Climate risk disclosure regulations are experiencing strong momentum globally, with US and European regulators expressing concerns about the quality of information available to environmental, social, and governance (ESG) investors.
The Rise of Sustainability Data
As ESG investing and climate change worries have grown, so too has the volume of ESG data in circulation. According to the Governance and Accountability Institute, just 20% of S&P 500 companies offered any sustainability reporting at the start of the last decade, compared to 90% today. In addition, the materiality of climate risk factors has become more widely accepted in financial reporting.
That said, standardization, consistency, and quality are ongoing global challenges in climate risk reporting. A recent report from the London-based Climate Disclosure Standards Board (CDSB), an international consortium of business and environmental NGOs, found that 78% of the largest European companies are not adequately reporting environmental and climate risks, despite EU guidelines.
In the US, the Securities and Exchange Commission (SEC) is considering new requirements for financial services firms to be able to label investment products as ESG or sustainable. The SEC recently invited comment on whether rules should be tightened, highlighting worries over “greenwashing” and whether fund names are reasonably aligned with their underlying investments. SEC commissioner Elad Roisman said firms should have to provide appropriate justification if they are using terms such as “green,” “ESG,” or “sustainable” in relation to their investment products. SEC chairman Jay Clayton also warned about the use of single ESG ratings, referring to them as “imprecise” by nature.
To learn more about investing in environmental sustainability, read Climate Change: Harnessing the Power of Public Capital Markets.
Europe’s Green Deal and the EU Taxonomy
The EU is effecting bold and ambitious plans to combat climate change. In December 2019, the European Commission (EC) unveiled its European Green Deal, embedding a legal commitment for the EU to achieve climate neutrality by 2050, as well as bolstering its climate change targets for the next decade. As these plans will require reliable and transparent climate reporting, the EC is currently considering measures to improve supervision of ESG ratings agencies.
A related measure, the EU Taxonomy was formally approved in June and will come into force later this year. It aims to educate investors to effectively direct capital toward sustainable activities. To enable the Green Deal’s sustainable economy reforms, the Taxonomy operates on six environmental objectives:
- Climate change mitigation.
- Climate change adaptation.
- Sustainable use and protection of water and marine resources.
- Transition to a circular economy for waste prevention and recycling.
- Pollution prevention and control.
- Protection and restoration of biodiversity and ecosystems.
As part of the Taxonomy, financial services firms active in the EU will need to report on how certain products measure up in terms of environmental sustainability. Coming under the regulation are investment products, pensions, and portfolio management, as well as insurance and investment advice. A comply-or-explain framework means such firms must disclose how their products align with regulation and how they do not.
Some 6,000 large firms across the EU will need to disclose in their annual accounts all revenue, capital, and operational costs that relate to sustainable activities. This is intended to give investors better information to effectively allocate capital to sustainable investments that are consistent with the EC’s climate change–mitigation goals. This applies to both nonfinancial and financial companies, including large listed companies, banks, and insurers.
The EU is also planning to introduce environmental labeling and standards to help investors evaluate financial products’ green credentials. Labels would help investors quickly understand how closely an investment product aligns with the Taxonomy.
Other New Climate Risk Disclosure Regulations
In July, the CDSB released new guidance for companies disclosing material climate-related information, while highlighting strong investor appetite for consistent, comparable, and reliable data. It seeks to align with other global standards, recommendations, and metrics, such as those from the Task Force on Climate-related Disclosures, the Global Reporting Initiative, the Sustainability Accounting Standards Board, and the CDP.
This summer, the Financial Stability Board (FSB), the international body that monitors and makes recommendations about the global financial system, pointed to significant variation in whether and to what degree financial authorities consider climate risks as part of their financial stability monitoring. An FSB survey found that three-quarters of financial authority respondents were considering or planning to consider climate-related risks as part of their monitoring, with most focusing on the implications of changes in asset prices and credit quality. According to the FSB, a minority of authorities were considering the implications for underwriting, legal, liability, and operational risks. The FSB pledged to progress further by October 2020 to assess the channels through which physical and transition climate risks could impact the financial system and how they might interact, including assessing available data and data gaps.
Investors’ increasing recognition of the materiality and impact of climate risks on long-term company performance may encourage publicly listed companies to put greater effort into reducing their carbon footprint. Regulators can help this process by working toward standardization and facilitating better quality data through appropriate climate risk disclosure regulations. This, in turn, could help asset managers quantify risks and opportunities in security analysis as they seek to maximize risk-adjusted returns.
How companies approach climate risk can have significant implications for shareholders and even impact their long-term viability; how regulators approach climate risk could have major repercussions for the entire financial system.