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“We recommend that the Commission now move to promote and enforce mandatory and meaningful disclosures of the material effects of climate change on issuers, and also that the
SEC work to provide more industry-specific guidance on how to account for climate risk.”
Former Secretaries of the Treasury H. M. Paulson, R. E. Rubin, and G. P. Shultz, Comment Letter to the SEC, 12016
I. INTRODUCTION
Federal securities regulation and case law uphold managers’ affirmative duty to disclose all material information in their firms’ Securities and Exchange Commission SEC filings SEC
2016; Sommer Report 1977. Yet, managers’ decisions whether to disclose climate-change risk CCR in Form 10-K are confounded by two key institutional factors.
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First, there is little consensus on whether CCR is a material risk to the firms Hulac 2016; Coburn and Cook 2014.
Second, federal CCR disclosure regulation has been inconsistently enforced across firms GAO 2016, 21; Gelles 2016. We argue that these factors, along with managers’ unobservable
evaluations of the costs and benefits of disclosing versus not disclosing CCR, create ambiguity about whether disclosing CCR in Form 10-K is voluntary or mandatory. This, in turn, hinders
investors’ ability to discern whether managers who choose to not disclose CCR are deliberately trying to conceal useful but adverse information, or are instead acknowledging that CCR is not a
material risk. This complex institutional context raises a fundamental empirical question: Are managers’ decisions whether to disclose CCR associated with firm risk, as measured by the cost
of equity capital? Regulation S-K requires firms to disclose in their SEC filings “the most significant
factors that make an investment in the registrant speculative or risky” Regulation S-K, Item 503c, SEC 2004. The 2010 SEC interpretive guidance clarifies Regulation S-K and specifies
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In the interest of brevity, from this point onward “in Form 10-K” is generally implied whenever we refer to managers’ decision to disclose CCR, and “users” refers to stakeholders who use Form 10-K to make their
decisions.
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that if managers assess CCR as material to the firm, then they are mandated to disclose it SEC 2010.
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Yet, according to analysts, “for investors interested in managing the economic risks of climate change, the SEC is among the least helpful places to look” Hulac 2016. On one hand, if
managers perceive that CCR disclosure regulation is strongly enforced but choose to not disclose, then they likely assess CCR as not material. Alternatively, managers may assess CCR
as material but choose to not disclose it if they perceive that regulation is weakly enforced and conclude that the costs of disclosing CCR exceed the benefits. Thus, if managers choose to not
disclose CCR, then it is difficult for the market to reliably infer managers’ assessments of the materiality of CCR for the firm. The lack of consensus about whether CCR is material to the
firm, and the SEC’s inconsistency in enforcing disclosure of material CCR provide the primary motivation for our inquiry on the association between managers’ decisions whether to disclose
CCR and firm risk. The importance of our inquiry is threefold. First, firms’ failure to disclose material CCR
in 10-K filings may leave investors, who are looking for information to assess and reduce risks in their portfolios, exposed to potentially significant losses McCann 2016; Olson and Viswanatha
2016; Newlands 2015. We discuss a recent example of CCR related to the concept of stranded assets. The United Nation’s 2015 Paris Agreement set a worldwide goal to curb greenhouse gas
GHG emissions to keep global temperatures from rising more than 2° C 3.6° F above pre- industrial levels.
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To achieve this goal, scientists estimate that three-quarters of the fossil fuel reserves, including oil, gas, and coal, will need to stay in the ground i.e., stranded.
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For a detailed discussion of the guidance, see Shorter 2013.
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Source: http:bigpicture.unfccc.intcontent-the-paris-agreemen
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Statement by Christiana Figueres, Executive Secretary, United Nations Framework Convention on Climate Change available at:
http:unfccc.intfilespressstatementsapplicationpdf20140204_ipieca.pdf .
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If fossil fuel companies are required to leave a significant bulk of their reserves i.e., their assets stranded, then their valuations could take a deep dive. This is the key argument invoked
by ExxonMobil’s shareholders in a recently filed class-action lawsuit against the firm. The lawsuit alleges that shareholders suffered financial losses after paying inflated prices for the
firm’s stock, even though the firm knew that the value of its oil reserves was significantly less than what it disclosed. Exxon publicly represented that none of its assets were stranded because
the impacts of climate change, if any, were uncertain and far off in the future Hasemyer 2016. Yet, i
n its 10-K filings in 2017, Exxon wrote off 3.3 billion barrels of oil equivalents which the company deemed as stranded Smith 2017. Further, in a recent nonbinding resolution led by
Exxon’s two largest shareholders, Vanguard Group and BlackRock, Inc., 62 percent of shareholders called for the company to disclose more open and detailed analyses of the risks
posed by climate change regulation. The proposal also pushes Exxon to conduct a climate “stress test” to measure how new energy technologies to reduce GHG emissions could impact the value
of its oil assets Cardwell 2017; Olson 2017. Second, our inquiry is important because mainstream investment analysts’ decisions to
buy, sell, or hold a security are increasingly influenced by sustainability disclosures SASB 2016, 2. In a 2015 CFA Institute survey of 1,325 institutional investors, 73 percent of
respondents indicated that they take environmental, social, and governance ESG issues into account in their investment analyses and decisions. The top reason investors incorporate ESG-
related information in their decisions is to determine whether a company is adequately managing risk CFA Institute 2015. Relatedly, BlackRock, Inc. has urged investors to incorporate climate
change in their investment decisions and to make climate-proof portfolios a key consideration for
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all asset owners BlackRock Investment Institute 2016.
