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  • SEC to Address Climate-Related Risks 0 comments
    Feb 9, 2010 12:23 AM
    The increased interaction amongst nations seeking to offset climate change is becoming more and more apparent in today’s business. International climate schemes, such as the European Union Emissions Trading Scheme are changing businesses profit formulas and are affecting the metrics investors use to evaluate a company.
    The European Union Emissions Trading Scheme (EU ETS) is the largest climate change scheme in the world and has delivered a price on the emission of greenhouse gases since 2005. The EU ETS, commissioned into action by the Kyoto Protocol, covers over 11,000 installations. In addition to the EU ETS, America’s Regional Greenhouse Gas Initiative monitors greenhouse gases in the Northeast. Continuing efforts around the globe, such as in areas like Japan and Australia, illustrate the worldwide commitment to environmental policy and the perceived impact climate change can potentially have on international business.
    Climate change increases the probability of economic damage caused mainly by sea-level rise, calamitous storms, and melting permafrost. A frightening estimate by author Kurt Kleiner of “Climate Science in 2009” suggests that adverse climate change can lead to the destruction of US$1 trillion in gross domestic product. These large estimates will only continue to increase with additional support from research on the unsustainable trend of greenhouse gas emissions. As such, the effect of climate change on business is evident.
    The Security Exchange Commission exists to reduce information asymmetry in the market. Just recently, the SEC publicized its intent to mandate increased disclosure of climate-related business risks which pass materiality tests. Exposure to climate change comes in many forms. There is both positive and negative exposure with respect to proposed legislation, such as “The American Clean Energy and Security Act” which passed through the U.S. House of Representatives in July of 2009. Such cap-and-trade legislation which grants companies the ability to trade the right to pollute in a new market makes it possible for “net-sellers” to raise revenue through the sale of these instruments. On the other hand, it also makes it possible for “net-buyers” to lose money should the price to emit increase during a specific period. Both of these possibilities are important to investors who need to make an educated decision about the company’s long-term profitability.
    There is also a risk of damage to physical assets, employees, supply chains and distribution routes which have material effects on companies’ financial strength. Some companies’ revenues may be largely dependent on operations that can be negatively affected by climate regulation. For example, consider Duke Energy who ranks in the top 20 globally for emissions. Stringent legislation to curb such emissions would certainly have a material effect on Duke’s ability to remain profitable for the foreseeable future. These are all material facts which would affect a reasonable investor’s perception of a company.
    Although some companies have already been required to include certain details about climate-related data in their financial statements, there is much more information publicly available through the Climate Registry that can add value to such disclosure. In addition, the “Global Reporting Initiative” developed a sustainability reporting framework that establishes the principles and indicators organizations can use to measure and report the economic influence of environmental factors. This type of out-reach makes reporting on environmental risks much more feasible.
    The SEC began discourse on the materiality of environmental issues beginning back in the 1970s. Materiality standards for disclosure were incorporated into securities laws throughout the 70s and 80s. The standard requirements for materiality have not changed.   According to these standards, information is considered to be material if there is a substantial likelihood that a reasonable investor would consider it important in making investment decisions. 
    As mentioned above, there are several ways a company can be exposed to climate change risks. As such, there are also many related issues that the SEC believes can require a company’s disclosure. First, the advancement of legislative proposals for cap-and-trade schemes triggers disclosure under the SEC’s new rules. 
    Certain companies’ yearly emissions would need to be monitored and recorded—these data points affect the materiality of disclosure. Based on historical information, investors can more accurately determine the long-term effect of legislation. If company management discerns that legislation would materially affect the firm’s financial condition, a management disclosure of climate-related effects is required by new SEC rules.
    Another concern the SEC would like to protect investors from is international exposure to foreign climate regimes. Many companies have operations all around the world. It is very possible that an American company can have a business unit based in the European Union, thereby necessitating compliance to EU ETS emission reductions. 
    More important, the SEC expresses that significant physical threats from climate change, such as severe weather damage and high sea-levels, must be analyzed and recorded. The SEC’s report highlights a statistic from the Government Accountability Office: approximately 88% of losses paid by insurers between 1980 and 2005 were weather related. The risk lies not only with those companies which have large physical assets on their balance sheets but also with the insurance companies that insure against the loss of such assets. Losing a key factory or plant can mean millions of dollars in losses of inventory and re-construction costs. Information on the likely hood of such events is exactly the type of information the SEC seeks to provide investors with.
    The unsustainable trend of greenhouse gas emissions has caused a frighteningly imminent risk to future lives and business relationships. From storms at sea to the warming of the Arctic, global climate change has certain ramifications for all of us. The SEC’s decision to update environmental disclosure requirements is a small step in the right direction. The real task will be left up to businesses and policy-makers, challenged with significantly reducing emissions to sustainable levels. 

    Disclosure: "No Positions"
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