Keeping Pace with Climate Change Disclosure

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The topic of climate change disclosure in the corporate securities market dates back several decades when environmental regulations started to require some companies to change their operations to have less impact on the environment. Even the United States Securities and Exchange Commission (“SEC”) has provided guidance regarding climate change disclosure including guidance in 2010. By early 2021, regulatory concerns that climate change risks were increasing to a degree that more thorough and consistent climate change disclosures by public companies were necessary. This led to a request in March 2021 by the Acting Chair of the SEC for public input on climate disclosure from investors, registrants, and other market participants. A year later, in March 2022, the SEC has proposed a new extensive climate change disclosure regime for public companies (the “Proposed Rule”). In what appears to be in the short future, the SEC will approve some form of rules that will substantially revamp climate change disclosure for public companies.

As the topic of climate change disclosure has garnered more attention in the corporate securities market, that attention has reached the municipal securities market. Climate change has been a topic of increasing frequency and extensiveness in municipal market disclosure and an increasing topic at conferences and other thought leadership forums. In December 2021, the Municipal Securities Rulemaking Board (“MSRB”) issued its own request for information, seeking input on climate change disclosure as it relates specifically to municipal securities disclosure. The MSRB’s request asked for input from municipal issuers and conduit borrowers on their current climate disclosure practices and whether they thought they would benefit from standardized disclosure requirements. The request also asked investors what they viewed as material climate information and whether they believe they currently have access to sufficient climate information to make informed investment decisions. The MSRB also sought input on regulating labelled bonds, such as “Green Bonds.”

It’s become clear that the securities regulators are focused on climate change disclosure and the topic will only increase in market focus and attention, not decrease. In addition, with such vast changes on the way in the corporate securities market, it is likely that the increased levels of disclosure in the corporate securities market by public companies will at some level spill over to the municipal securities market. The municipal securities market is different in structure, kinds of securities, and kinds of credits, and thus the topic of climate change disclosure will need to be dealt with differently from the corporate securities market.

What can we learn from the SEC’s Framework for Climate Change Disclosure?

While climate change disclosure has become one of the hot topics in the municipal securities market, many market participants are struggling with what good climate change disclosure should look like. The municipal securities market involves a host of diverse credits with a range of sizes, sophistication, and revenues sources. Developing climate change disclosure can be paralyzing for market participants because of so many of the uncertainties presented by climate change—How do we develop good disclosure when we know so little? In this context, disclosure can become not much more than generic disclosure that does not inform investors of much more than they already know. In this article, we will suggest a framework by which market participants can consider climate change disclosure with a view toward more factual, specific climate change disclosure that informs investors of those unique facts that are known about a credit. That being said, we must observe that with some credits much will not be known and there may not be a deep set of facts that can inform investors. But with other credits that will not be the case. Our approach suggests treating each credit on its own and evaluating what we know and what we do not know about how climate change may impact that credit.

Moving from disclosure hot topic to a regulatory focus

The SEC’s Proposed Rule does not apply to the municipal securities market and only applies to public companies governed by the more proscriptive corporate securities regime, but that does not mean that we cannot glean a lot of guidance from the framework for climate change disclosure in the Proposed Rule. The Proposed Rule sets forth a helpful framework for disclosing climate change risks. The Proposed Rule defines “climate-related risk” as “the actual or potential negative impacts of climate-related conditions and events on a registrant’s consolidated financial statements, business operations, or value chains, as a whole.” The Proposed Rule also defines two different types of climate-related risks: physical risks, or risks to issuers as a direct result of a changing climate (like rising sea levels, droughts, wild fires, stronger storms, etc.), and transitional risks, which are risks associated with a potential transition to a low carbon economy.

Physical Risks. The Proposed Rule defines “physical risks” as “both acute and chronic risks to a registrant’s business operations and the operations with whom it does business.” “Acute risks” are “event-driven risks related to shorter-term extreme weather events, such as hurricanes, floods, and tornadoes.” “Chronic risks” are “risks that the business may face as a result of longer term weather patterns and related effects, such as sustained higher temperatures, sea level rise, drought, increased wildfires, as well as related effects such as decreased arability of farmland, decreased habitability of land, and decreased availability of fresh water.” The Proposed Rule specifies what kind of substance should be included in disclosure of physical risks. Disclosure should include the nature of the physical risk and whether it is an acute or chronic risk. Issuers would also have to identify the location of their exposure to physical risk, including what properties and operations are subject to the risk. Disclosure of chronic risks may also intermingle with disclosure of acute risks. For example, rising temperatures in the long term would be a potential chronic risk an issuer faces. If an issuer has personnel who need to work outdoors, rising temperatures could limit the number of days such personnel can safely operate. Rising temperatures can also lead to the acute risk of wild fires that pose risks to an issuer’s physical assets and ability to operate.

Transitional Risk. The second type of risk the SEC defines in the Proposed Rule is “transitional risks.” Transitional risks are defined as “the actual or potential negative impacts on a registrant’s consolidated financial statements, business operations, or value chains attributable to regulator, technological, and market changes to address the mitigation of, or adaptation to, climate-related risks.” These risks include “increased costs attributable to climate-related changes in law or policy, reduced market demand for carbon-intensive products leading to decreased sales, prices, or profits for such products, the devaluation or abandonment of assets, risk of legal liability and litigation defense costs, competitive pressures associated with the adoption of new technologies, reputational impacts that might trigger changes to market behavior, changes in consumer preferences or behavior, or changes in a registrant’s behavior.”

