US investors brace for upcoming climate risk regulations

US regulators are expected to issue new sets of disclosure requirements around climate-related risks this year, as companies and investors ask for more guidance around how to incorporate sustainability into their practices. 

Over the past year, there has been an increased focus from regulators on how institutions manage their climate risk exposures internally. It all started with the current administration issuing an executive order on tackling the climate crisis early last year, leading to FSOC’s report that said climate change poses a risk to financial stability, and imposes significant costs on the US economy. 

At the SEC, Chair Gary Gensler recently announced that he’s been working closely with fellow Commissioners to “work out the details of a mandatory climate risk disclosure proposal for our capital markets”. 

Some key principles the SEC is taking into account are consistency, comparability, the depth of disclosures in terms of their quantitative and qualitative detail, and whether these disclosures should be filed in the 10K form that companies are already required to file. 

“I believe mandatory climate risk disclosure would represent significant progress – requiring companies to assess climate risks, collect and publicly disclose relevant metrics for the first time and giving investors information they’ve needed for years. It’s essential we get this right,” Gensler said.

US bank regulatory agencies have all signaled that they're going to start incorporating climate risk into their supervisory or oversight programs, and have an expectation that banks start incorporating climate-related financial risks into their existing risk management programs, said Tracy Basinger, senior advisor at investment firm Klaros Group and former head of supervision at the Federal Reserve Bank of San Francisco.  

“We're also seeing many of the larger institutions starting to hire climate experts or people with climate risk management expertise, and putting them in their risk management function, as opposed to in some sort of Corporate Social Responsibility group,” she told Tearsheet.

Companies aren’t likely to provide all of the relevant data without a government mandate, according to Brian Deese, the White House’s National Economic Council director, who previously led BlackRock’s sustainable investing business.

"Just because a risk is material and present doesn’t mean that the market left to its own devices is going to disclose that through voluntary disclosure," Deese said last month.

About 90% of S&P 500 companies publish voluntary reports disclosing statistics on things like carbon emissions and how much renewable energy they use, but content isn’t typically reviewed by regulators, according to WSJ. Only 16% report similar metrics in regulatory filings, according to S&P Global Sustainable.

Financial regulators globally have been developing various guides, regulations, and standards that focus on climate and environmental impacts. In the United Kingdom, firms will be required to disclose climate-related financial information starting in April 2022, while the European Union established reporting guidelines in 2019.

But in the US, adoption of such standards has been slower. The SEC released some guidance back in 2010 to encourage climate-related risk disclosures, but it didn’t manage to move the needle as there was no real accountability.

A common reporting standard for climate-related disclosures would benefit both markets and investors, who are beginning to express the need for enhanced guidance on addressing material sustainability issues.

Seventy-five investors with $4.7 trillion in assets under management sent a letter to the commissioners to the SEC to voice their mounting concerns about climate change and the systemic and material risk it poses on the wider economy. 

In the letter, investors explain why the anticipated climate change disclosure requirements must include verified Scope 1-3 value chain emissions reporting, with a particular emphasis on Scope 3 reporting.

Scope 3 emissions are the largest source of greenhouse gas emissions for most companies, including financial institutions, comprising the carbon footprints of activities from assets not owned or controlled by the reporting organization. These indirect emissions are part of a financial entity’s value chain and its most significant source of carbon footprint reduction. 

A lack of Scope 3 emissions disclosure requirements could result in the largest source of emissions remaining unaccounted for and unaddressed in company activities, investors said in the letter. This would in turn impact a wide variety of actors that rely on accurate and consistent emissions information including investors, banks, insurers, and policymakers. 

Nevertheless, enforcement of such standards is no easy feat. While investors may be eager for additional clarity, implementing additional rigor to a reporting process comes with challenges for a reporting company. 

A gradual implementation could give companies a transition period to adapt to potential new costs and operations, and also allow the SEC to refine its set of standards over time. Plus, larger companies would also need more time to adjust to a new reporting environment.

Another important factor is whether the SEC will decide to implement industry-specific disclosures or opt for a standardized set across all industries. While the former would provide more qualitative industry information, it lacks comparability across other industries. The watchdog could also implement both options in order to have a better understanding of the risks posed to the US economy. 

ESG

More regulation on climate risks is also expected to bring some more clarification in the ESG arena. While still relatively new, the ESG investment ecosystem is growing exponentially.

At the end of 2019, sustainable investing accounted for $17.1 trillion of the total US assets under professional management, according to a report by the US SIF Foundation - a 42 percent increase from the $12.0 trillion identified two years prior. This was a third of the $51.4 trillion in total US assets under professional management tracked by Cerulli Associates. 

But this sector is also proving tricky to navigate as there are no industry standards or methodologies as to what actually constitutes ESG. While there is no legally binding definition, the term refers to investment portfolios in which environmental, social, and governance factors are integrated into the investment process.

This lack of consistency has increased concerns around greenwashing and debates on what investments or financial operations should get the green stamp. 

There’s also a need for additional clarity on how to balance the three factors that constitute ESG. For example, a project could be environmentally friendly but have negative externalities on the local workforce as investors might opt to shift away from carbon-intensive businesses.

If ESG was lumped together initially, throughout 2020 there was a lot more focus on the social side of the equation in the US, according to Basinger. 

“In the conversations I’ve been a part of, we’ve separated the three ESG components and think about them differently, such as areas where the E and the S collide,” she said.

The FSOC report acknowledged that climate-related financial risks and any mitigations will likely disproportionately impact financially vulnerable populations, so striking the right balance will be a big issue going forward, according to Basinger.