Climate Change: The New Kid on the Block

information to make informed judgments about the financial condition of companies. This includes events that create possible future obligations based on the outcome of current events where it is not known with certainty whether the outcome will create a liability for a company.

For years now, a debate has been held between the SEC and business community about the reporting of events related to corporate social responsibility (CSR). The SEC has examined the potential economic effects of mandated disclosure and reporting standards for CSR, environmental, social, and governance (ESG) criteria and sustainability. There is no agreement about mandated disclosures. However, there are some important points to make that argue for disclosures in the annual report  

ESG are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.

On June 14, 2021, the SEC issued a statement evaluating the potential economic consequences of a requirement for sustainability reporting for U.S. SEC-registered firms, including effects in capital markets, on stakeholders other than investors, and on firm behavior. The SEC statement addresses the costs of not disclosing information about ESG.

The critics of ESG disclosure requirements often point to the costs associated with preparing the disclosures. Consideration of such costs is important, as is getting clear about their causes. But just as important is the recognition of the costs associated with not having ESG disclosure requirements. For investors, despite an abundance of ESG data, there is often a lack of consistent, comparable, and reliable ESG information available upon which to make informed investment and voting decisions.

Investments are being held back in the absence of that information. The status quo is costly for companies, and increasingly so over time. Companies face higher costs in responding to investor demand for ESG information because there is no consensus ESG disclosure system. Rather, they are faced with numerous, conflicting and frequently redundant requests for different information about the same topics. These higher costs can be particularly burdensome for smaller and more capital constrained companies, and yet if these companies do not provide ESG disclosures, they risk higher costs of capital.

The SEC is also looking at whether ESG disclosures should be mandatory or voluntary. The SEC’s existing system contains some mandatory ESG disclosure requirements (e.g., disclosure of how a company’s board considers diversity in identifying director nominees). It permits significant differences in how companies respond to a variety of “mandatory” requirements, including in many cases disclosing items if and only if they are material. The system contains “comply or explain” requirements (e.g., if a company does not have an audit committee financial expert, it can explain why, and where the ability to explain makes the requirement less than rigidly mandatory and for some companies potentially more informative).

Finally, companies generally are mandated to make disclosures as needed to prevent other disclosures from being materially misleading. As companies continue to disclose more in sustainability reports, they should already be evaluating those disclosures considering existing anti-fraud obligations.

ESG disclosures may take on a new look if recent proposals to disclose information about climate change are adopted by the SEC. Investors are increasingly pressuring businesses to disclose the emissions of greenhouse gases related to their products and services. Within the next couple of years, every public company in the U.S. might well be required to report climate information.

Regulators also want better disclosure of climate-related risks for public companies. These can range from physical ones such as effects from extreme weather to financial risks such as if a fossil-fuel asset like a coal mine loses value.

The demands from some investors for more and better climate-related information carry increasing weight as "green" financial products surge in popularity. Some $51 billion poured into sustainable U.S. mutual funds and exchange-traded funds last year, according to data provider Morningstar Inc.  That was almost 10 times the level of 2018 and represented nearly a quarter of the cash that went into all U.S. stock and bond funds last year, Morningstar said.

The SEC is working on a potential climate-disclosure regulation and has sought public comment. It has the backing of the White House, which has called for drastic cuts in greenhouse-gas emissions. Countries in Europe already require that companies doing business there honor governments’ demands for climate disclosures.

One solution to the problem of what to disclose about ESG, including climate change data, is to require a CSR report in the annual report along with the financial statement report. The time has come to seriously consider this outcome to ensure that investors, creditors, and other users of financial statements have all the information they need, both present and future, to make informed judgments are where the company is headed and how its policies affect communities, the environment, and governance.

Posted by Dr. Steven Mintz, The Ethics Sage, on August 17, 2021. Steve is the author of Beyond Happiness and Meaning: Transforming Your Life Through Ethical Behavior. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.