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Imagine an investor trying to compare the outlook of a global energy conglomerate and a North American refining company amid an energy-price shock created by the Ukraine war.
The immediate conclusion might be that both companies experience volatility amid spikes in energy prices. But each will have its own share-price fluctuation, given changes in the price and demand landscape for its particular type of fuel.
And, of course, longer trends have their own effects — for example, as renewable energy gets less expensive and becomes a valid alternative to fossil-fuel sources.
In this way, a bout of share-price volatility hitting markets is a natural experiment to show how markets will be pressured over time by climate change as companies and governments seek to decarbonize while reducing their exposure to energy imports.
For an investor trying to choose among companies — particularly as the world moves toward a host of net-zero targets and international climate accords — she needs stronger disclosures. The types of disclosures typically released by companies today can read like marketing brochures, with lots of non-standard information topped by public-relations spin.
Companies that aren’t legally bound to report standard emissions information may disclose hopeful initiatives in renewable energy or tout green credentials, but they are not mandated to report emissions in a standard and comparable way.
Proposed SEC rule
And that’s why the disclosure of companies’ overall dependence on fossil fuels — which would be mandated by a newly proposed Securities and Exchange Commission rule — would be a game changer.
The rule would require disclosure of three metrics related to fossil fuel impact: Scope 1 emissions, which refer to direct emissions; Scope 2, which encompasses indirect emissions such as energy used in manufacturing or production; and Scope 3, which are emissions from a company’s supply chain.
Scope 3 emissions may be considerable for many companies and seem beyond their control, but they are in fact often able to make choices on where they source products, how they are delivered, etc.
Many business models are based on distant, cheap labor or natural resources without real concern if it’s wildly inefficient from a fossil-fuel perspective. That’s made it too easy for even well-intended investors to overlook the future consequences of how businesses operate, especially as the world tries to meet climate commitments such as the Paris Accord through regulation, carbon pricing and so on.
If a company’s profitability is dependent on a heavy-emissions supply chain, and without it profits would sink, investors must be provided with that insight. Companies that don’t want to expose their true fossil-fuel reliance are hiding enormous risks.
What’s an investor to do
For now, the best that most investors can do is attempt to create their own calculus to determine how much the global and diversified nature of a company might insulate it to the energy transition, at least relative to the example above of the North American pure-play oil refiner. Or an investor can imagine a corporation’s sheer size may mean it will be that much harder to turn the ship away from fossil fuels.
Climate change will imperil $11 trillion in assets in the next three decades, according to the United Nations Environment Program Finance Initiative. And from our own statistical analysis of the S&P 500
SPX,
we found 23% of publicly traded companies’ investor returns are still optimized to a “business as usual” energy pathway. As the world decarbonizes to meet the agreements signed by governments and net-zero commitments made by companies, these companies’ share prices will be under pressure.
Some data firms have attempted to aggregate all of the publicly available information related to companies’ carbon footprint and transition efforts. But, as always, it can be garbage in, garbage out. If companies are not mandated to report in comparable ways, expect a high “greenwashing” coefficient in that data.
That’s why the SEC’s proposal is a big deal.
A higher-stakes game
Yet it might not have seemed that way. Amid the 84-minute SEC meeting last month announcing the rule, a discussion dominated by talk of perilous temperature increases, greenhouse gas emissions and corporate profit risk turned to … recipes. It was SEC Commissioner Hester Peirce analogizing how companies are going to have difficulty moving from voluntary climate disclosures to a legally binding and standardized approach.
“I liken the rule to cooking,” Peirce said. “When I follow a recipe, I pick and choose which aspects to follow based on how much time I have, how ambitious I’m feeling and which ingredients I have on hand.”
If Peirce, a Republican appointee, were a chef and told she “had to prepare the same recipe in a Michelin-starred restaurant for a table of eminent food critics, my stress level would rise considerably,” she said. “For all those companies that have been making voluntary disclosures, the mandatory version we’re introducing them to today is a much higher-stakes game.”
We agree with Pierce on one thing: this is indeed a very high-stakes game. Given the existential threat we face from climate change — whole species, cities and nations hang in the balance, never mind trillions in investor dollars — we’re surprised anyone would want casual cooks in the kitchen, picking and choosing which aspects of climate impact they want to report.
Detractors are misreading not just the risk to the planet. They also don’t seem to grasp the growing and immense risk to corporate profits and investor returns. This is one that should unite tree-huggers and pure capitalists among us.
To begin to comprehend the scope of the impact, it’s helpful to remember that every company uses energy. Fossil fuel use is so pervasive that we are like fish who do not know they are wet.
Climate change risk is already, by definition, material, and protecting investors from huge potential losses is utterly in the purview of the agency charged with safeguarding and regulating the securities markets.
Following in the steps of Germany, the UK, Japan
Such changes are not new to economic systems. Regulators in Germany, the UK, Japan, South Korea and Singapore, among others, have mandated corporate climate disclosure. The SEC proposal would be phased in over several years. As SEC Chairman Gary Gensler put it, “Companies and investors alike would benefit from the clear rules of the road.”
Disclosures of larger companies would be subject to audit. Other reporting requirements to be applauded include information on risks that climate poses to short-, medium- and long-term financial performance. This will likely require scenario analysis, something that has long been imagined by the Task Force on Climate-Related Financial Disclosures, a consortium of some 32 members selected by the Financial Stability Board to represent affected industries and investors across a broad swath of the G-20.
Given the complexity of capturing the interrelatedness of the climate and the economy — both such complicated systems that most quantitative analysis needs to use a system-dynamics approach to even imagine how changes in one will impact the other — will be critical to plotting the path forward.
The SEC’s climate disclosure recipe may not be perfect yet, and the ingredients may need to be adjusted. But if the goal is to protect investors while companies thrive and the planet survives, the SEC’s menu is particularly appealing.
Thomas H. Stoner Jr. is co-founder and CEO of Entelligent, a climate analytics and investment data firm. Pooja Khosla is the company’s executive vice president of client and product development.
