In its March 2024 climate risk disclosure rule, the SEC makes a compelling case that climate change risks faced by public companies are material to investors. It cites evidence that when a business’s climate risks are disclosed, investors factor them into the share price they are willing to pay. Companies with high carbon emissions are generally perceived as riskier investments, resulting in lower valuations and a higher cost of capital.
This is not universally true: some carbon-intensive firms are positioned to make a shift to low-carbon business models and are rewarded by savvy investors with transition finance. But when companies are perceived as failing to manage transition risks–the risks that changes in policy, technology, and customer and employee sentiment regarding carbon emissions will render them less profitable–investors demand a higher rate of return, known as a carbon premium, for bearing exposure to higher carbon emissions.
This cost-of-capital calculus creates a powerful incentive for carbon-intensive companies to conceal their transition risks. In fact, as discussed below, widespread concealment has been documented. Continued progress with disclosure rules, with enforcement by financial regulators, is the only hope for investors seeking transparency about transition risks.
The Looming Prospects Of A Climate-Related Financial Crash
Greater transparency is needed for more than just individual investment decisions. As the Bank for International Settlements explains, artificially inflated carbon-intensive assets (a carbon bubble) creates enormous instability for the financial system, threatening sudden asset deflation that cascades across the economy. The Intergovernmental Panel on Climate Change warns that the failure to update valuations to reflect the transition could result in trillions of dollars in stranded assets. (A related systemic risk, markets’ failure to price in tipping points such as the potential Antarctic ice sheet collapse and other physical climate impacts, will be addressed in future writings.)
Audited Financials Versus the Media
Seeking to preserve valuations, fossil fuel interests have worked hard to undercut the Paris Agreement and persuade financial markets that the world remains on a carbon-intensive development trajectory. This narrative becomes increasingly absurd as each day passes: the economy is now steadily and inexorably transitioning towards cleaner technologies. Research firms RMI and Climate Analytics each recently issued reports suggesting that the world is approaching peak fossil fuel demand, highlighting, among other indicators, the “S” curves promising continued exponential cost reductions in the renewable energy, electric vehicle, and battery storage sectors.
Earlier this month, the International Energy Agency highlighted how oil exploration and production is continuing despite peak demand’s anticipated arrival at the end of the decade. It forecasted an oil supply glut and crashing commodity prices.
In this low-price environment, only the lowest-cost producers can survive. What fate awaits the Permian Basin, where U.S. oil majors recently acquired assets with combined valuations of $125 billion? Wood McKenzie projects that break-even commodity prices for Permian producers will be at “the top end of the global cost curve” in the 2030s. Despite this, U.S. oil majors have not written down or retired Permian assets or otherwise disclosed assumptions about project breakevens in their SEC filings. Instead, as analyst Justin Mikulka has shown, they have effectively used the media to disseminate an unsupported claim that their Permian assets will be among the world’s low-cost producers.
Deceptive narratives in the media and concealment of risks in audited financial statements operate in tandem to create a dangerous carbon bubble. This is the reality that must inform our next steps on transition risk disclosure policy.
Action Needed While The SEC’s Climate Risk Disclosure Rule Is Stayed
Litigation filed by the fossil fuel industry and its allies to effectively deny the SEC any ability to require climate risk disclosure is now underway, and the SEC has stayed the rule pending the outcome. Robust implementation of the rule, and making necessary improvements, must await the conclusion of this litigation.
Does this mean that work to expose hidden transition risks must be suspended? Not at all. In fact, actions by four regulators–including the SEC–must be taken during the stay, without any reliance on the contested rule, using existing statutory authorities.
Action 1: Investigate The Transition Assumptions In The Financials
In the past three years, Carbon Tracker has released a series of “Flying Blind” studies showing that the world’s most carbon-intensive firms are largely failing to adhere to basic accounting standards requiring disclosure of assumptions about a material risk–the energy transition–in financial statements. They’re also failing to explain how their valuations align with their net-zero emissions reduction commitments. See Figure 2. These failures by the world’s most transition-exposed companies should raise alarms among regulators about potentially material misstatements of assets and liabilities.
The SEC commonly uses letters to Chief Financial Officers to investigate compliance with disclosure duties, including inquiring about disclosures of material climate risks. Yet it has not inquired about companies’ assumptions regarding the impacts of transition risks to their financial statements. It must now acknowledge the enormous financial impacts of the transition on carbon-intensive companies and use these letters to investigate the extent to which these impacts are being concealed from investors.
Action 2: Tell Auditors to Disclose Critical Climate Matters
Carbon Tracker’s Flying Blind studies also show that auditors are not disclosing any efforts to hold U.S. clients accountable for failures to address transition impacts in the financials. The Public Company Accounting Oversight Board has the duty under the Sarbanes-Oxley Act to ensure auditors’ reports reflect their independent professional judgments, not management’s interests in a favorable presentation of risk management. The good news is that an investigation is underway on whether Critical Audit Matters–matters that, among other things, “involved especially challenging, subjective, or complex auditor judgment”–are adequately being disclosed to board audit committees and investors. The PCAOB should use this opportunity to require auditor disclosures of their judgments about transition impacts to the financials.
Action 3: Update Standards for Asset Retirement Obligations
Carbon Tracker research shows that oil companies face trillions in liabilities from Asset Retirement Obligations–legal obligations to plug retired wells and remediate environmental damage. Yet, many are likely understating these liabilities, using inflated estimates of asset lives, or not recording them at all, using a loophole in accounting standards allowing this practice for asset lives deemed to be “indefinite.”
The Financial Accounting Standards Board, the accounting standards setter for the U.S., should move swiftly to address these hidden liabilities. In today’s economy, where both the climate and energy systems are changing at unprecedented speed and scale, absolute precision about the future can no longer serve as the standard for any disclosure. Asset lives of wells were certainly estimated in arranging project financing, and many of these estimates are now inevitably outdated due to transition dynamics. FASB must insist on updated estimates, with disclosures of scenarios considered and sensitivities of the estimates to those scenarios. Such updates will provide critical information about the profitability of oil companies and their ability to fulfill cleanup obligations.
Action 4: Ensure Transition Impacts and Expenditures are Disclosed by Large Companies Doing Business in California
Last year, California enacted two historic climate risk disclosure laws: SB 253, calling for comprehensive greenhouse gas emissions disclosures, and SB 261, calling for disclosures of the climate risks facing companies and actions they are taking to mitigate or adapt to those risks. Applicable to companies doing business in the state and meeting certain revenue thresholds, the laws will produce critically needed disclosures from thousands of public and private companies. The California Air Resources Board, charged with implementing these laws, should write regulations that secure comprehensive information on management of transition risks–especially the transition’s impacts to the financials and any expenditures on the transition.
A Critical First Step to Addressing Financial Instability
In October 2021, the Financial Stability Oversight Council issued its first-ever report on climate risk, finding that it is “an emerging and increasing threat to America’s financial system” and highlighting how mandatory climate risk disclosure is an important step in addressing this threat. Nearly three years later, important progress has been made, but the Council continues to highlight this threat in its reports and robust disclosure rules are still not in place. Urgent action on transition risk disclosure is needed from regulators, investors, and all others concerned about climate change’s impact on our economy and our future.
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