Climate risk disclosures must be transparent
On June 5, the finance ministers of the G7 nations met in London, and announced their unanimous support for “moving towards mandatory climate-related financial disclosures that provide consistent and decision-useful information for market participants.” This was more welcome news for the growing chorus of public officials, policymakers, scientists and private sector leaders who support climate-related financial regulations on public companies that require them to disclose their anticipated risks from worsening climate change to investors and the broader public. Such regulation now seems like a matter of when, not if.
While this will be an important milestone in the fight against climate change, it is also critical that any future regulations are implemented with scientific integrity at the forefront. If we want climate risk disclosures to be more than just symbolic gestures, financial institutions and regulators must require that the data, models and methodologies used to determine those risks be made public as well. Otherwise, this potentially important tool in the fight against climate change risks being useless, or worse.
Momentum for climate-related financial regulation has been building for months. Last year, in its groundbreaking report, Managing Climate Risk in the U.S. Financial System, the CFTC sounded the alarm that “escalating weather events also pose significant challenges to our financial system and our ability to maintain long-term economic growth.” In May, President Biden ordered his administration to model climate risk disclosure for the federal government. The Federal Reserve has joined the Network for Greening the Financial System, and in September, New York State issued new guidelines for companies to address the financial risks from climate change. And just recently, the Securities and Exchange Commission (SEC) requested input and announced intended rulemaking for climate-related disclosures.
This momentum comes at a critical time, as the reality of what’s at stake is no longer abstract. Extreme weather disasters currently cost tens of billions of dollars each year in the U.S. alone. In the case of an individual business, supply lines, physical infrastructure, their balance sheet, and their workforce may be at risk from storms, flood, wildfire, or excessive heat. Unfortunately, science tells us that these risks will continue to worsen until we stop adding greenhouse gases to the atmosphere, and even then it will not get better, but will merely stop getting worse.
The playbook for risk management in financial markets will have to be rewritten for climate change. With climate change, we must build our understanding of climate risk from scratch, using mathematical models and scenarios. Rather than ask whether a business has enough capital to weather a market downturn, we must look at appropriateness of business models to withstand the impacts of what is on the horizon.
The science for assessing increased physical climate risks is ready for widespread implementation. While there is always need for improvement, scientists today can model the rapidly evolving risks from perils like flood, wildfire, extreme heat and more, with unprecedented accuracy. New methods allow scientists to connect those perils to economic risks over the next few decades. Such modeling is already used in the financial industry to incorporate climate risks into asset valuations.
It is critical that risk disclosure be based upon transparent and publicly accessible models and data. Without this requirement, disclosures may be inaccurate, misleading, or impossible to interpret and compare between firms. As climate change worsens, investors may seek to offload assets where they know climate risks are underpriced, creating opportunities for malfeasance or fraud. Here, the SEC and others can make a meaningful contribution by requiring uniform and clear standards of disclosure.
Individuals and even corporations can, and generally do, insure against their idiosyncratic climate-related risks, but that is insufficient to meet the challenge at hand. Only with universal, standardized, disclosure does the full magnitude of the situation become apparent. Climate risk is ubiquitous, it is not feasible for investors to simply avoid risk; we must take action to reduce risk across the system.
We should have reacted decades ago to this threat. Because we did not, climate change is causing significant damage right now, and risks increase by the day. Good risk management and disclosure requirements are not a cure all, but they can serve as an important step to help investors and the public grasp what is at stake, and understand how businesses are preparing for a world where the climate is changing beyond anything we have ever experienced.
Dr. Philip Duffy is the president and executive director of the Woodwell Climate Research Center.
Robert Litterman is a founding partner of Kepos Capital and chairman of the Risk Committee.
Joseph Majkut is the director of Climate Policy at the Niskanen Center.