative effects will multiply if global warming exceeds 1.5 degrees Celsius, which is likely in the next few decades unless greater action is taken to reduce greenhouse gas emissions. Climate change is a reality for all of us.

For investors, climate risk is therefore a reality. 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 goal of the proposed rule. Currently, some companies are reporting on their emissions, some have transition plans, some are discussing the risks and opportunities they face due to climate change and threats to their business models. But certainly not all do, and the information they provide is often difficult for investors to use when evaluating their investment options.

To be sure, investors will vary in the importance they place on climate risk in their investment decisions, but for the foreseeable future – let’s call it the next three decades – it is hard to imagine the investor who will succeed by ignoring the climate risk completely. .

What is climate risk?

Climate risk is the material risk that a company faces due to climate change and its climate change-related activities. These can be short, medium or long term risks. It is useful to consider them in terms of “transition risks” and “physical risks”.

Transition risk relates to the greenhouse gas emissions a company is responsible for and the costs of transitioning from fossil fuel use 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 have greater value in a low-carbon economy. For others, the fossil fuel industry in particular, the energy transition poses a major threat to their economic model.

Physical risks include the impact of increased extreme weather events, such as floods, hurricanes and tornadoes, and longer-term chronic effects of global warming, such as higher temperatures, rising levels of the sea, forest fires and drought. These physical manifestations of climate change can affect a company’s operations, supply chain, distribution, workforce health and customer stability. As with transition risk, some companies and industries are more vulnerable than others to physical climate risks depending on where their activities are located along their value chain and with their customers, as well as their management of these risks.

Is it just ESG?

Absolutely not. The proposed rule will benefit all investors equally: by giving them more reliable, comparable, and decision-useful information about the climate-related risks of every public company in the United States. For those who already place considerable weight on climate risk in their investment decisions – and most environmental, social and governance conscious investors fall into this group – the proposed rule will make life easier by reducing the time and resources they currently devote to making sense of the fragmentary information currently available. Indeed, the complexity of assessing climate risk in the absence of required disclosure could prevent many investors from taking it fully into account 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’s possible that future climate risk regulation will affect mutual funds, but I think that’s unlikely.

Nevertheless, mutual fund managers will benefit from the proposed rule by having better information about climate risk at their disposal when making their investment decisions. Again, this applies to all fund managers, not just ESG fund managers.

Even passive managers will benefit from access to better information on climate risks. Large passive asset managers like BlackRock and State Street have ramped up their climate risk stewardship on the theory that the only way to add long-term value for their fundholders in an otherwise indexed portfolio predetermined is through direct engagement and proxy voting.

One of the unintended benefits of the proposed rule could be that it will encourage mutual fund managers to disclose to investors how they account for climate risks in their portfolios. Check your funds’ websites today and see how long it takes you to find this information, if it even exists. Given the scale of this problem, it seems to me irresponsible that funds do not consistently provide investors with a full description of how they account for climate risk. With this rule in place, maybe they will.

Who supports the proposed rule?

Although media reports may present environmental groups and climate activists as the main supporters of the proposal, it is important to note that investors strongly support it. In fact, if investors had not supported the idea of ​​mandatory climate risk disclosure, it is unlikely that this proposal would have seen the light of day. In a statement issued this week, SEC Chairman Gary Gensler says asset managers with $130 trillion in assets under management have asked companies to disclose their climate risks.

It also seems 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, commercial and fossil fuel trading organizations. All are on the side of what Michael E. Mann discusses “climate inactivists”: organizations that have dropped their outright denials of the reality of climate change in recent years, but still oppose any political action to combat it.

In this case, they argue that the existing SEC guidance on materiality disclosures is sufficient and no further rules are needed. They refer to interpretation guide published in 2010 which reminds companies to report on climate risk if they believe it is material to their business. The SEC believes that only about a third of the corporate annual reports it recently reviewed contained climate information.

Opponents also argue that requiring reporting of greenhouse gas emissions by companies that do not consider their emissions to be at the level of a significant risk is an unnecessary burden on public companies and falls outside the jurisdiction. of the SEC. This is particularly the case, they say, for scope 3 emissions, which are hard-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 Scope 3 emissions and allows them to decide whether that information would be material to investors.

It is important to note that none of the opposition that I know of comes from the investment industry. Indeed, asset managers and wealth managers understand that smart investing considers all relevant risk factors, which clearly requires an assessment of climate-related risks.

What happens now?

The proposed rule is now entering a public comment period of up to 60 days. Anyone can comment, and everything will be made public. The SEC will then consider public comments before finalizing the rule, which would go into effect from 2024. Since the proposed rule is 500 pages long, certain elements of it will no doubt be changed or removed as a result of the public comments.

But the bottom line is that the SEC has responded to investors’ demand for more and better information about climate-related risks, and that will allow investors to make more informed decisions.

A final thought: the proposed rule is not only good for investors, but also for public companies. It will focus their attention on assessing climate risks, reducing emissions and articulating the relevance of their business case as we make the inevitable transition to a low carbon economy.

Martin E. Berry