SEC should strengthen required climate risk disclosures

As the present effects and likely future consequences of climate change become ever more apparent, its damage will affect more and more aspects of our lives. Some are obvious: the dangers of building in low-lying areas or where risks of extreme weather or wildfires are rising. Others, however, remain largely hidden, nasty surprises awaiting those who believe they have taken proper precautions. 

One such hidden risk is investing in companies whose businesses can be adversely affected by climate change. Just as ordinary investors who put their life savings into Enron stock or highly-rated mortgage-backed securities were pitched into financial ruin they could not have anticipated, so too might those whose superficially diversified investments all turn out to be exposed to climate risk: They could see their financial security washed away like a low-lying island. 

Fortunately, the Securities and Exchange Commission has recognized this risk and is taking action to combat it.

Building on the work of two non-governmental groups, the SEC has proposed a rule that would require companies to disclose the extent to which their profitability could be endangered by climate change. The SEC rule would be a major step forward in making these disclosures mandatory. That being said, the SEC has been disappointingly timid in the scope of the disclosures it requires. Public comments, due by Friday, June 17, can encourage the SEC to move forward with this rule and to plug the loopholes that threaten to undermine its effectiveness. 

Congress created the SEC in the wake of the Black Thursday stock market crash that launched the Great Depression. Although some investors that lost heavily in the crash knew they were playing risky games, others had no idea their families’ well-being was at risk. Since its establishment, the SEC has sought to prevent a recurrence of that calamity. The SEC cannot and should not eliminate risk from investing, but it plays a crucial role in ensuring that investors have a fair chance of knowing what risks they are taking. 

Some risky practices are obvious: obscure bookkeeping practices, outsiders secretly buying up large fractions of a company’s stock, various pump-and-dump maneuvers, etc. The SEC’s mandate is not, however, limited to such risks. Whenever the Commission becomes aware of a set of practices likely to lead to misled investing on the front-end or destructive panic selling on the back-end, its mission calls on it to shine the light of mandatory disclosure on the problem. Indeed, these less well-recognized risks are more likely to ensnare innocent investors — and to escape the scrutiny of sincere board members — than more prosaic financial skullduggery. 

As climate risks become better-known, most responsible managers have endeavored to reposition their companies to enter growth markets, such as those in renewable energy and climate adaptation or mitigation fields, while reducing their dependence on lines of business that may become unprofitable because of changes in physical conditions, government regulation, or consumer preferences. As seemingly always is the case, however, a few corporate wolves are donning sheep’s clothing to infiltrate the flock, trying to extract short-term profits by staying in dying industries while leaving their companies with dim prospects for long-term viability. 

With both the impacts of climate change and the strategies for combatting it touching so many facets of our lives, ordinary investors are ill-equipped to recognize most investment risk related to climate. Yes, a company devoted exclusively to coal mining is certainly riskier than one focused on solar panels, but most real-world cases are not that clear. Indeed, without trustworthy, legally mandated reporting of climate risks, even corporate directors will be ill-equipped to assess how well the managers they supervise are minimizing the climate risks their companies are taking. 

Unfortunately, the SEC’s proposed rule contains a gaping loophole. Although it would require reporting of emissions directly caused by the company’s activities — such as exhaust from its fleet of cars — and those required to generate electricity the company consumes, it would not require companies to report climate risks that are deemed indirect (“Scope 3”). 

Thus, for example, a company would not have to report that its profitability depends heavily on leasing oil drilling equipment because the actual emissions are caused by the lessees. A company committed to this line of business will be in grave peril as the world turns away from fossil fuels, yet under the SEC’s proposed rule, investors and conscientious board members would have no idea of the risk. Similarly, a company that sold equipment that reduced the fuel economy of vehicles would not have to report that risk because the actual emissions occur after the product is sold. 

This direct-indirect distinction will leave many huge threats to corporate viability in the shadows. Worse, it will subvert the reporting requirements the rule does establish by encouraging companies to develop accounting gimmicks to recharacterize its involvement in climate-harming activities as indirect. 

A common middle-ground in these situations is to require reporting only of those risks that the company deems material. This might yield some information from companies with little to hide, but it invites the truly reckless ones — the companies SEC should be most worried about — to absolve themselves of reporting duties. Managers seeking to deceive their investors and board members could readily cite all their (unrelated) activities that do not carry climate implications to claim that large risks that they are taking are proportionately too small to be material. The SEC should not open itself, and investors, to these tactics. 

The days when climate change concerned only environmentalists are long gone. Those in many other fields — very much including finance — must think carefully about its implications for their work.

The SEC’s initial foray into mandating climate risk reporting is admirable. The Commission needs, however, to close the loopholes already apparent in its proposal and to commit itself to regular review of this rule to respond to changing conditions and new evasive tactics.

David A. Super is a professor of law at Georgetown Law. He also served for several years as the general counsel for the Center on Budget and Policy Priorities. Follow him on Twitter @DavidASuper1