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The Time for Comprehensive, Mandatory, and Consistent Climate Risk Disclosure Is Now

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David Post, CFA

Director, Investment Strategy

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Both investors and regulators agree: The world can’t wait to tackle climate change. That’s why mandatory climate reporting is vital.

Regulations regarding corporate financial reporting are about as interesting to most people as the fine print in an insurance contract, unless you’re an accountant—or an investor. Securities regulators around the world, including the US Securities and Exchange Commission (SEC), write regulations that require companies listed in their country’s exchanges to report information that’s “decision-useful” for investors. The resulting company regulatory filings are consistently reported over time, comparable among companies, and of high quality.

As we live through the damage from our changing climate, corporate disclosure of material climate risks and opportunities is proving more important than ever, yet such disclosures tend to be spotty and incomplete. That’s why securities regulators are rapidly coalescing around the need for required and specific corporate climate disclosure, which will help investors better incorporate climate risks and opportunities in their investment decisions.

How do companies report climate risks and opportunities now?
Financial statements have long been at the center of traditional corporate valuation practices. However, it’s widely recognized that financial statements may not completely reflect a company’s value. This problem can be especially acute for service-based companies that are more reliant on intellectual and human capital than physical capital. Financial statements may also fail to adequately value a company’s physical capital as well, particularly when stranded assets or regulatory risks are at play. 

As investors contemplate the best way to remedy the disparity between financial accounting value and market value, some are turning to nonfinancial reporting, which is disclosed in corporate sustainability reports and management discussion and analysis (MD&A) in SEC filings. Although this kind of information is certainly relevant from a financial perspective and helps investors value companies more accurately, it’s called nonfinancial because it isn’t included in standard financial accounting statements. Many investors recognize this limitation, but formal adjustments to accounting standards remain a work in progress. In the meantime, we’re seeing great investor and regulator interest in figuring out how nonfinancial issues can be better measured and reported.

Why is climate change such an important systemic nonfinancial risk?
Systemic risks arise through interdependencies, where the failure of a single component can cause a series of cascading failures that can bring down the entire system. Climate change is the epitome of a systemic risk: Rising temperatures can have cascading effects in the physical world and therefore the corporate operating environment and financial markets. More frequent catastrophic flooding, droughts, wildfires, and storms can destroy or strand physical assets and drive costly business transition and regulatory responses.  

One estimate of the cost of ignoring climate change is more than 30% of global per capita GDP by the year 2100. Recognizing the magnitude of this risk, 191 governments around the world have signed the Paris Climate Agreement, committing to do their part by reducing greenhouse gas (GHG) emissions. The Sustainability Accounting Standards Board (SASB), widely regarded as having the most robust approach to identifying material nonfinancial issues, has assessed climate risk as material to 90% of all industries. But there’s still no consistent and comparable set of nonfinancial indicators that companies are required to report.

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Are climate disclosure standards within reach?
Despite investors rallying behind the importance of reporting climate risks, corporate reporting to date has been disappointing. A 2018 General Accounting Office report highlighted that even companies directly and substantially impacted by climate change seldom made any mention of climate in their regulatory filings. The systemic nature of climate risk and poor corporate climate reporting likely drove the SEC to ask for public comment in March 2021 regarding current disclosure rules as they relate to climate, a clear precursor to new regulation. As we put bluntly in our June 7 letter to the SEC: 

Voluntary reporting of corporate climate exposure has been tried, and has failed to result in decision-useful information for investors. It is time for mandatory reporting with clear and specific reporting standards.

The SEC isn’t the only entity taking a hard look at climate disclosures. The International Financial Reporting Standards (IFRS) Foundation will likely set up a global sustainability standards board that it would oversee along with the International Accounting Standards Board, which is responsible for setting standards on traditional financial reporting. 

As the SEC and the IFRS explore setting new climate reporting standards, investors would rejoice if they could coordinate with each other and align their reporting requirements. Instead of trying to reinvent the wheel, they could even unite behind SASB. This move would be similar to the SEC’s selection of the Financial Accounting Standards Board (FASB) when they looked to make financial reporting more decision-useful in 1973. 

The bottom line
Climate is a global problem that deserves one lexicon and one global set of disclosure standards. Securities regulators recognize the urgency for companies and investors to address climate change. As the ultimate arbiters of the metrics that companies must report, these regulators clearly agree that you can’t manage what you don’t measure.

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