If you have not yet seen SEC Commissioner Allison Herren Lee’s speech delivered last week to the PLI’s annual Institute on Securities Litigation, you should take a few minutes and read what she had to say. In her November 5, 2020 speech, which can be found here, Lee warns that climate change represents a “systemic risk” to markets, the financial system, and our economy. After noting that climate change presents an even greater risk of “grave human and economic costs” than we experienced in the pandemic — and urging that we should learn the lessons that the pandemic presents — she calls for a coordinated effort to create uniform climate change reporting and disclosure standards to ensure that investors and markets are better informed about the risks that climate change represents.
Lee opened her speech by noting that as a result of the pandemic, we now know “what a crisis feels like,” and what it feels like when seemingly theoretical risks become real. One “real risk” that “looms even larger” than the pandemic is climate change. The lesson from the pandemic is “not to wait in the face of a known threat.” Specifically, “we should not wait for climate change” to make its way from scientific research and news reports to the point that it is affecting our daily lives; rather, we should “come together now to focus on solutions,” particularly given that science “tells us that the need to act is urgent.”
The SEC’s role with respect to climate change, she says, is not substantive policymaking, but rather “to ensure that [the agency] work(s) with fellow regulators to understand and, where appropriate, address systemic risks to our economy posed by climate change.”
In order to assess the systemic risk that climate change represents, we all need “complete, accurate, and reliable information about those risks.” The provision of this type of information “starts with public company disclosure and financial firm reporting,” so that investors can “protect their investments and drive capital toward meeting their goals of a sustainable economy.” She added further that the agency should consider its regulatory mission “more broadly,” including the agency’s oversight of funds and their advisers, credit rating agencies and accounting standards.
In order to assess what specific steps the Commission might take, Lee first summarized what she called “a growing consensus that climate change may present a systemic risk to financial markets.” Among other things, climate change presents the risk of “shock amplification,” because in many instances “climate risks are currently underpriced,” particularly with respect to long-dated assets, utilities, commercial mortgage-backed securities, and municipal bonds. Underpricing, she notes, can lead to abrupt and disruptive re-pricing as markets discover the anomalies.
Climate Change also presents systemic risk because of the possibility that the impacts of climate change could spread through financial markets and the economy in unexpected ways, particularly given that climate risk is “unique in terms of scope, breadth, and complexity.” Climate risk could interact with non-climate related risks and vulnerabilities – such as historically high levels of corporate leverage and the effects of the COVID-19 pandemic – to further magnify the vulnerabilities. Even further increasing the likelihood that climate change effects could lead to an “overall shock to the global economy with systemic implications” is the fact that “climate change, unlike other types of risk, is potential irreversible in terms of the damage it can cause.”
These factors, Lee said, “creates an imperative for the SEC to focus on climate change risk as systemic risk,” and to coordinate with other regulators “to monitor and address this risk.” The place to start, she said, is with data. Policy should proceed from a “foundation and clear-eyed analysis of accurate, reliable data.” This need, which applies to policymakers and investors alike, is “borne out by the extraordinary demand we see in the market for climate-change disclosure,” as well as for other types of ESG disclosure.” Businesses, she noted, now “actively compete for capital based on ESG performance.”
In order for that competition to be “open, fair and transparent,” ESG disclosure needs to be “uniform, consistent, and reliable.” The Commission, she said, should “work with market participants toward a disclosure regime specifically tailored to ensure that financial institutions produce standardized, comparable and reliable exposure to climate risk.” Regulatory involvement is needed, she said, “to achieve standardized, comparable, and reliable disclosure in this critical area.” Implementing regulatory action in order to develop standardized disclosures represents a challenge, she said, and the agency must ensure that the brings the right personnel and resources to bear on this project.
Beyond disclosure from companies and those who finance them, there are additional areas that, according to Lee, merit the SEC’s attention with respect to climate and other ESG factors. For example, mutual funds and their advisers promote and pursue “green,” sustainable, or ESG-focused strategies, but the funds’ disclosure should be clear about what they mean when they use these terms to describe their strategies. Standardized disclosure from issuers on ESG matters could facilitate clearer and more consistent disclosure from funds. If issuers’ disclosures are uniform, funds could more easily and directly disclose how they use that information. The SEC might also consider rules that would “require advisers to maintain and implement policies and procedures governing their approach to ESG investment.”
The SEC could also consider encouraging greater transparency from credit rating agencies on how ESG factors affect their ratings, and also consider ways in which climate change risks need to be reflected within financial statements.
Lee concluded by noting, with reference to the pandemic, that “we have all recently witnessed in real time the market consequences of waiting until a crisis is upon us to respond.” We need not “suffer those consequences when it comes to climate change and ESG if we move thoughtfully and quickly.”
There arguably is nothing new in Lee’s speech. For me, what is important about her speech is the extent to which she has made it clear that for her at least climate change disclosure issues are not only a priority, but that climate change disclosure issues need to be addressed with urgency. Lee’s emphasis on the fact that climate change represents a systemic risk fraught with “grave” dangers underscores the fact that addressing climate change issues is a critical objective that cannot be delayed.
Joe Biden’s election as President means, among many other things, that Mr. Biden will have the opportunity to appoint a new SEC Chair. The presence of a Biden appointee as the agency’s Chair increases the likelihood that Lee’s climate change disclosure agenda could gain traction. UPDATE: Knowledgeable readers have pointed out to me that current SEC Chair Jay Clayton’s term runs until June 2021, and he could serve in the role until that time unless he withdraws or resigns prior to that.
Lee’s comments clearly have important implications for reporting companies. The emphasis in her speech was on the need for the Commission to promulgate standards ensuring uniform reporting, but the necessary corollary of that is that reporting companies will need to be prepared to up their climate change reporting game. There is a long list of items companies will have to consider, such as the vulnerability to company facilities and supply change to climate events and changing climate conditions; the prospect that current assets (such as, for example, undeveloped energy properties or gasoline-engine vehicles) could be “stranded” by changing market or social priorities; and the possibilities that changed regulatory requirements could affect operations and financial results. Climate change-related disclosure has been an issue for years, but it has also been somewhere in the background for most companies. Lee’s speech represents something of a declaration that climate change disclosure needs to move from the background to the forefront.
One particularly important aspect of Lee’s speech is her emphasis on the fact that in order for climate change disclosure – and indeed all ESG disclosure – to be meaningful, disclosure requirements need to be standardized. A November 6, 2020 Law360 article about Lee’s speech (here) quotes Stanford Law Professor Joseph Grundfest as saying that “ESG investing is obviously one of the most important investing themes in the market today …But what precisely does ‘ESG’ mean or measure? Anything that the commission can do to add a rational and efficient degree of consistency and transparency to the process is surely to be welcomed.”
I for one am glad that Commissioner Lee has chosen to try to make climate change disclosure a priority. There is no doubt that there are immediate issues that seemingly loom larger – we are in fact in the midst of the worst public health crisis in more than a century, and we just finished a bitter, divisive Presidential election. Racial justice and diversity, international relations, immigration, trade, many other issues demand our immediate attention. Climate change is a longer-term issue, but it is no less important than the issues that predominate on a day-to-day basis. Lee titled her speech “Playing for the Long Game,” which is just right for me, because in the long run the long game matters.