Idea #25

Mandating Disclosure of Material Climate Risks and Mitigation Strategies

by Witold Henisz

According to the most recent National Climate Assessment of the United States government, the material impact on the US economy alone of inaction on climate change is over $500 billion, but this could be reduced to $220 billion if appropriate policies are implemented. Firms facing such a range of material risks from climate change and potential remediating policies should have to disclose those risks and their mitigation strategies in their publicly audited financial statements. Investors and creditors should incorporate that information in their analysis of future cash flows. While support for the recommendations of the Task Force for Climate-related Financial Disclosures (TCFD) continues to grow, voluntary compliance is leading to only partial and selective reporting. Without more data transparency, investors and creditors lack the information needed to assess laggards from leaders in their response to climate change risks.

To date, only France has codified disclosure of climate change risks into law with the European Union, actively assessing an update of its non-financial reporting directive to include the recommendations of the TCFD. An important policy-relevant and solution-oriented idea that could alter the current trajectory of emissions and improve our collective ability to adapt to that trajectory would be for the United States Securities and Exchange Commission and/or the New York Stock Exchange to mandate additional data disclosure for publicly traded companies on their sensitivity to climate change risks.

From 2012 to 2018, there has been a dramatic increase in the share of global assets under management that actively weight Environmental, Social and Governance (ESG) issues, with investment surging from $13.5 Trillion (21% of total global Assets Under Management) to $30.7 Trillion (39% of AUM). The share of executives, board-members and investment managers who perceive ESG issues to be material has doubled over the same time period (see here, here, here, and here). Numerous high profile convenings of business, financial, and public sector leaders[1] have also highlighted the need to take a longer-term perspective on corporate performance that recognizes the medium- to long-term risks generated by imposing environmental (and social) externalities on society as well as the long-term opportunity for business and society offered if business were to devote greater attention and resources to large societal challenges such as climate change. (Examples of such convenings include Focusing Capital on the Long Term, the Embankment Project of the Coalition for Inclusive Capitalism, the Sustainable and Responsible Investor Forum, the Bloomberg Sustainable Business Summit, and the Global Responsible Investing Forum.)

Numerous triggers and stimuli have fueled these trends. ESG issues—which have long motivated values-based investors, managers and employees—are increasingly perceived as impacting value (i.e., being material). Interest in ESG issues by asset owners and managers continues to climb, spurred on by high profile letters to investees by Black Rock, State Street and Vanguard as well as the rise of activist ESG hedge funds such as Jana Partners, Blue Harbour Group, Impactive and Apache Capital Management. Millennial investors, customers, and employees are also placing greater emphasis on ESG issues, as compared to preceding generations. Approximately half of millennials expect CEOs to speak out on issues such as air and water quality, renewable energy, climate change, sustainability, land conservation, among others. Millennials also say that they would reward such companies with greater loyalty as employees, greater purchasing as customers, and a greater share of their investment portfolios. More generally, the growing effects of climate change have triggered a reappraisal of corporate purpose and the role of business in society.

Yet, at the same time that financial and human capital turn their attention to ESG issues, executives, board-members and investment managers are growing less confident in the data that they have to evaluate such issues (see here and here). The weaknesses of scoring companies’ voluntary unaudited sustainability reports or their responses to exhaustive surveys are increasingly apparent (see here and here). ESG scores across proprietary data providers exhibit low inter-rater reliability and frequently omit, or incorporate with a lag, material environmental, social and governance factors. Academic and corporate research seeking evidence of the materiality of ESG factors using this data has been inconclusive.

Recent innovations in data and analytics have the promise to help demonstrate the materiality of ESG issues and the efficacy of management strategies to identify and mitigate risks as well as seize opportunities. ESG data providers are turning from voluntarily released corporate reports to myriad new sources of real-time information on stakeholder actions and statements in their efforts to rate companies and provide valuable signals on their idiosyncratic risks and opportunities to both active and passive investors. Data sources include media and social media monitoring; text analysis of speeches, press releases, and other public documents; corporate and individual political contributions; regulatory, administrative, and legal records; satellite photography; customer reviews of products; and employee reviews of employers. While academic research using these new data sources is generating promising evidence of an investor case for addressing ESG issues, data limitations remain the greatest impediment to amassing an evidentiary base that could contribute to a shift in behavior.

Were the US and EU to mandate such disclosure, investors and creditors would have comparable information on firms’ exposure and mitigation strategies to the material risks of climate change. Greater transparency in the magnitude of risks and opportunities would lead to improved allocation of financial and human capital seeking only financial returns as well as the growing pools of such capital seeking to contribute to climate risk mitigation and adaptation.

Witold (Vit) Henisz is the Deloitte & Touche Professor of Management in Honor of Russell E. Palmer, former Managing Director at The Wharton School, The University of Pennsylvania.