The SEC’s climate change disclosure framework is helpful for the municipal securities market for a couple of reasons. First, the SEC made an effort to define the universe of what risks public companies should be investigating, analyzing, and disclosing. We can follow suit in the municipal securities market even if, as we suggest below, the framework we use is different than the SEC’s framework. Second, the SEC provides helpful guidance on the ways that these risks can materialize into risks for investors that become helpful examples for the municipal securities market as well. While, as we explain below, the climate change disclosure framework for the municipal securities market would be different given the differences in the market, we think that starting with the SEC’s framework will help form more effective climate change disclosure.

Developing an Effective Climate Change Disclosure Framework for the Municipal Securities Market

The SEC’s Proposed Rule is directed at public companies in the corporate securities market and, no matter how comparable climate change risks are between the markets, an effective climate change disclosure framework in the municipal securities market will be different. Building on the SEC’s framework, though, we believe that municipal securities market participants should consider the following four factors when evaluating climate change disclosure.

Physical Risks. Physical risks from climate change can impact municipal credits as much as public companies and, thus, the SEC’s approach to physical risks can be helpful in helping municipal securities market participants identify and disclose physical risks. Some examples of this are droughts impacting water utilities, or storms that can damage infrastructure.

Capital Improvement Plan Risks. In many instances in the municipal securities market, the most significant climate change risk is the ways that potential physical risks may require the issuer to develop capital improvement plans that ensure that the operations remain operational and resilient to those physical risks. This materializes as a risk for investors because the issuer may need to issue bonds to fund those capital improvements, which can place a substantial amount of debt on parity or in competition with outstanding bonds. Issuers may have already identified components of their capital improvement plans that need to change in order to address climate change.

Political Risks. As political bodies, cities, counties, and other governmental entities may, for reasons that may not be purely financial or operational, take actions that can represent climate change risks. A good example of a political risk factor is the alignment of many cities with the principals of the Paris Climate Agreement after the United States withdrew in 2017. As a result, cities that adopted the principals of the Paris Climate Agreement committed to make significant expenditures on initiatives such as making public transportation emissions free, which could in turn impact the financial positions of those cities.

Transition Risks. Transition risks can also apply to the municipal securities market, but perhaps not as commonly as many public companies. Some issuers, such as public power issuers, have faced transition risks for several decades as environmental regulatory developments have required them to transition their operations. But many municipalities will not be subject to direct regulatory changes like public companies. These municipalities, however, are likely to be subject to political risks and other risks we discuss above. Regardless, it is important to evaluate each credit to determine whether it faces material transition risks because many municipal credits do face such risks. The SEC’s Proposed Rule defines transition risks well and would be a helpful starting point to outline examples of how an issuer could face transition risks.

We believe that, like the SEC does in the Proposed Rule, this can serve as a helpful checklist of potential ways that climate change risks can impact municipal credits.

What is the right process for developing climate change disclosure?

The municipal securities market includes a wide variety of credits and climate change risks will range from negligible to substantial and material to the credit. In our view, the key to slicing through this wide range of credits to develop good climate change disclosure for specific credits is to develop a sound process of evaluating how climate change risks affect each credit. Here are some steps to a process we suggest:

Due diligence the credit

The first step to creating climate risk disclosure is doing the diligence to understand the current and potential risks the municipal credit faces following a framework like we lay out above. Are there internal or external reports available addressing physical climate risks particular to the issuer, or to the geographic area in which the issuer operates? If so, are the issuer’s systems completely, or only partially exposed to physical risk? How might potential regulation impact different parts of the issuer’s operations? Does the issuer have personnel who monitor and plan for climate risks, and do they have a climate change resilience plan in place or in discussion?

What does management know?

One of the important ways to cut through a topic like climate change disclosure where there are so many uncertainties and so many potential developments that remain unknown is to focus on what management of the issuer knows and how management anticipates responding to what it knows. For example, a water utility may not know how droughts may affect its water supply, but if the water utility expects to undertake significant capital improvements for storage or other drought mitigation projects, then how the water utility responds to the uncertainties may actually be more material than the physical risks themselves. In addition, as the SEC states in its Proposed Rules, management can develop scenario analyses that attempt to quantify the potential impact of climate change risks given various scenarios. Sometimes in circumstances that are as unknown as climate change, what can matter most to investors is what management knows, what management is considering, and how management will respond to address those uncertainties.

Try to move away from generic climate change disclosure and move toward disclosure that focuses on facts that are known and that can inform.

One of our takeaways from the SEC’s Proposed Rule is that the SEC is trying to find knowable facts that can give investors a sense of how one public company differs from another. The SEC seems to be reacting to overly generic disclosure that tells investors about risks that at some level are already widely known. There are some credits about which there are no real facts that can be known. For example, bonds backed by ad valorem property taxes may have only generic climate change risks and no one knows much beyond that. But other credits may have facts that can inform investors. Focusing on any facts that are known will help disclosure be more informative. If climate change disclosure is so generic that it could apply to almost any issuer, then it will not inform investors about what is unique and different about the particular municipal credit relative to others.

Concluding thoughts

Topics like climate change disclosure can be difficult because we can become paralyzed by the uncertainties of what the future holds. But regulatory guidance is providing the municipal securities market with a better picture of how to fashion effective, informative disclosure in the face of so much uncertainty. This involves developing a good framework so that we know what we are trying to uncover and disclose, and then considering an effective process so that we consistently develop good disclosure that matches the uniqueness of credits.