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Notably, 52 percent of shareholder proposals in proxy filings in 2015 related to environmental and social issues EY 2015.
Finally, our inquiry regarding the capital-market effects of mandating disclosure of material CCR in SEC filings is important in light of recent global trends towards increasingly
requiring such disclosures. These trends include, among others, the European Union’s EU recent mandate European Parliament 201495EU on ESG disclosures and the ESG disclosure
guidance developed by the World Federation of Exchanges WFE 2015. These global trends highlight the need to better understand the association between disclosing CCR and firm risk.
We hand-collect 2,996 firm-year observations of SP 500 firms’ choices whether to disclose CCR for 2008 to 2014. We obtain our sample from the intersection of the SP 500
index firms and the Ceres, SASB, and CDP databases.
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We collect our sample firms’ decision to
disclose CCR from the Ceres database. A majority of the firms in our sample voluntarily report CCR through the CDP climate change survey. Therefore, we control for this voluntary disclosure
by including firms’ decision to participate in the survey. Because users’ judgments of CCR
materiality are industry-specific Khan, Serafeim, and Yoon 2016, we use SASB’s Materiality Map
™
, an industry-based classification of CCR materiality. To proxy for firm risk, we construct a composite implied cost of equity COE measure
using the median of the following four measures suggested by the accounting and finance literatures:
Easton’s price earnings growth PEG model 2004, Gebhardt, Lee, and
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In addition, corporate board responsibility for climate change has increased from 67 percent to 95 percent from 2010 to 2015, according to a 2015 climate change report from CDP CDP 2015, 6.
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Ceres is a coalition of investors, companies, and public interest groups whose mission is to build a sustainable global economy. In 1997, Ceres launched the Global Reporting Initiative GRI, which has been widely adopted as
the standard for sustainable reporting worldwide. The first year of data availability in Ceres is 2008. See http:ceres.orgabout-uswho-we-are
. We provide details on SASB in Appendix A. CDP formerly Carbon Disclosure Project is a nonprofit that surveys the world’s largest companies by market capitalization on various
sustainability topics. Its advisers consist of a network of 827 institutional investors representing over 100 trillion in assets under management. See
https:www.cdp.neten .
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Swaminathan 2001 GLS, Claus and Thomas 2001 CT, and the price-earnings ratio. Our
analyses using propensity score matching and doubly robust regressions offer two important results. First, even after controlling for firms’ decisions to voluntarily disclose CCR in the CDP
survey, we find a negative association between disclosing CCR and COE. Specifically, our doubly robust regression results indicate that the COE of disclosing firms is significantly lower,
by 21.3 bps, than the COE of non-disclosing firms. More importantly, and central to our materiality prediction, we find that, in industries
where users judge CCR as material, the COE of disclosing firms is 49.1 bps lower than the COE of non-disclosing firms. In contrast, we find that disclosing vs. not disclosing CCR is not
significantly associated with the COE for firms in industries where users judge CCR as not material. We conduct several robustness tests to assess the sensitivity of our main results and our
inferences are unchanged. We contribute to and extend in several ways the growing literature on capital-market
implications of voluntary and mandatory sustainability disclosures. First, most of the extant research examines disclosures that are either unambiguously mandatory Kravet and Muslu
2013, or unambiguously voluntary Dhaliwal et al. 2011. Unlike prior research, we examine a setting where there is considerable ambiguity as to whether CCR is a mandatory or voluntary
Form 10-K disclosure. Second, recent studies urge researchers to examine interactions between mandatory and
voluntary disclosures Beyer, Cohen, Lys, and Walther 2010; Heitzman, Wasley, and Zimmerman 2010. Our study extends Matsumura, Prakash, and Vera-Muñoz 2014, who find a
negative association between firm value and carbon emission levels. They also find a higher median market value for firms that disclose their carbon emissions to the CDP voluntarily than
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for non-disclosing firms. Our study further contributes to the literature by examining the risk relevance of disclosing CCR in 10-K filings
, incremental to voluntary CCR disclosures to CDP .
Our findings lend support to the concerns that managers’ failure to disclose CCR imposes additional risk on firms, but only in industries where users judge CCR as material. Our results
also extend those of Khan et al. 2016, who find a positive association between sustainability investments and future abnormal stock returns, but only in firms that have strong ratings on
material sustainability issues. Finally, our study sheds light on the SEC’s recent call for public comment on whether
certain Regulation S-K disclosure requirements need to be updated to better serve the needs of investors and registrants SEC 2016. The materiality principle is intended to balance investors’
need for information to make informed decisions, without being burdened with excessive information, against the cost to registrants of providing information. Our findings provide
evidence that disclosing CCR is associated with lower COE, but only when users judge CCR to be material.
The remainder of this paper is organized as follows. The next section discusses institutional background on CCR, while section III reviews the research literature and develops
our hypotheses. Sections IV and V describe our research design and provide the results of hypotheses tests, respectively. The last section briefly summarizes the findings and discusses the
study’s limitations and implications for research and practice.
II. INSTITUTIONAL BACKGROUND ON CLIMATE-CHANGE RISK
