SEC’s Climate Change Guidance Could Mean Increased Scrutiny of Overseas Supply Chains

By Jim Coburn 22 July, 2010

Ceres’ Cobourn provides insight into the usefulness and impact of the guidance and the next steps for regulators.

In February, the U.S. Securities and Exchange Commission (SEC) released the world’s first economy-wide guidance outlining climate change disclosure companies should be providing in financial filings.  The guidance, backed by SEC enforcement authority, is likely to improve reporting of climate risks and opportunities, including those related to water.  It’s an important first step towards standardized reporting of climate issues for the benefit of investors.  Moreover, it is expected to spur increased corporate scrutiny and disclosure of climate and water risks in overseas supply chains.

The SEC guidance was issued in response to petitions in 2007, 2008 and 2009 from investors representing $1.5 trillion in assets. The petitioners included 11 U.S. state and city treasurers and comptrollers, as well as the nation’s two largest public pension funds, CalPERS and CalSTRS.  The requests for guidance also received letters of support from 50 additional European and U.S. investors representing $6.5 trillion in assets.

The guidance covers regulatory risks and opportunities, such as the financial impacts of proposed climate legislation before the U.S. Congress and existing regional greenhouse gas (GHG) agreements.  It also covers physical risks—including impacts on water availability and quality—and indirect consequences of regulation or business trends, such as increased demand for lower-emitting products or decreased demand for goods that produce significant GHG emissions.

In addition, it clarifies how climate reporting fits into long-established SEC regulations requiring forward-looking disclosure of material environmental risks.  Companies should have been reporting these risks for years, but multiple reports released in the past few years show that corporate disclosure has been inadequate.¹

Water risks and supply chains

The SEC guidance calls attention to the impacts of climate change on water availability and quality, both in a corporation’s direct operations and in its supply chain:

• “There may be significant physical effects of climate change that have the potential to have a material effect on registrants [companies] . . . . . Changes in the availability or quality of water, or other natural resources on which the registrant’s business depends . . . can have material effects on companies.”²

• “Significant physical effects of climate change, such as . . . the arability of farmland, and water availability and quality, have the potential to affect a registrant’s operations and results.”³

• The guidance also notes that the physical effects of climate change “can impact a registrant’s personnel, physical assets, supply chain and distribution chain.”⁴

This focus on water impacts has been well received by investors concerned that water risks have been under-disclosed.  A 2010 Ceres study found that while many water-intensive companies publicly report some risk information, few reference specific at-risk operations or supply chains, and none attempt to quantify or monetize this exposure.

Because the SEC guidance mentions the strong links between climate change and water availability issues, it could lead to significant new reporting about water risks.  In its 2009 10-K filing, the Coca-Cola Company disclosed that ”water scarcity and poor quality could negatively impact the Coca-Cola system’s production costs and capacity” and stated that “climate change may also exacerbate water scarcity and cause a further deterioration of water quality in affected regions, which could limit water availability for our system’s bottling operations.”  In future filings, Coca-Cola and similarly situated companies may provide additional material information by highlighting specific geographies and operations facing higher levels of water risk.  For example, it is likely that high growth markets—like China and India—are precisely those areas where these risks are most significant.

Strengths and weaknesses of the guidance

The SEC should be commended for discussing the material risks from climate change in a fairly comprehensive fashion, addressing physical, regulatory, and indirect risks and opportunities.  The guidance is applicable to all sectors, an acknowledgement that adaptation risks could impact a wide range of industries and may have the most impact on companies with extensive global supply chains.  For high emitting sectors, the Commission pointed out that laws on all levels matter—local, national and international—so companies should consider all of them when calculating regulatory risks.

However, the guidance has potential shortcomings in two ways: first, disclosure is left up to the discretion of company management.  This means that the culture of a company and its attitude towards investors, transparency, and regulation in general could affect the quality of disclosure.  Failures to disclose material risks in SEC filings—as demonstrated by the financial sector before the subprime mortgage crisis—could potentially recur with climate change risks.

Second, because robust climate reporting depends on these corporate governance decisions, a strong investor-focused SEC is needed to enforce the guidance.  However, the SEC’s emphasis on enforcement has varied in the past depending upon the Chairman’s priorities, and will probably do so in the future.  Material climate risks are a serious problem which has arguably risen above the level of management discretion to disclose, and should be enshrined in new SEC rules with clear disclosure criteria.

Next steps for securities regulators

Although the SEC guidance is an important development and could embed climate risk management in many companies that never examined the issue before, additional guidance or rulemaking is needed.  Since the SEC’s mission is to protect investors, partly by ensuring that companies disclose material issues, new SEC action must keep investors’ needs at the forefront.

The SEC should look first to investors’ frameworks about the disclosure they require.  The Global Framework for Climate Risk Disclosure, created by investors in 2006, asks companies to disclose carbon-related emissions data and emissions management plans in securities filings.  The emissions data can be used by investors to assess regulatory risks, and the emissions management plans can be used to assess the quality of a company’s governance.  This type of standardized reporting is vital for helping investors compare companies within an industry.  Although the SEC guidance does not address these topics, new SEC action could.

Also, securities regulators in other countries, including China, should follow the SEC’s lead and issue guidance or rules related to climate change disclosure.  The Ontario Securities Commission is the first regulator poised to do this; the OSC has committed to issuing environmental disclosure guidance by December 2010.  However, the materiality of both climate and water risks dictates that other securities regulators should not adopt a wait-and-see stance, but should examine the SEC’s and OSC’s work now and plan similar moves.

Finally, securities regulators should look at water risks and opportunities in their own right, and not only in relation to climate change.  Investors are paying more attention to material water issues by filing shareholder resolutions with U.S. companies and supporting voluntary disclosure efforts.  In addition, 41 investors with approximately $1.4 trillion in assets wrote to the SEC in June 2009, asking the Commission to “require disclosure of material environmental, social, and governance (ESG) risks,” including water scarcity issues. Securities regulators should improve disclosure of water risks and opportunities by examining the adequacy of current reporting and determining if additional action is required.

₁See also McGuireWoods LLP, 2008 and 2009 climate change disclosure reports; Michelle Chan, Friends of the Earth, 2003-2006, Surveys of Climate Change Disclosure in SEC Filings ofAutomobile, Insurance, Oil & Gas, Petrochemical, and Utilities Companies.

²Id. at 6.

³Id. at 26.

⁴Id. at 6.