Could Financial Disclosures Curb Climate Change?

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Climate disclosures—if designed well—can bridge the gap between financial actors and regulatory goals.

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Climate change is regarded as one of the greatest failures in human history. The devastating consequences of climate change include droughts, floods, global warming, heat waves, rising sea levels, wildfires, and biodiversity destruction.

The wide-reaching and complex nature of climate change makes tackling this challenge exceptionally difficult—especially in the domain of economic decision-making. Many outcomes of economic activities, often unintended or unforeseen, contribute to climate change and environmental degradation.

Responding to this challenge, economists, environmentalists, and politicians seek ways to ensure that financial decision-makers consider climate change. In 2015, the international Financial Stability Board established an industry-led task force on climate-related financial disclosure. The task force developed guidelines for voluntary climate-related disclosures to promote informed investments and allow stakeholders to understand reporting entities’ exposures to climate-related risks.

Progressing beyond voluntary rules, governments worldwide have started developing initiatives aimed at fighting climate change by adopting new disclosure requirements. These countries include Brazil, the United Kingdom, New Zealand, Switzerland, and Singapore, which have already adopted regulations that mandate disclosures. At the same time, many other jurisdictions, including the United States and the European Union, have issued concrete proposals for such mandates.

Climate-related risk disclosures compel financial actors to report the impact of climate change on their businesses, including their operations, risks, balance sheets, and future profitability. Presumably, these disclosures are based on the rationale that systematic, comparable, and understandable disclosures promote better climate-related decision-making and risk management. The assumption is that climate-related disclosures will elucidate how companies react to and consider the impacts of climate change and thus improve their response.

To illustrate, consider the potential exposure of an insurance company to climate risks. Some homes, perhaps many homes, may become uninsurable because of increasing flood and storm surge risks. Other insured assets may incur greater damages, resulting in more claims against insurers. These risks, however, are important not only to the insurance company’s profitability but also to homeowners, mortgage lenders, renters, investors, and banks.

As they proceed to design disclosure regimes, policymakers and other stakeholders should consider several key policy features. They should, for starters, define the target audience of these disclosures. New Zealand’s proposed disclosure framework targets “primary users,” defined as investors, lenders, and other creditors. In other words, the definition of primary users does not encompass employees, customers, or the public.

This definition may be too narrow. Targeting a wider audience would increase the impact and relevance of climate-risk disclosures and thus better serve their goals. A wider audience also better aligns with a modern conception of the firm, called stakeholder capitalism, which focuses on stakeholders rather than merely shareholders.

Unlike shareholders, stakeholders typically look beyond the narrow and sole perspective of the firm’s short-term profits. Stakeholders attend to broader social and community interests and the firm’s long-term sustainability. Stakeholders seek and demand strategies that benefit wider present and future populations rather than merely the shareholders.

Interestingly, the European Union adopted such a broad perspective in 2019 when it published guidelines on reporting climate-related information. The EU guidelines specify a “double materiality” standard for determining what to report. This standard considers what is material for both shareholders who are the financial audience and stakeholders who are the environmental and social audiences. Other countries should follow this path when developing guidelines for climate-related disclosures.

A closer examination of proposed disclosure guidelines and frameworks reveals additional issues that merit discussion. One of these issues relates to the dilemma of rules versus standards. While rules are specific and clear—consider, for example, speed limits, deadlines, and age restrictions—standards and principles are more general and ambiguous.

Policymakers may be tempted to use standards in designing disclosures. The New Zealand initiative, for example, makes “fair presentation” the overarching principle of climate-related disclosures. Fairness, however, is a notoriously ambiguous legal norm. Without making it more concrete, firms can abuse such ambiguity and comply with the letter of the law while evading its spirit.

Another key issue relates to ensuring that disclosures are readable and understandable. Indeed, the literature suggests that disclosures, especially when they target individuals such as consumers, clients, and patients, tend to be too complex and do not achieve their goals.

In advancing climate-related disclosures, regulators and legislators should articulate clear metrics and rules about what “understandable” and “readable” disclosures are. Here, policymakers could use established linguistic formulas, such as Flesch-Kincaid readability tests, or advanced tools, such as the open-source CommonLit Ease of Readability corpus, which can measure text readability and complexity. Specific organizational signals—such as headings and subheadings, paragraph numbering, table of contents, a one-page summary, and eliminating all caps—can also promote readability and understandability.

To enhance the effectiveness of disclosures further, policymakers should consider comparability and consistency. Unified and consistent standards help people understand disclosures and make them more effective while reducing reading costs. We recommend that regulatory frameworks adopt a standardized template or disclosure structure that all reporting entities must follow. Furthermore, we suggest that there should be specific climate scenarios—for example, a pre-specified increase in mean temperature, sea levels, and the extent of the shift in the statistical distribution of high precipitation events—against which entities must report.

Disclosures typically include large amounts of data, but humans have limited cognitive capacities. Multiple disclosures in various domains tax humans’ ability to read and process them. Automating the process and capitalizing on technological developments can aid meaningful disclosure.

To that end, companies should make their disclosures machine-readable. To ensure machine readability, disclosures should be provided in an adequate digital format, include unique data identifiers, and have a structured layout and standardized taxonomy. This processing will enable humans to defer to machines and rely on technology to process the disclosed information.

Likewise, big data and recent developments in artificial intelligence and sophisticated language models and reading tools—for instance, GPT-3—offer significant social and economic benefits. Presumably, they should turn reading, analyzing, and comparing disclosures into a simple, cheap, and easy task. These tools, however, are not a magic bullet, and they are prone to mistakes and adversarial attacks. At least for the foreseeable future, any proposed legislation mandating disclosures should consider the requirements, benefits, and limitations of machine-readable texts and automatic reading tools.

Climate-related disclosures have the potential to prompt the business community to consider more regularly and more deeply the effects of climate change and the risks they entail. Well-designed disclosures could encourage firms to adopt more climate-friendly strategies and lead a smoother transition to a resilient and sustainable economy.

Samuel Becher is a professor of law at Victoria University of Wellington, New Zealand

Ilan Noy is a professor of economics at Victoria University of Wellington, New Zealand.