Can the SEC Help Protect Investors Against Climate Risk?

This week’s unprecedented winter storm in Texas this is the latest reminder of intensifying weather events across the globe, and the damage left in its wake opens up important questions about whether our financial systems are prepared to withstand the impacts of climate change. One of the most important functions of regulatory bodies like the SEC is to protect the market from systemic risks, and there is a widening consensus that climate change is one systemic risk for which the SEC must prepare.

As defined by SEC Commissioner Allison Lee during her keynote speech at the PLI’s Annual Institute on Securities Regulation in November 2020, a systemic risk is “characterized by the following features: (1) ‘shock amplification’ or the notion that a given shock to the financial system may be magnified by certain forces and propagate widely throughout; (2) that propagation causes an impairment to all or major parts of the financial system; and (3) that impairment in turn causes spillover affects to the real economy.” [1]

Put more simply, a systemic risk is one with the potential to result in the downturn, or even collapse, of an entire market system. The ongoing COVID-19 pandemic is one recent example of such a risk, as we continue to see its economic impacts across every sector of the market. During her speech, Lee noted that although the SEC is not in a position to regulate and slow the actual drivers of climate change, it can – and should – address climate risks through standardization of the environmental, social, and governance (ESG) disclosures that financial institutions make.

The SEC’s interest in managing climate risk seems to be gaining momentum, as John Coates, the SEC’s acting Director of the Division of Corporation Finance, recently echoed Lee’s sentiments by recommending that the SEC take a leadership role in creating a standardized disclosure system for ESGs. [2] Coates commented that ESG disclosures are becoming “less voluntary” than they historically have been, as investor interest in this information has risen significantly. Investors are beginning to expect sustainability reports, and in turn, some form of standardization by the SEC will help protect and inform investors moving forward.

From an outside perspective, a June 2020 report by Ceres, titled “Addressing Climate as a Systemic Risk: a call to action for U.S. financial regulators” offers additional insight into the economic impacts of climate change, along with recommended actions for a slew of financial institutions like the SEC. [3]

The report states that some of the most significant risks inherent in climate change include economic losses and health risks stemming from extreme weather events, as well as the ripple of economic impacts from the eventual transition toward a low or zero-carbon economy.

As seen from this week’s tragic winter storm in Texas, the economic impacts of severe weather events are staggering, and these events are only getting more extreme and more common. Experts are expecting insurance claims from the storm to top $19 billion, the previous record for Texas’ most expensive storm set by Hurricane Harvey in 2017. [4] Not to mention the extensive costs borne by disrupted supply chains, among other market sectors.

Further, as our economy necessarily transitions toward net-zero carbon in order to reduce greenhouse gases that accelerate climate change, there is the potential for widespread disruption of critical industries like transportation and energy. When these multi-trillion-dollar industries suffer, the entire market does too.

While regulatory bodies like the SEC may not lead the charge in slowing climate change itself, they have the unique opportunity to prepare and stabilize the market as climate risks loom. Their recent prioritization of formalized ESG disclosures is a promising sign, but only time will tell whether measures like these will effectively protect the market from the extreme risks posed by climate change.

Sources:

[1] https://www.sec.gov/news/speech/lee-playing-long-game-110520

[2] https://www.reuters.com/article/us-climate-change-disclosures/secs-coates-says-agency-should-help-create-esg-disclosure-system-idUSKBN2AI2CG

[3] https://www.ceres.org/sites/default/files/2020-05/Financial%20Regulator%20Executive%20Summary%20FINAL.pdf

[4] https://www.dallasnews.com/business/2021/02/18/this-years-winter-storm-could-become-the-costliest-weather-event-in-texas-history/