Author: Andrés Larios, Graphics: Walton Bullard
The BRB Bottomline:
With the SEC’s new climate disclosure rule forcing all public companies to release their climate emissions data, green companies will be rewarded with growing investment rates.
With the growing popularity of green movements in every facet of society, the Securities and Exchange Commission (SEC) is looking to launch the largest green financial initiative in history. They plan on implementing a new climate disclosure rule that will require all public companies to disclose their climate data. If the rule is adopted, it will bring about large pivots in global equity portfolio management and alter the market landscape for many industries.
The New Role of the SEC
It seems almost unusual for profit-maximizing private businesses—especially those that thrive most in global markets—to practice active environmental conservation. However, with an intensifying climate crisis and piling evidence suggesting that drastic changes are needed to save the planet, consumer pressure for businesses to correct their poor environmental practices has mounted to an all-time high. The new proposed climate rule came as a response to demands from multiple activist groups for the SEC to increase transparency about the business-related risks of climate change. This new rule would require publicly traded companies listed on U.S. exchanges to release comprehensive information about their emissions, climate change plans, and the impact of climate change on their finances.
The SEC’s proposal is complex and has several components; it calls for various disclosures related to climate risks to be released by publicly traded companies. Those disclosures are categorized into four sections: corporate governance, climate risks, greenhouse gas emissions, and financial statement metrics. By making this new information available for investors to base their decisions on, the SEC believes they will be forging more sustainable markets. Firms that have higher returns per unit of risk will be promoted, meaning that more transparent and efficient companies will see higher rates of investment. In essence, investors will now know which firms prioritize environmentalism throughout the different stages of their production processes, providing them with a useful framework to guide their decision-making process. This disclosure marks the beginning of a rise in the incorporation of environmental, social, and governance (ESG) ratings into the American financial landscape. ESG ratings measure how active companies are in furthering social practices rather than just maximizing profits and are becoming an increasingly important financial indicator for investors.
Yet, with this new disclosure, proponents of free-market capitalism are calling for the SEC to re-evaluate its approach to tackling climate risks. The primary role of the SEC is to enforce the United States’ securities laws and prevent market manipulation so that investors are on a level playing field. However, its new initiative casted doubts on their supposed mission. In fact, in a statement released by former SEC Commissioner Hester Peirce, she declared her opposition to the new climate rule and the perceived shift in the SEC’s priorities. Peirce—who disagreed with the interventionist nature of this new climate rule—feared that it may drive a sharp decrease in market activity and thereby hurt the economy.
While Commissioner Peirce raises legitimate points, she neglects to mention the lack of climate transparency put forward by public companies on their own volition, as well as the relative ease with which many of these firms use climate virtue-signaling to maintain a facade of environmentalism. Companies often opt for media campaigns rather than conducting more expensive, actual research and development (R&D) to improve business practices—while maintaining a facade of climate consciousness. Therefore, while the SEC’s policy may slightly overstretch the scope of their mission, it’s also a necessary push to make businesses practice active environmentalism. Furthermore, the SEC’s proposed rule would incentivize companies to embrace environmentally-friendly business practices by mandating just a simple report. In no way does the rule explicitly force private corporations to change their actual practices; it simply allows for consumers to see which businesses are enacting meaningful change in their production process. Consumers would then invest in those businesses, effectively aligning the private interests of corporations with what used to be completely disconnected environmentalist interests.
Moreover, this new rule is more consistent with the SEC’s ethos than it might appear at face value. It allows the SEC to tackle the issue of asymmetric information, a problem stemming from transactions in which one party has more information than the other. Here, the SEC specifically aims to balance the knowledge of public investors with the non-public knowledge of the operations of private firms—effectively symmetrizing the spread of information. While the proposed rule isn’t perfect and may require revision by climate specialists and input from the firms that it affects, it is still a step in the right direction to fight climate change with better economic practices.
