By Nora Mardirossian
Last week’s Hurricane Harvey demonstrated the devastating risks that climate change poses to people and the planet. At least 60 people have lost their lives and some meteorologists are saying Harvey is the worst rainstorm and the one of the most expensive disasters in U.S. history. Climate change is making extreme weather events more extreme and more frequent. Warmer seas feed more power into hurricanes, and higher temperatures increase evaporation rates and the carrying capacities of rainstorms. As such, a number of scientists have suggested Harvey’s damage was magnified by the warming climate. Now Hurricane Irma is tearing up the Caribbean, strengthened by the same abnormally warm sea waters.
Climate change also poses serious risks to businesses and the entire economy. Today’s investors are more seriously seeking out information to understand these risks in order to protect their investments. Institutional investors—investment advisors, pension funds, mutual funds, and sovereign wealth funds which pool assets to purchase investments—are particularly sensitive to climate risks because they own portions of the entire economy, and climate change poses risks to the entire economy. Institutional investors also tend to make long-term investments, and climate change poses long-term risks to those investments. In July, Schroders, the U.K.’s largest publicly listed asset manager, warned that if warming trends persist, the world will experience up to a 50 percent long-term loss in global GDP. A recent study in Nature Climate Change concludes that there is currently only a five percent chance of keeping the global temperature increase below two degrees Celsius by 2100, the goal of the Paris Climate Accords.
This information, combined with the changing investment landscape, shows that it is time for companies to start including how they contribute to and are impacted by climate change in the information they provide to investors.
How Might Climate Change Be Bad for Business?
To provide examples from Hurricane Harvey, a variety of companies will experience losses due to the devastation. Flooding has damaged industrial facilities, including oil and gas refineries and chemical plants, which will need to be repaired. The damage to these facilities has also caused water and air pollution, which may result in fines under state and federal regulations, including the Clean Water Act, as well as lawsuits from private citizens and property owners. The Conservation Law Foundation has already brought suits against Shell Oil and ExxonMobil alleging they failed to take into account sea level rise, increased precipitation, and the increased frequency of storms at their waterfront facilities. Similar lawsuits could emerge in Harvey’s wake.
Following in the footsteps of groundbreaking litigation in California, high carbon emitters such as fossil fuel companies also risk being held liable for their contribution to climate change and the corresponding damages caused by Harvey. In California, coastal communities are suing companies such as Chevron, ExxonMobil, BP, and Royal Dutch Shell alleging their emissions have contributed to sea level rise, which will result in monetary damages for these communities that amount to a public nuisance and negligence. While it is currently difficult to establish whether damages incurred during a specific weather event were caused by climate change, as event attribution science improves, lawsuits seeking damages for the effects of climate change on extreme weather events may become viable. Emitters could be found liable for damage, but so too could companies who constructed buildings or infrastructure without consideration for predicted flooding resulting from climate change.
In addition to these acute risks, companies also face market forces such as decreased demand for goods that produce high greenhouse gas emissions. They will also be confronted with risks posed by legislation and regulation at federal and state levels which intend to curb carbon emissions.
Despite wide acceptance among investors and the public that climate risks to businesses are real, companies are not yet adequately disclosing their exposure. Schroders reports that the impacts of climate change are not adequately “priced in” to companies’ valuations, which they warn creates enormous financial risks, characterizing this failure as “accelerating towards a cliff edge.” The Climate Disclosure Standards Board reports that many companies that do not disclose climate risks say it is because they do not think they are material to their businesses.
However, it is becoming more evident that climate risks are material for many companies.
