What exactly is the SEC's latest climate risk proposal?

The United State SEC unveils its climate risk proposal

The United State SEC unveils its climate risk proposal

On March 21, 2022, U.S. Securities and Exchange Commission (SEC) unveiled its highly anticipated climate risk proposal. The move, which is hailed by various climate-focused organizations and financial groups as a welcome step, would require publicly traded companies to actively disclose and apprise investors of the risks posed by climate change.

Under the proposal, companies would now be required to report the following:

  • Direct and indirect greenhouse gas emissions, known as Scope 1 and 2 emissions, respectively, as well as the emissions generated by suppliers and partners, known as Scope 3 emissions, if material.

  • Transition risk, i.e. the risk attributed to a societal or regulatory shift towards a low-carbon and more sustainable future - would also need to be disclosed in the companies’ filings.

  • Climate Risk i.e., the risks they face from ‘climate-related events' such as floods, storms, droughts, landslides, extreme temperatures (like heat waves or freezes), and wildfires.

  • Any targets or goals the company has set as well as a description of the activities covered by the target(s), how the company plans to meet its target(s), and progress toward the goal(s)

  • A description of any scenario analysis used to evaluate the resilience of the registrant's strategy

“This is a watershed moment for investors and capital markets. The science is clear and alarming and the links to capital markets are clear and evident” said Commissioner Allison Herren Lee, one of three Democrats on the four-member commission who voted to support the draft rule.

According to the press release issued by the SEC, the proposed disclosures are similar to other broadly accepted disclosure frameworks, such as the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol.

Core elements of recommended climate-related financial disclosures. Source: TCFD

Core elements of recommended climate-related financial disclosures. Source: TCFD

The SEC proposal is a step in the right direction and it might just be the first step in averting a global financial crisis like the 2008 subprime mortgage situation.

The Subprime Mortgage Crisis

The roots of the 2008 subprime mortgage crisis can be traced back to the underestimation of risk of two financial products, mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs). These were complex structured financial products issued by banks that were backed by a pool of loans/other assets and sold to investors. These products were priced according to the risk associated with them, i.e. the risk associated with the mortgages/other assets that backed them up.

How risk measurement and valuation of an asset are intertwined?

The guiding principle of pricing assets is that, the riskier the asset, the lower its valuation, and the less risky an asset, the higher its valuation.

Risk Curve Source: Investopedia

Risk Curve Source: Investopedia

For example, in August 2017, Amazon issued bonds worth $16 billion to finance the takeover of Whole Foods. These bonds were to be paid back in 10 years and yielded an approximate return of 3.2%; which was lower than the ten-year bond yields of governments of Greece, Mexico, and Russia. In simpler terms, the market perceives it to be riskier to lend $16 billion to nations like Greece, Mexico, and Russia, as compared to Amazon.

Decoding the crisis

The lower federal fund rates in the US in the early 2000s, intended to help provide more money to businesses, ended up triggering an upward spiral in the housing market as buying houses became cheaper due to the lower interest rates on loans. This meant that subprime or high-risk borrowers, with poor or no credit history, were now able to become homeowners.

It was not before long, that a huge secondary market for originating and distributing subprime loans emerged. Soon, CDOs and MBSs containing these high risk subprime loans started gaining popularity. The banks however, undervalued the risk associated with these loans leading to underpricing of the underlying financial products.

To worsen the situation even further, insurance companies started selling insurance on these investments, safeguarding people against defaults (failure of repayment) (as was the case with AIG).

Eventually, however, the interest rates started to rise and homeownership in the US saturated, causing prices in the housing market to plummet. This essentially meant that homeowners were left with houses that they could no longer afford to cause a rise in default rates among these loans. This initiated a domino effect that caused monumental repercussions in the entire global financial system and the insurance market.

