Recently, the Securities and Exchange Commission issued a concept release inviting feedback on Regulation S-K, including how sustainability disclosure must evolve to meet the needs of today’s investors. A fundamental question posed in the concept release is whether the SEC should promulgate rules for line-item disclosure of sustainability information.
Here’s where we must be careful. Though tempting, line-item disclosures are not the best solution in this circumstance. As reiterated in a 2014 speech by Keith Higgins, director of the SEC’s division of corporation finance, the agency has the power to “prescribe rules as necessary or appropriate in the public interest or for the protection of investors,” including line-item disclosures. While this approach ensures a topic will be addressed by companies in their filings, it removes the materiality determination, resulting in corporate cost burdens and immaterial information that clouds the total mix of information for investors.
Line-item requirements are not appropriate for sustainability issues because sustainability issues are not material for all companies, and when they are material, they manifest in unique ways. Take climate change: Just seven out of 79 industries account for 85 percent of the carbon emissions from public equities. The other industries are affected by climate risk, but not because of the threat of regulation related to carbon emissions. For apparel companies it’s the ability to source cotton, a crop that’s vulnerable to shifting weather patterns. For commercial banks it’s financed emissions: loans to oil and gas companies, industrials and utilities. For automakers it’s progress on developing alternative-fuel vehicles. Analysts cover industries, not issues. They need industry-specific metrics to assess risk.
To see the importance of an industry approach, take the SEC’s 2010 climate guidance, which set expectations for companies to report on material risks and opportunities related to climate change. Because the guidance lacked industry specificity, it led to ineffective disclosure: More than 40 percent of disclosure on climate risk is boilerplate, and 27 percent of companies identify no climate risk at all.
Climate change is not the only sustainability issue that’s potentially material. How would the SEC decide which line items were most important for rulemaking? Is climate risk more important than human rights? Are water resources more important than child labor? When Congress and the SEC depart from materiality and stray into political territory, it negatively affects the functioning of our capital markets. Rulemaking for all the potential line items would be infeasible and undesirable.
Instead of line-item disclosure, we can look to securities law. If an issue is likely to materially affect the financial condition or operating performance of a company, then disclosure to investors is compelled. To yield effective sustainability disclosure from existing regulation, we need an industry approach because material sustainability issues differ at the industry level. Exposure to counterfeit drugs is likely to be material for pharmaceuticals companies, but not for miners. Product safety is likely to be material for automakers, but not for real estate companies. Water risk is likely to be material for beverage manufacturers, but not for banks.
An industry approach allows for material information to be unearthed, interpreted and employed via the same lens investors use to diversify portfolios, benchmark companies and price risk. As early as the 1960s, researchers King, Cohen and Pogue understood that an industry lens was the most important “common factor” to describe residual returns in securities. In 1976, Rosenberg and Marathe furthered the concept of industries as significant microeconomic determinants of risk because companies in industries share fundamental characteristics and hence respond similarly to macroeconomic events, such as climate change. Beyond company-specific factors, industry exposure has been the most influential driver of equity market returns, accounting for 22 percent of gains for U.S. stocks over the past 20 years.
Sustainability disclosure does not require political force. When sustainability information is material, it’s already required to be disclosed. An industry approach to sustainability disclosure — underpinned by standards — will ensure it’s done effectively, so risk can be priced and understood.
Jean Rogers is CEO and founder of the San Francisco–based Sustainability Accounting Standards Board.