Measuring Emissions to Minimize Externalities
The SEC believes that the best way to measure the effects of a company on the environment is to measure all the emissions released throughout the production process. So how do they plan on quantifying emissions? The SEC plans to use the Greenhouse Gas Protocol’s Corporate Standard for Scope 3 emissions, which measures the quantity of seven greenhouse gasses from a company’s assets’ electricity, cooling, steam, and heat. This protocol uses three scopes; however, per the proposed new rule, all public companies will only have to report the results of the first two scopes as part of their emissions reports to the SEC.
Only specific industries (notably gas and oil) and companies with concrete and public greenhouse gas emissions goals will have to release data regarding the third scope, which essentially measures the carbon footprint of every part of a company’s supply chain up to when an asset has been leased or a good consumed. Scope 3 emissions are already used by more than 90% of Fortune 500 companies, highlighting the relative ease with which already established companies would be able to transition into this newly proposed protocol. While production processes would need restructuring to adjust to new stock market expectations, the rapid popularization of ESG ratings among consumers would accelerate this process within most, if not all, American industries.
The purpose of ESG ratings is to benefit firms making considerable efforts to sustainably manage the company’s assets and capital through environmentally sustainable business practices. Instead of solely crunching the numbers on companies’ income statements, ESG ratings compound a company’s genuine social efforts with their profit-maximizing activities. Therefore, while a higher ESG rating does not necessarily associate with excellent financial performances by a firm, the rating fulfills two primary purposes: reducing negative externalities stemming from asymmetric information and providing better returns per unit of risk for investors.
New Rules, Different Results?
At its current rate of growth, the United States’ real GDP is projected to increase at high rates every year; however, those projections don’t take into account the growing threat of climate damages. However, if the new SEC rule passes, global economies are expected to edge closer to decarbonization, albeit after suffering a short-term blow due to mass operational restructuring. With the imposition of this rule, the economy would have significant net growth and sustainability in the long run, enabling the world’s resources to be used more efficiently and thus allowing for greater profits over a long time horizon. This distinction is very important in weighing whether or not the SEC is making the right decision in proposing its new rule. The formalization of ESG ratings within domestic markets surely bodes well for projected GDP growth in the coming years, which will hold steady with new technology and practices being used by companies. In summary, the long-run benefits of the SEC’s initiative outweigh the short-run costs as seen in Figure 3, especially when considering the hidden costs of climate damages.
The SEC’s proposed legislation would bring many positive long-term benefits to the global economy by minimizing climate damages from essential industries and improving business practices within publicly traded companies. But, what role do investors play in contributing to this change?
Investors are entities who typically have their assets vested in equities but also in alternative securities such as bonds, options, and mutual funds. Their main goal is to expand the value of their portfolios by intelligently investing in assets that appreciate in value. Critically, that often translates to equities of firms or industries with high growth potential. If investors shift their portfolios towards more ESG-oriented investments, Deloitte’s Economic Institute predicts the economy’s growth will at first stagnate for around two decades; however, there will be a turning point where decarbonization technology will reduce climate damage and improve efficiency. While most investors are not yet profiling their investments based on ESG ratings, the SEC’s new rule would propel mass adoption of environmentally-conscious investing, especially since around 50% of investors are currently open to this idea.
To reach this turning point as soon as possible, firms must figure out how to streamline the process of moving towards decarbonization, as well as the best ways to minimize climate damages within their own operations. Cooperation between existing companies, in conjunction with rising industries dedicated to enabling legitimate ESG practices are to be expected in the transitional period between the SEC’s ruling becoming official and economic activity getting back on track. We should consider the temporarily lower rates of GDP growth in the effort for decarbonization and reduction of emissions as a necessary cost to secure our future on this planet. Alternatively, if firms do not take active conservationist efforts, we can expect increased climate-related damages that would present much more significant problems than simply whether or not we have a strong economy for a few years.