Can 2008 subprime mortgage crisis be traced to gross risk underestimation? ©BSA, 2022

Can 2008 subprime mortgage crisis be traced to gross risk underestimation? ©BSA, 2022

The banking and insurance system completely failed due to the epidemic failure of these institutions to accurately measure risk which led to the eventual underpricing of the financial products. The bottom line for the failure of the global banking and insurance industry boils down to the enormous information asymmetry that existed in the entire interlinked ecosystem.

Can climate change cause a global financial crisis?

Globally, we are observing a marked amplification in the past few years with climate-related disasters intensifying significantly. Undoubtedly, as global temperatures rise, the occurrence and potency of extreme climatic events like floods, fires, droughts, etc. have also increased.

These disasters are having direct as well as indirect impacts on businesses. According to a 2018 Center for Disaster Philanthropy report215 of the world's 500 largest companies risk losing an estimated one trillion dollars within five years from the impacts of climate events, unless action is taken.

The increased intensity of the effects of climate change in recent years and their increased overall impact has resulted in the conversion of climate risk from non-systemic risks into systemic risks that can stress entire local economies and—more grimly—cause market failures.

How the potential climate-induced financial crisis could play out ©BSA, 2022

How the potential climate-induced financial crisis could play out ©BSA, 2022

Hence, similar to the subprime mortgage crisis, the lack of disclosure practices in the ecosystem will have a significant impact on every global asset, and in turn, the value of those assets. This leads to the overall mispricing in the global economic markets making the need for an overarching monitoring system and efficient disclosure practices extremely urgent.

To date, however, climate or environmental data has never been part of the global markets. Players of a financial ecosystem like bankers or investors have rarely incorporated any environmental data in their financial modeling sheets.

The insufficiency of existing disclosure practices is evident from the fact that 93% of institutional investors claim that markets haven't accurately priced climate-related financial risks. Major investors and companies from BlackRock to Walmart have called for mandatory climate risk disclosure.

If we view the current situation in the light of the 2008 Subprime Mortgage crisis, in order to stop a global economic collapse, there is an urgent need to add transparency to the entire market and deep dive into climate signals to prepare our companies, economies, financial models, against similar or even significantly greater climate risk.

Disclosure proposals - a welcome first step! But where is the data and infrastructure to support that?

Having drawn the parallels between the 2008 subprime mortgage crisis and the potential climate-induced global crisis, the recent impetus on disclosure practices is bound to serve as a first step in the long road towards averting an impending global crisis. The SEC climate risk proposal and initiatives like TCFD will invariably allow companies to become more transparent and would initiate the journey toward the much-needed convergence and harmonization of climate reporting standards. With clarity on the direction of the SEC's rulemaking, now is the time for companies to take the necessary steps to treat the calculation of their carbon footprint and climate strategies with the same rigor as their financial disclosures.

However, these disclosure regulations and efforts need to be supplemented by innovation and development in our data capabilities to efficiently satisfy corporate needs and ensure their successful implementation. Global modeling agencies, companies, and research institutes, currently have a long way to go to be able to achieve the level of efficiency and accuracy that we need today for the estimation and quantification of climate risks for various assets.

There is substantial work required in the form of technological innovation, system optimizations, and data modeling & processing, before climate and environmental data of apt quality can be provided to different companies across the world.

More than 40 different parameters and earth signals contribute to building a comprehensive understanding and quantification of climate risk ©BSA, 2022

More than 40 different parameters and earth signals contribute to building a comprehensive understanding and quantification of climate risk ©BSA, 2022

The Climate Data market is in a very nascent stage, almost like the internet market in the 90s or early 2000s. It is not an easy task to provide climate data at the resolution required to be actually able to do the climate-based financial disclosure as advocated by groups like TCFD or as expected by SEC. There is still significant time, effort, and investment required to facilitate the technology development that can then build those environmental and climate datasets to provide to companies and organizations. However, finally, stacking up both the demand and supply sides of the market would accelerate the development, innovation, and much-needed investment in this market.

Accordingly, let's work together to simplify this complexity, measure carbon footprint accurately and reliably to comply with the SEC rules, ease disclosures to your diverse stakeholders, and stay ahead of additional changes in regulations and standards!