Risk Management

Limit ESG Disclosures to Cash-Flow Impacts: Economists

The SEC should avoid forcing companies to disclose how business operations affect the environment and society, says the Financial Economist Roundta...
Vincent RyanOctober 11, 2021

Should the Securities and Exchange Commission write rules that require disclosure of greenhouse gas (GHG) emissions from a company’s operations and, possibly, its entire value chain? Not if those emissions don’t affect the company’s financial performance, says the Financial Economists Roundtable.

In a position paper last week, the group of senior financial economists said that any environmental, social, and governance (ESG) disclosure rules being written by the SEC should be limited to financial matters, specifically, a company’s cash flows.

For the SEC to go beyond that and require companies to report on how their operations broadly affect society and the environment, including whether they accelerate climate change, would constitute regulatory overreach, said FER.

“The SEC should not yield to pressure from proponents of mandated disclosures about firms’ environmental- and social-related societal impacts, and the U.S. Congress should not require the SEC to mandate such disclosures,” a statement from the 50-member organization, founded in 1993, said.

“The SEC’s expertise lies in financial disclosures; … it does not have the expertise to design disclosures that seek to influence societal outcomes, nor the resources to review such disclosures,” the paper continued.

In speeches over the past few months, SEC Chair Gary Gensler has said the SEC could require companies to report on everything from how a company manages climate risk in day-to-day operations to the reporting of scenario analyses on how climate change could affect the business’s future.

Other SEC Commissioners have drawn a line around how far the SEC should go, saying any disclosure mandates should be limited by the concept of materiality and therefore include only the impact on a company’s financial condition or operating performance.

If the SEC mandated reporting of environmental and social outcomes, it would be setting U.S. ecological and social priorities, said FER. “What gets measured gets managed … Mandates of this type allow the SEC to become a political tool,” the group said.

In addition, FER said any product and capital market pressures for firms to change their behaviors that arise from mandated disclosures would cost companies. “The burden of this cost would likely fall unequally on firms and among the different stakeholders of most firms,” it said. Burdensome disclosure requirements would also drive some public companies to become private and others to avoid going public.

The cash-flow impacts that FER recommended companies be required to report in a 10-K or similar filing would involve either anticipated future cash flows (estimated), or current cash flows (investments or expenditures).

One kind of disclosure would be the cash-flow impacts of material ESG risk factors, such as a firm’s assets being subject to increasingly severe natural disasters; regulatory actions that impose costs, such as increased diversity reporting; or consumer preferences for “green” products that reduce sales.

The second kind of disclosure would be cash-flow impacts from the company’s internal decisions to “decrease its adverse societal impacts or enhance its positive impacts.” For example, according to FER, a firm could choose to invest in greener technology or forgo investments that involve the use or production of fossil fuels or maintain its equipment more frequently to reduce its environmental impact. All would affect cash flow.

Notably, FER said the SEC’s mandate should be principles-based — “the firm must disclose, but it can choose what and how,” instead of requiring the release of specific ESG metrics.

Notably, FER said the SEC’s mandate should be principles-based — “the firm must disclose, but it can choose what and how,” instead of requiring disclosure of specific ESG metrics.

“We envision rules and guidance similar to those for the management discussion & analysis (MD&A),” FER said. “The framework could require or suggest categories of disclosures such as (1) regulatory environment and anticipated intervention; (2) supply chain activities/risks; (3) distribution channel activity/risks; (4) current investments/activities; and (5) metrics tracked by management if any.”

The problem with requiring specific ESG metrics is that “there are hundreds of possible metrics to choose from, and the relevant metrics can vary by industry, region, and firm size,” said FER.

“Should a public utility that generates electricity by hydraulic power generators earn a high score on an E measure because it has low carbon emissions? Or should it earn a low score because its dams destroy the populations of endangered wild salmon?”

Inconsistent or poorly defined terms exacerbate the problem of measuring ESG impacts, FER added.

For example, “CO2 emissions differ from other GHG emissions … [And] commonly used terms such as carbon footprint, climate change, governance, workforce diversity, physical risk, and transition risk have come to mean different things to different users of these terms. Without definitions, one cannot easily compare and verify across firms.”

While FER members don’t see any benefit from the SEC being involved in disclosures of a business’s impacts on the environment or climate change, it said agencies such as the Environmental Protection Agency, the Labor Department, and the Equal Employment Opportunity Commission potentially have the expertise to set reporting requirements for things like carbon emissions or workforce diversity.

FER added that other government policy solutions could more effectively meet regulatory goals related to ESG risks, such as taxing GHG emissions or imposing firm-specific caps on emissions.

The executive director of FER is Larry Harris of the University of Southern California. Its steering committee includes Professors Jay Ritter of the University of Florida and Robert McDonald of Northwestern University.

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