Policy Considerations
During the early 2010s, cap and trade policies—implemented in an attempt to limit overall pollution within an industry by allowing companies to trade for higher pollution caps—were promoted by governments and private industries alike as a way to cooperate to reduce carbon emissions. In theory, cap and trade policies internalized the externality of pollution, and introduced environmentalism into firms’ private interests. Almost a decade later, these policies have fallen out of favor with legislators as firms can too easily manipulate standards within their respective industries, yielding poor emissions results.
By contrast, the new SEC rule is a positive start to enacting green change that actually favors the American economy. In the past decades, climate disasters have cost the U.S. billions (Figure 5); while public infrastructure and local governments are usually the most affected by climate disasters, American industries have already lost billions and are expected to lose more than $500 billion from climate-related costs if climate change is left unchecked. The new rule, however, will help mitigate climate-related disasters and the associated costs to supply chains in the American economy by removing the need to continuously renovate both public and private infrastructure.
The current proposed SEC rule will effectively place an implicit cost on emissions by disincentivizing investment in high-polluting firms. As a result, more ESG-friendly firms will gain traction globally as the market value of highly-rated firms will be raised relative to that of pollutant firms.
But, there should also be further policies enacted by the government to help continue these climate-related efforts. The SEC’s new proposed policy does a good job in preventing future climate hazards, but communities affected by past disasters should be helped up to their feet so that they can continue pumping money into the economy. Government revenue redirected towards the aid of afflicted communities would be one fiscal solution to help communities revitalize their businesses and regain their purchasing power. On the supply-side, subsidizing firms conducting R&D regarding reducing greenhouse gas emissions would accelerate the rate at which the turning point comes for decarbonized economic growth.
Furthermore, the role that entities of centralized power ought to play in this process should not be underestimated by economists. For one, state and federal governments must work together to eradicate overlapping policies where similarities or total contrasts cause confusion as to how to tackle the climate crisis at the local level. Secondly, investing in sustainable infrastructure resilient to climate disasters will sustain ESG goods and services in the long run. By investing heavily in infrastructure, the public sector will be aiding in the effort started by the SEC to minimize additional costs related to climate damages. In terms of monetary policy, the Federal Reserve must also consider the aggressiveness with which the United States transitions into greener practices. Aggressive shifts will cause extreme supply shocks that will negatively impact current capital stocks, labor markets, and supply chain networks—causing the Fed to have to choose between optimizing inflation rates and output fluctuations. These are just some of the considerations government entities have to keep in mind as we transition into a zero-emissions economy.
This new SEC rule presents public companies with the opportunity to transition into environmentally friendly business practices without being left behind by profit-maximizing (and polluting) firms. Should the proposed rule be enacted, the first financial framework for constructing a decarbonized economy would be created by prioritizing ESG investing in American exchanges. For this rule to achieve its intended outcome, it cannot act alone, as its success is largely contingent upon complementary policies to push for continued climate action. Even so, by making the environment a priority in American markets, sustained economic growth and innovation through green technology R&D would lead to a reduction in climate disasters and a slowing down of global warming. The SEC’s new policy may only be a disclosure at this point, but it has the potential to make the environmental movement mainstream by emphasizing climate action through investment and monetary incentives.
Appendix
Figure 1: Graph depicting energy consumption ranked by carbon intensity of electricity consumed.
Figure 2: Different data types for measuring scope 1 & 2 emissions.
Figure 3: Different GDP growth trends with or without decarbonization.
Figure 4: Expected GDP growth with and without decarbonization.
Figure 5: Graph depicting number of American climate-related disasters and their costs in billions over the past four decades.
Figure 6: Graphic displaying the different climate scenarios for different rates of corrective transition.
Take-Home Points
- New SEC Climate Disclosure would require all publicly traded companies to release emissions and climate change data.
- Although debate has ensued regarding the necessity for this rule, emissions data is pivotal for tracking asymmetric information.
- The predicted effects of this disclosure agreement would lower GDP in the short run due to industrial reorganization.
- Long-run benefits, aided by good policy by other institutions, would aid global industries and our environment as climate-related costs fall.
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