Climate Change, Corporate Valuation, and the Proposed SEC Disclosure Regulations

On March 21, 2022, the Securities and Exchange Commission (SEC) released its statement on proposed mandatory climate risk disclosure. In the statement, Chairman Gensler said, “Today, investors representing literally tens of trillions of dollars support climate-related disclosures because they recognize that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions.” Gensler added, “In making decisions about disclosure requirements under the federal securities laws – including decisions about today’s climate-related disclosures – I am guided by the concept of materiality. As the Supreme Court has explained, information is material if “there is a substantial likelihood that a reasonable shareholder would consider it important’ in making an investment or voting decision.”[1] In terms of financial economics, the information that an investor would consider important is that which would alter the investor’s assessment of the value of a company.

Corporate Valuation

There is no mystery as to what determines the value of a business. In its simplest form, that value comes from the expected cash flows it can generate over time, discounted back at a “risk adjusted” discount rate. This is the standard discounted cash flow (DCF) valuation model. If climate change is going to have an impact on value, it will have to show up in either expected future cash flows or the discount rate. In practice, virtually all investment banks and valuation practitioners use DCF models with an explicit forecasting horizon of five to 10 years.

Climate Change and Valuation

At the start of the industrial revolution the CO2 concentration in the atmosphere was approximately 280 parts per million. (Each part per million equates to  about 7.8 gigatons of atmospheric CO2.) By 2021, the concentration was 420 ppm (0.04 percent). That amounts to a net increase of atmospheric CO2 of about 1,000 gigatons. Currently, humanity is adding more CO2 at a net rate of about 20 gigatons per year.

Well established scientific models imply that the 1,000 gigatons of CO2 (plus the other related GHGs) will result in an ultimate warming of about 1.5 degrees centigrade. Of that total, only about half, or 0.8C, has occurred to date. The planet will reach the three-quarters point by about 2100. The remaining 0.3 to 0.5C will take centuries.

The foregoing calculation ignores the fact that civilization continues to pump GHGs into the atmosphere. To take account of future emissions, the Intergovernmental Panel on Climate Change (IPCC) has developed a series of Representative Concentration Pathways (RCPs) that use various assumptions regarding future emissions to project future warming. At present the two realistic scenarios are RCP 7.0 and RCP 4.5. RCP 7.0 is a “modest emission abatement effort” scenario. This is often referred to as a “business as usual” scenario. Given the emissions path of RCP 7.0, the predicted increase in temperature is 3.0C by 2100. RCP 4.5 is an “active intervention” scenario based on current government pledges. Under RCP 4.5 emissions would peak this decade and global temperatures would rise 2.5C by 2100

Climate change activism is not about avoiding expected global warming of about 2 to 3 degrees C. Instead, it is about pushing Earth from about RCP 7.0 to RCP 4.5 i.e., reducing warming by about 0.5 degrees C. Currently, the OECD countries account for less than half of total emissions. Therefore, reducing future emissions in OECD countries consistent with a switch from RCP 7.0 to RCP 4.5 would reduce global warming by about 0.2 degrees C. If the United States acted alone, the impact would be about 40 percent of that, or less than 0.1degrees C.

Although climate change is an issue of immense importance to human civilization, it is also very slow moving, global in nature, and largely predictable, as evidenced by the relatively small difference between the impact of RCP 4.5 and RCP 7.0. To the extent that future events alter the rate of emissions, those events are almost certain to occur outside the OECD countries in Asia (including the Indian subcontinent), Africa, and Latin America, where development will be faster and population growth greater. By 2050 the OECD countries are expected to account for only 28 percent of total emissions. From a valuation perspective, the climate information that investors need is related to future energy use in non-OECD countries.

The SEC Disclosure Proposal

The proposed new rules would require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.

