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What the SEC Climate Rule Means for Adaptation and Resilience

New requirements could spur more investment in climate-proofing, but don't go as far as they could have

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  • The US Securities and Exchange Commission (SEC) published its long-awaited climate risk disclosure rule for public companies yesterday (March 6)

  • The rule mandates disclosure of the material impact of physical climate risks on the companies’ strategies, business models, and outlooks

  • This information should drive investor appreciation of the value of adaptation and resilience (A&R) investment and stimulate A&R innovation

  • However, caveats and limitations in the rule may limit the usefulness of the physical risk data produced

  • Mandatory expenditure metrics shine a light on the costs of climate shocks, but not on the costs of building resilience

It took long enough.

Almost two years after it was first proposed, yesterday the US Securities and Exchange Commission (SEC) finally approved its climate risk disclosure rule for public companies.

To the chagrin of climate advocates, the final rule is less ambitious and prescriptive than the one proposed in 2022. Dominating headlines is the absence of a Scope 3 emissions disclosure mandate, meaning companies don’t have to report the planet-warming gases produced up and down their value chains. Smaller public companies also get a pass on disclosing their direct Scope 1 and 2 emissions.

But this is a publication about adaptation and resilience (A&R) finance, so what does the final rule have to say about climate physical risks and companies’ climate-proofing efforts?

The Basics

Despite many rowbacks, the bones of the SEC’s 2022 proposal remain. Under the final rule, public companies will have to produce disclosures on climate-related risks that materially impact, or are likely to have a material impact on, their business strategies, results, or financial conditions.

The data and insights this disclosure mandate yields could be a gamechanger for A&R. By shining a light on how climate shocks could rattle companies, investors will be able to pinpoint those organizations and industries crying out for A&R investment, and clarify what A&R technologies, products, and services make for sensible bets.

The enforced transparency should also accelerate A&R spending by companies themselves. With their climate exposures revealed for all the world to see, firms will inevitably come under pressure from investors to put money to work climate-proofing their operations and value chains. 

However, aspects of the final rule mean these disclosures may be less useful for A&R than they might have been. 

Materiality, too often, is in the eye of the beholder.

Dan Firger, Great Circle Capital Advisors

One factor likely to crimp their utility is the final rule’s materiality screen, which carries over from the proposal. This means companies only have to disclose actual or future climate-related risks if there is a “substantial likelihood” that an investor would consider the information important to its decision making. This threshold is important in the context of the SEC’s statutory authority, which limits its ability to compel disclosure to material issues. Still, it gives companies latitude to determine what they do and do not disclose.

“In theory, this should mean all physical risks, whether to direct assets/operations or across a registrants’ value chain, ought to be disclosed if they impact or could impact the registrant’s business,” says Dan Firger, founder of Great Circle Capital Advisors, a climate finance consultancy, and former sustainable finance lead at Bloomberg Philanthropies. “In practice, it’ll be up to companies in the first instance, and almost certainly courts, to police the boundaries. Materiality, too often, is in the eye of the beholder.”

The US suffered a record-breaking number of US$1bn-plus climate disasters in 2023. The frequency of costly weather extremes, from hurricanes to floods, may have conditioned investors to pay more attention to firms’ physical risk exposures. As a result, they may be more likely to consider these important for decision making.

Julie Gorte, Senior Vice President for Sustainable Investing at Impax Asset Management, says investors and investees often squabble over what’s material. Still, she expects the rule to increase physical risk reporting.

iStock / krblokhin

“The fact that physical risk reporting is still in this final rule, and that the commissioners discussed it at some length in the meeting, is noteworthy, and if there was a signal sent, I think it’s that the percentage of companies that could face material physical risk is probably larger than the proportion that face significant transition risk. I would hope that the companies with huge global daisy-chain value chains would see the handwriting on the wall with physical risk. I don’t necessarily expect it to happen overnight, but I would expect that we will see more reporting from those companies,” she says.

In addition, buried in the rule’s definition of climate transition risk is a line that could force companies to describe how climate adaptation efforts by governments and other entities could also imperil their businesses. The definition says transition risks include (emphasis added): “the actual or potential negative impacts … attributable to regulatory, technological, and market changes to address the mitigation of, or adaptation to, climate-related risks.”

Emilie Mazzacurati, co-founder of Tailwind Climate, says this means adaptation issues have to be referenced in the context of policy, market, and similar risk disclosures. “That’s a very important departure from the TCFD’s [Task Force on Climate-related Financial Disclosures]  precedent, which opens much more widely the scope of disclosures by including not just direct physical risks (whether on operations or supply chain) but also adaptation risk in a much broader sense. Changes to zoning law, to water rights, shifts in commodity prices or market conditions indirectly due to climate impacts will now need to be assessed and reported. This is a critical development to widen the lens of how corporations think about adaptation risk,” she says.

Data Granularity

The mountains of fresh physical risk data the rule produces should make investors more aware of climate shocks’ threat to companies. However, the quality and granularity of this data may leave something to be desired, and make the flow of A&R capital less efficient than it could be.

The final rule allows for discretion when it comes to describing material risks, meaning companies need only provide enough information for investors to gain “an understanding of the nature of the risk presented and the extent of the registrant’s exposure to the risk.” This means that unlike the 2022 proposal, the final rule does not require that companies provide ZIP code-level locational information on their physical risks. Instead, they can basically choose the level of geographic information disclosed, so long as it gives investors a decent level of understanding. 