The New “Reasonable Shareholder”
In the U.S., publicly traded companies are required to use standard forms to annually disclose information to prospective shareholders so they can make informed investment and proxy voting decisions. In the 1930s, Congress adopted federal securities laws that used the principle of “materiality” to identify the information that was most useful to investors while filtering out the less important information. If the important or “material” information is falsely stated or omitted, this amounts to securities fraud. In 1976, the Supreme Court crystalized this definition in TSC Industries v. Northway, as follows: “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”
In this decision, the Supreme Court emphasized that they wanted to issue a limited definition in order to avoid a situation in which companies dump large amounts of “trivial information”—which would be both costly and unmanageable for the so-called “reasonable shareholder” or “reasonable investor.” But who is this “reasonable shareholder”?
Courts have attributed certain characteristics to this shareholder, including being rational, knowledgeable about the risks of investing, and focused on making a profit. The Court acknowledged that the risks and profit time horizon would vary among investors and would change over time. In determining and considering changes to the materiality standard, the Securities and Exchange Commission (SEC) and the courts say they define the “reasonable investor” in hypothetical terms, but in practice they have considered what average investors at the time find important.
As early as 1947, the SEC adopted rules in which materiality was defined based on what “an average prudent investor ought reasonably to be informed before purchasing the security registered” (emphasis added).
Later, in the 1970s when the NRDC requested social and environmental disclosures (considered “non-material information”) be required by the SEC, the SEC decided they were not needed because, based on their investigation into the matter, only a small fraction of investors considered this information important. Namely, they found that only 0.0005 percent of the total value of stocks and bonds in the U.S. in 1974 was invested using ethical investing principles and shareholder proposals on environmental and social issues received, on average, between 2 and 3 percent approval during the 1970s. Two federal courts upheld the SEC’s determination.
This analysis suggests that disclosure of certain information would be required when a sufficiently large percentage of reasonable investors or assets under management consider that information to be useful in their decision-making.
Nowadays, the much more prominent role of long-term institutional investors in the economy suggests their investment criteria should be assigned to the “reasonable shareholder.” Their desire for and ability to consume data on climate risk makes that information material to the reasonable shareholder.
Not Trivial to Them
Currently, a much larger percentage of investors consider ESG (environmental, social, and governance) risks, including climate risks, to be important and nontrivial. Institutional investors that care more about climate risks, can process the data, and are demanding it represent a larger percentage of investors and manage a larger percentage of assets than they did in the 1970s. The SEC Commissioner reports that the proportion of U.S. public equities managed by institutional investors has risen from between 7 and 8 percent of market capitalization in 1950 to about 67 percent in 2010. In 2009, institutional investors owned 73 percent of the outstanding equity in the largest 1,000 US companies, and pension funds own almost 40 percent of this amount. As Shlomitt Azgad-Tromer notes, between 1945 and 2014, individual households went from directly owning 93 percent of outstanding corporate entities to a mere 36 percent. Additionally, passive index funds which reward long-term growth currently account for approximately 30 percent of the U.S. market, and Moody’s anticipates that they will surpass active fund assets by 2024 at the latest. Beyond just the U.S., in OECD countries between 2000 and 2011, institutional investors doubled their total assets under management from $36 trillion to $73.4 trillion.
Compared to the estimated 0.0005 percent of stocks and bonds invested using ethical investing principles in 1974, many of these institutional investors, particularly pension funds and sovereign wealth funds, now have explicit policies requiring ESG risks to be considered in their investment decisions and some are offering specific ethical or ESG exchange-traded funds. In a survey of over 320 institutional investors, Ernst and Young found that 92 percent agreed that ESG issues will have real and quantifiable impacts and 80 percent believed companies do not adequately disclose the ESG risks that could affect their current business models. In fact, the SEC itself acknowledged that climate risks can constitute material risks to investors in its 2010 Guidance Regarding Disclosure Related to Climate Change.
