The SEC Risks Misinformation If Standardized And Detailed Climate Risks Disclosures Are Adopted
Based on the well-established materiality standard, public companies must disclose any potential financial risks from global climate change. The SEC is questioning whether these disclosures are inadequate, and is considering additional more detailed and standardized disclosure standards. Imposing such standards would be costly for public companies and will lessen investors knowledge regarding the potential financial risks from global climate change.
More precise disclosures require an excessive number of assumptions. Each assumption contains unknown errors, and how these errors will compound upon one another is also unknown. As a result, forcing companies to provide more detailed and standardized disclosures regarding the financial impact from global climate change will result in more precise, but less reliable, information for investors.
The challenges that arise for fossil fuel companies exemplify the problem. Fossil fuel companies face risks from global climate change because the demand for fossil fuels may decline, harming their revenues and creating financial risks for investors.
The International Energy Agency’s (IEA) Sustainable Development Scenario, which foresees a large drop in the demand for fossil fuels, provides a sense of the potential economic outcome should demand fall as activists expect. However, declining future demand for oil is far from certain and there are sound arguments supporting a forecast of growth in fossil fuel demand for the foreseeable future.
Oil currently fuels one-third of the world’s energy needs and is an irreplaceable component in thousands of consumer products. While it is possible that viable alternatives will pan out, it is also possible that none of them will. And, even when the technologies pan out, these new innovations must experience dramatic growth to meaningfully impact the demand for fossil fuels, which is far from certain.
Take electric vehicle (EV) sales as an example. EVs are supposed to be a major displacer of oil demand, yet still represent only 2.6% of global car sales. Therefore, a radical market transformation is still necessary in order for EVs to displace a substantial amount of oil demand.
There are significant barriers standing in the way of an EV revolution that include insufficient supplies of the necessary rare earth elements. Without these materials, it is technologically impossible to physically build the necessary number of EVs. The shortage of EVs will mean that sales of traditional internal combustion engine automobiles will remain robust, as will oil demand.
There are also unknowns regarding whether consumers will accept EVs. According to the head of Ford UK, most people are “still concerned about a number of things – range, the charging infrastructure, the lack of information available to customers and obviously the price as well.” Unless consumers embrace EVs more wholeheartedly, the IEA’s declining oil demand scenario is unlikely to come to pass.
Obstacles to the development of alternative energy is not just applicable to EVs either. Similar market obstacles exist for the alternative electricity generation technologies, the replacement for fossil fuel-based plastics, and the thousands of other products that use or are derived from fossil fuels.
Beyond such market uncertainties, there is also policy uncertainty. Countries have a poor track record meeting their climate goals, likely in response to the large economic costs associated with these policies. Acknowledging this reality, the IEA also projects scenarios where oil demand is flat or growing for the next two decades. This policy ambiguity creates additional uncertainty regarding the applicability of the declining oil demand scenario for the disclosure statements of fossil fuel companies.
Then there is the problem of how these targets will be achieved. The typical assumption is that countries will meet lower emissions goals by transitioning away from fossil fuels. But, this is also an assumption. Another way that global emission goals can be met is through carbon capture and sequestration, or other technologies that reduce emissions from fossil fuels. Meeting the targets through these technologies could mean that global emissions will be declining, but fossil fuel use may not be – it could even be increasing.
All of these unknowns make it extraordinarily difficult for an oil company to implement more precise disclosures regarding how global climate change will impact its business. If oil demand does grow, then providing a more detailed disclosure based on a presumed decline in oil demand will provide investors with inaccurate information.
Ultimately, it is investors who bear these significant, and unnecessary, financial risks. Adverse consequences for investors exist regardless of whether the firms overestimate the impact from global climate change on oil demand or underestimate these risks. A methodology that overestimates the decline in demand will impose a large opportunity cost by inaccurately discouraging oil investments. A methodology that underestimates the decline in demand will inaccurately encourage oil investments and set investors up for large financial losses.
Either way, in light of the large amount of uncertainty regarding the precise impact from global climate change, more specific disclosure requirements are more likely to perpetuate misinformation rather than promote greater clarity for investors. Further, if there were consistent assumptions used across all of the companies, then there is a risk that the reporting requirements would be perpetuating widespread systemic misinformation in the financial markets to the detriment of investors. These impacts would be more acutely felt by smaller investors who lack the resources to perform their own analyses.
The difficulties quantifying the impact are not lessened for companies in other industries that are less directly impacted by global climate change. How global climate change will impact demand for their products, cost structures, or financial risks is just as uncertain and attempts to provide a more precise reporting will prove costly, and likely inaccurate.
Requiring companies to provide more detailed disclosures will more likely promote misinformation for investors rather than information. Due to the large number of policy and market uncertainties, the potential costs from global climate change simply defies a precise and replicable methodology. Attempting to impose such a requirement provides investors with a false sense of certainty regarding an unknown outcome that is largely outside of the company’s control.