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Increasingly investors view environmental, social and governance factors as prudent inputs for managing risk and delivering returns — but variability in company approaches to climate-related disclosures has inhibited the ability of investors to analyze and compare investments.
Recognizing the challenge, regulators and governing bodies around the world are considering new ways of capturing this information. In the United States, the Securities and Exchange Commission has proposed new rules that require disclosures about a company’s governance, risk management, and strategy with respect to climate-related risks. Meanwhile the International Sustainability Standards Board is progressing toward establishing a global baseline of ESG disclosure standards — similar to accounting standards, but for climate and wider sustainability-related risks and opportunities. According to the SEC’s proposal, disclosures are aimed at “providing investors with consistent, comparable, and decision-useful information for making their investment decisions.”
That’s a goal shared by asset managers like PGIM. Eugenia Unanyants-Jackson, PGIM’s global head of ESG, in collaboration with ESG experts from across PGIM’s affiliate managers, outlines nine principles they believe will drive the best outcomes for investors:
Think globally. A patchwork of varying rules and standards in different countries will not help create consistent and comparable information. When developing its disclosure framework in the U.S., for example, the SEC should permit foreign private issuers to file their climate-related disclosures in accordance with the standards established by any final global standards such as ISSB as an alternative to compliance with any local rule. For entities that are global investors and asset managers, aligning local requirements with international standards creates consistency and compatibility in issuer disclosures.
Be holistic, not granular. Pinpointing the exposure of factories, offices and equipment from physical climate risks including sea-level rise, flooding and wildfires is important risk management. However, an overly granular level of disclosure for these risks — e.g., at a zip-code level — will be counterproductive, as investors must aggregate and process information at a registrant and portfolio level, a significant task for a large registrant with multiple assets in many different locations. Furthermore, such granular disclosures may exclude upstream and downstream risks, such as impacts on suppliers or the supply chain. By disclosing the percentage of total assets, operations or revenue exposed to acute and chronic physical risks, complemented with a breakdown by the type of physical risk and a breakdown at a regional or countrywide level, a more holistic and ultimately useful view of physical risks can be achieved.
Define the terms. Ambiguity is the Achilles’ heel of any reporting framework and leaves the door open to incomparable data. For example, by specifically defining what constitutes a “short-, medium- and long-term” time horizon (such as 5-, 10- and 20-year periods), rather than leaving that determination to the registrant, it allows investors and managers to evaluate different registrants and their related risks over the same periods.
Weed out “greenwashing.” Disclosure requirements related to the role that carbon offsets and renewable energy certificates play in a registrant’s climate-related business strategy are essential; however, the quality of offsets varies and many are currently low quality. To separate efforts that check off a box versus those that truly make a difference, registrants should be required to disclose sufficient information for investors to gauge the cost and quality of those offsets.
Make ESG everyone’s responsibility. A commitment to ESG at the board level is important for meaningful action. However, disclosure requirements around the climate-related expertise of a registrant’s board members could suggest that boards should always include a climate expert. That may result in the rest of the board deferring to the climate expert on climate matters or dilute board effectiveness by requiring boards to fill a “slot” with someone who checks off the climate expertise box, rather than by selecting the best overall candidate. Instead, registrants should disclose the steps that the board and management have taken to build overall climate competence.
Reduce the noise. The financial impacts of climate risk can range from those that are purely environmental to those that are material. To ensure information is relevant, an appropriate materiality threshold must be applied to climate risk disclosures. Low materiality thresholds for financial statement disclosures result in immaterial information being disclosed that is unlikely to sway either equity or credit views. When defining what is material, registrants should be encouraged to lean on well-established existing frameworks, such as those put forth by the Sustainability Accounting Standards Board.
Clarify “climate-related costs.” Because impacts from climate can show up in many places and for many reasons, it’s important to clearly define the scope of a climate-related cost. Otherwise, registrants could find themselves reporting never-ending financial impact metrics. For instance, should all hurricane damage be considered a climate cost, or only where an attribution study has been done that indicates the hurricane was made materially more likely by human climate change? Should only direct costs and benefits be considered, or should costs in supply chains feature as well?
Encourage, don’t deter. Many registrants would benefit by using scenario analysis to determine materiality of certain climate risks. However, detailed disclosure requirements around scenario analysis could serve as a deterrent. For example, disclosures may require exhaustive quantitative and qualitative information, inclusion of parameters, assumptions and analytical choices, and the projected principal financial impacts on a registrant’s business under each scenario. Instead, a less-daunting summary reporting on the conclusions from the scenario analysis and a discussion of any material impact on the business would be sufficient to inform investors.
Report negative and positive impacts. Companies should report not only on financially material sustainability and climate-related information, but also on the significant negative and positive environmental and social impacts produced by their businesses — increasingly useful to investors with sustainability and portfolio decarbonization objectives. This “double materiality” approach would not only help investors identify significant negative externalities that may not be financially important in the short term, but also understand significant positive externalities that may lead to business opportunities. For instance, successful businesses that produce products that transform customers’ lives for the better provide employees with enriching places to work and can allow employers to attract global talent. A great example is Merck & Co., whose decision to distribute its drug Mectizan for free has substantially reduced river blindness worldwide and significantly enhanced Merck’s global reputation.