Furthermore, very recently, institutional investors have begun to push companies to disclose their climate risks through shareholder resolutions, a major shift away from their usual tendency to side with boards. While shareholder proposals on environmental and social issues received only 2-3 percent approval on average in the 1970s, they have now begun to win majorities due to institutional investor support. In May, California Public Employees’ Retirement System, the largest public pension fund in the U.S., led an effort that was later joined by BlackRock, the world’s largest asset manager, to pass a shareholder resolution at Occidental Petroleum Corporation demanding disclosures on risks related to climate change and the transition to a low-carbon economy. This resolution represented the first time one of the world’s biggest investment management firms had ever overrode the board in approving a climate proposal. BlackRock said it took action because Occidental failed to improve its climate change-related reporting following a similar unsuccessful proposal last year. Soon after the success of the Occidental resolution, BlackRock and Vanguard, the world’s largest provider of mutual funds, both joined in passing a parallel resolution against the recommendation of the board of ExxonMobil.
A large percentage of reasonable investors and assets under management consider climate risk to be a pressing long-term risk to their portfolios. They have demonstrated such through their more vocal engagement with companies.
Smarter Than the Average Joe
Rather than fearing an avalanche of unintelligible information, the majority of investors are increasingly demanding more data on how climate change will impact the businesses in which they invest. This suggests companies should increase their disclosure of material climate risk data and courts should take that materiality seriously.
In addition to investors demanding this information, the concern about overwhelming investors is abated by the sophistication of these new “average investors.”
When the SEC and courts were considering the definition of materiality, the average investors were retail investors, or individuals with less time and technical knowledge than institutional investors. However, today’s average investor—the institutional investor—has the time, resources, expertise, and sophistication necessary to analyze and make use of complex climate risk data. They accept the fact that climate change will impact their investments, and are demanding more data so they can better understand precisely how climate risks will affect them.
While providing this information to the more sophisticated average investors, companies should still present information in a digestible way for less sophisticated investors. However, the complexity of the information and inability of some less sophisticated investors to understand its importance does not mean companies are excused from providing it entirely. Of course, it should be presented as clearly and concisely as possible.
The main purpose of the securities laws that define materiality is to protect investors. Full disclosure is required to facilitate the shareholders’ right to vote as their judgment directs. Thus, the standard of materiality should be broad enough to permit shareholders to exercise their statutory franchise fully and reasonably. Information related to climate risks meets the test of materiality because it is important enough that shareholders ought to be given access to it, and they are in fact demanding them. Companies are bound to tell investors the full story of their risks, and climate change is a critical part of that story that is of interest to shareholders. These risks are thus material as a matter of law, and companies should take more seriously their duty to report them.
In fact, the G20-affiliated Financial Stability Board’s Task Force on Climate-related Financial Disclosures’ (TCFD) final recommendations, which have received support from financial institutions managing assets of around $25 trillion, note that organizations with material climate risks must disclose them in mainstream public annual financial filings, but also encourage organizations where climate-related issues could be material in the future to begin disclosing such information in other reports to facilitate the incorporation of such information into financial filings once climate-related issues are determined to be material. The TCFD cautions organizations against prematurely concluding that climate-related risks and opportunities are not material based on perceptions of the longer-term nature of some climate-related risks.
As the new “average investors,” more sophisticated institutional investors are seeking more detailed information on climate risks in order to make their investment and proxy voting decisions, and thus the fear of overwhelming shareholders has diminished.
Why Should Companies Disclose?
As of yet, companies have been providing scant information on their climate risks, in part because they see the risks of disclosing as greater than the risks of failing to disclose. They are aware that if they do internal assessments, they will have to disclose their findings and fear exposing themselves to litigation. Companies also succumb to pressure from activist hedge funds and other investors to perform in the short term, achieving quarterly growth and responding to demands for dividends.
However, disclosure can help companies better understand their risks and more adequately address them. It will also enable companies to distinguish themselves as leaders in addressing and adapting to climate risks. Companies that assess their position in a lower carbon world can implement measures now that will reduce the need for greater expenditures at a later stage, once new policies and the physical impacts of climate change begin to set in. Opportunities may be capitalized on, such as investing in alternative forms of energy.