The SEC may have concluded that since many companies are only just starting to gather asset-level and location-specific physical risk data, they would be overwhelmed by a ZIP code level mandate. Firger says that while asset-level data is the “holy grail”, it is hard for companies to get a hold of and cumbersome to report.

“It’s not a dealbreaker here as registrants still need to provide location data in a format that's decision-useful for investors. But it sure would have been nice to have the SEC set some common parameters for what counts as “decision useful” here,” he says.

Of course, the lack of a granularity threshold does provide an opening for companies to gloss over their physical risk exposures, and in turn mislead investors on their A&R needs.

However, Gorte thinks recalcitrant firms will be swiftly disciplined. “The market will judge how far is too far in stretching things; if you get, say, a hotel company that only reports on physical risk data continent by continent, you’ll see a relatively meaningless disclosure that they’re subject to all the possible hazards, chronic and acute, from physical risk; that would fall into a category I term ‘malicious compliance.’ I think any company choosing to do that would just be poking the bear, and I doubt that many will,” she says.

The Dawn of A&R Metrics

Perhaps the most useful aspect of the rule from an A&R standpoint are the “expenditure metrics” it introduces. These require companies to report the aggregate “capitalized costs, expenditures expensed, charges, and losses incurred” by extreme weather events and other “natural conditions” so long as they exceed 1% of the total incurred in the fiscal year. 

This will force companies to put a clear price tag on the acute and chronic physical risks that assail them. In turn, this should get investors to pester companies on reducing these costs by – you guessed it – investing in A&R. 

“We’ll now be able to understand the financial impact of a drought on a manufacturing site, of a hurricane on a production facility or network of stores, even if each single event didn’t meet the higher bar of financial materiality,” says Mazzacurati. “This will help advance modeling and science and enable better investment decisions for shareholders.”

Severe Weather and Other Natural Condition Financial Statement Impacts

The aggregate amount of expenditures expensed as incurred and losses, excluding recoveries, incurred during the fiscal year as a result of severe weather events and other natural conditions, subject to a threshold of the greater of 1% of pretax income (loss) or US$100,000

The aggregate amount of capitalized costs and charges, excluding recoveries, recognized during the fiscal year as a result of severe weather events and other natural conditions, subject to a threshold of the greater of 1% of stockholders’ equity or deficit or US$500,000

But once again, the rule arguably doesn’t go far enough. Notably, the expenditure metrics apply only for costs incurred “as a result of” climate shocks. They do not require firms to disclose costs incurred preparing to withstand future extreme weather events – in other words, costs associated with building climate resilience. The SEC argues this is because it’d be too tricky for firms to forecast these yet-to-occur impacts and determine how they factor into spending decisions. They also make the point that it’d be hard to tease out pure-play A&R expenditures from those made for other reasons. 

Whatever the merits of these arguments, the watering-down of the expenditure metrics means investors will have less insight into how much companies are spending on climate-proofing their businesses. This will make it harder to benchmark A&R spending across companies and sectors and to figure out which companies may be underspending on their own protection. 

It’s a concern voiced by Stacy Swann, member and co-founder of Resilient Earth Capital, a community of angel investors focused on climate resilience.

“Disclosure of already-experienced-financial losses due to climate change will be lagging information. What investors and other stakeholders might want to then understand is what companies are doing about those risks. Those options could be multifaceted ranging from investing in adaptation and resilience, to pivoting operations to less exposed locations. But traditional approaches to deal with these risks by relying on insurance are going to be, themselves, short-lived and increasingly costly as warming accelerates,” she says.

Furthermore, the final rule adopts de minimis thresholds that exempt expenditure metric disclosure if aggregated amounts come to less than US$100,000 on the income statement or US$500,000 on the balance sheet. This is supposed to ease companies’ overall reporting burdens. But the ultimate effect may be to obscure total climate impact costs across the US economy, leaving investors blind to all the small ways that physical risks chip away at enterprise value if left unaddressed.

The SEC also pulled its punches on financial impact metric disclosures, another part of the proposed rules that’s fallen by the wayside. Unlike expenditure metrics, these would have forced companies to report climate physical and transition impacts on all relevant line items in their financial statements – such as revenues, impairments, and reserves – if they exceeded 1% of that line item. 

These metrics would have revealed how climate impacts are affecting companies at a granular level, and helped with the translation of climate risk into financial risk. In turn, they could have helped companies and investors craft more nuanced and effective A&R responses. 

Still, their omission does not allow companies to avoid all disclosure of how climate shocks hit these financial line items. After all, the overall requirement that firms “disclose the actual or potential negative impacts of climate-related conditions and events” is binding, and investors could push for these to be disclosed at the line item level if they believe it necessary for understanding the nature of these impacts.

A Step in the Right Direction

Here’s the bottom line. The SEC rule should extract data from companies that allows investors to better understand the risks, costs, and impacts of climate perils. This should in turn help them appreciate the value of A&R investment and direct more capital toward climate-proofing assets, activities, and supply chains. 

However, the SEC’s backsliding on some of its more ambitious requirements makes it possible that this climate data will suffer from gaps and shortcomings that continue to lead investors astray on their A&R journeys. 

SEC Commissioner Caroline Crenshaw may have put it best in her remarks yesterday approving the rule: “We owe it to investors to ensure that they can adequately assess financial risk. Today we take a step in that direction. And while important, this rule could have been more.”