The proposed rules also would require a registrant to disclose information about its direct greenhouse gas (GHG) emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2). In addition, a registrant would be required to disclose GHG emissions from upstream and downstream activities in its value chain (Scope 3) if material or if the registrant has set a GHG emissions target that includes Scope 3 emissions. According to the SEC, these proposals for GHG emissions disclosures would provide investors with decision-useful information to assess a registrant’s exposure to, and management of, climate-related risks, and in particular transition risks.

Emission Related Disclosure and Valuation

For the proposed rules to provide value-relevant information, two things are required. First, the disclosed climate change information must affect expected corporate cash flows or the risk to those cash flows. Second, the mandated disclosures must provide value-relevant climate change information.

As to the first point, it is reasonable to conclude that long-run climate information, by which is meant 2050 and beyond, could well have an impact on corporate valuation. However, we are talking about the very long run, with virtually all the impact occurring more than 20 years in the future, far beyond the horizon of any reasonable DCF valuation model. In addition, the risk that the world might follow RCP 7.0 instead of RCP 4.5 should already be reflected in the values of publicly traded corporations. Only new information related to which emission path is more likely should affect valuations. But the relevant news has nothing to do with the company’s own emissions. The risk to cash flows depends on global emissions. If the SEC could mandate disclosures by the governments of China and India related to their energy plans, that might well provide useful information to investors. But with the two exceptions discussed below, the emissions data of individual American corporations provide essentially no value-relevant information.

The same arguments that apply to expected cash flows also apply to the risk to those cash flows. The primary climate change risk that companies face is that China, India, Africa, and Latin America will increase future emissions. Those risks are the same whether or not the company emits any CO2. Furthermore, those risks must already be disclosed. As SEC Commissioner Pierce observes, existing SEC rules require companies to disclose material risks regardless of the source or the cause of the risk.[2]

There is one valuation effect of the proposed disclosure rules about which there can be little dispute. The reporting requirements will transfer wealth from investors, and other corporate stakeholders such as customers and employees, to consultants, lawyers and accountants who will be required to help companies comply with the complicated new rules. For large firms, this is unlikely to have a significant percentage impact on their valuations, but for small firms it could be meaningful. Aware of this, the proposed rules do offer a safe harbor for small companies with respect to Scope 3 emissions, but even complying with Scope 1 and 2 regulations will be costly and produce an incentive for smaller firms to remain private.

Two Exceptions: Marketing and Regulation

There are two exceptions to the conclusion that variation in the value of American companies is unrelated to their emissions: marketing and regulation. If consumers want to do business with “sustainable” companies, and if they use a company’s emissions as a proxy for sustainability, then information about emissions will affect value. But this is a marketing perception that has virtually nothing to do with climate change.

There is also a marketing element with respect to investors. The growth of sustainable investment funds, most of which charge higher fees than traditional funds, are an indication of investor preferences. However, much of the enthusiasm for sustainable investments appears to be based on the perception that they will provide higher long-run average returns. Finance theory implies that just the reverse is true – investor preferences for certain securities leads to lower average returns in the long run.

Another imminent risk to companies is potential government policies enacted in response to climate change. Unlike climate change itself, which is slow moving and largely predictable, government policy can change abruptly and unpredictably. For instance, a carbon tax could have a meaningful impact on major producers and consumers of fossil fuels. Although government regulation can have a significant impact on corporate valuation, it is odd for an agency of the government to require added disclosures related to emissions because another government body may decide to tax or prohibit those emissions.

ENDNOTES

[1] Gensler, Gary, March 21, 2022, Statement on Proposed Mandatory Climate Risk Disclosures, https://www.sec.gov/news/statement/gensler-climate-disclosure-20220321.

[2] Pierce, Hester M., 2022, We are not the Securities and Environment Commission – At least not yet, https://www.sec.gov/news/statement/peirce-climate-disclosure-2022032.

This post comes to us from Bradford Cornell, emeritus professor of finance at UCLA’s Anderson Graduate School of Management.

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