If companies fail to disclose their material climate risks or misrepresent those risks, they could be liable for securities fraud. There are a number of pending securities actions against companies who failed to disclose their climate risks. Some of the most high-profile cases include a series of actions brought by shareholders and the New York State Attorney General against ExxonMobil claiming the company failed to accurately disclose the climate risks their scientists have known about since the 1970s. Investors are also suing Volkswagen based on their misrepresentation of the fuel efficiency of their diesel cars.
The significance of this sort of securities litigation is threefold. First, they suggest that the retail investors bringing these suits are becoming more aware of and concerned about climate risks to businesses they have invested in. Second, these legal challenges are themselves climate risks as they are costly to litigate and can result in monetary damages for the company. Third, they are a consequence of failing to take the underlying risks of climate change seriously by acknowledging their materiality to business operations.
Companies must stop deflecting and recognize the devastating business risks of climate change, and courts must hold them accountable for failing to do so.
While it is unlikely that additional federal regulation and more aggressive enforcement of securities laws will take place in the next several years, companies will eventually have to respond to economy-wide energy transitions and pressure from investors. Given the flexible definition of materiality based on the ever-changing reasonable investor, courts have the power today to more rigorously require the disclosure of climate risks where they are material.
Companies should not wait for the market and regulatory changes to materialize before taking action, because, as Schroders’ head of sustainable research Andy Howard warns, when the market starts pricing in climate considerations, it will happen quickly, and investors cannot afford to ignore the impacts of climate change any longer. Deferring or slowing down necessary change in order to seek short-term profits in the meantime will be risky to businesses and the entire economy in the long-run.
What Should Investors Do?
Institutional investors who care about climate risks should encourage better disclosure by using their sizable leverage. Their clients, such as pension holders, can likewise get involved by pressuring their managers to use this leverage. Engaging with stakeholders and boards to ensure companies understand and disclose their risks is one way institutional investors should exercise their leverage. They should make sure companies express a vision of sustainable long-term growth, support the nominations of directors with long-term approaches to corporate growth, and ensure companies’ compensation plans are based on more than simple short-term results. For example, three-year performance periods can be used to determine cash bonuses of directors.
Institutional investors should push companies to extend their strategic planning horizons to be sensitive to the time horizons of their investors. Institutional investors should also make sure companies explain their materiality determination process, which boards should have the ultimate responsibility over, rather than sustainability departments. In general, boards should be determining new business strategies to address climate risks and should hold the ultimate accountability for such matters.
When companies fail to consider their climate risks, institutional investors should hold them accountable, as BlackRock reports doing by supporting the Occidental resolution. If institutional investors vigorously advocate a long-term approach to shareholder value, they should be able to block programs that do not meet that objective and beat out short-term-thinking activist hedge funds which tend to have smaller percentages of a company’s stock. They need to continue pushing for more disclosure and action to address climate risks by vigorously opposing hedge funds in proxy fights when their proposals thwart a company’s long-term growth strategy.
Institutional investors should stop outsourcing voting decisions to proxy advisory firms that might not share their long-term perspectives. They should maintain control over their investment decisions and stay active and involved in proxy voting.
To make the process more predictable for companies and easily comparable for investors, institutional investors can call on companies to use specific disclosure frameworks. The TCFD’s final recommendations are a good place for companies to start. In Australia, for example, Origin Energy shareholders are demanding implementation of TCFD, namely by disclosing scenario analysis, and metrics and targets that would allow investors to assess the company’s resilience across a predicted 2 degree Celsius rise in the global thermostat by the end of the century.
Finally, institutional investors have been hesitant in the past, but they should begin to join securities class action lawsuits against companies who fail to disclose their climate risks, in order to encourage transparency and action.
Nora Mardirossian is a lawyer with a background in business and human rights. She works as a policy analyst at the Columbia Water Center, researching water risk in the mining industry.
