Climate change is one of today’s most salient policy challenges. Under the Paris Agreement, 195 governments agreed to limit temperature increases to well below 2, preferably 1.5, degrees centigrade relative to pre-industrial levels. Since the magnitude of global warming is roughly proportional to the amount of carbon in the atmosphere, the Agreement in effect specified a ‘carbon budget’. To stay within that budget, emission reductions equivalent to what was forced upon us by the worst pandemic in 100 years need to occur every two years throughout the 2020s and beyond. Clearly, just ‘doing less’ is not going to cut it—meeting the target will instead require a fundamental rewiring of the way our economies work. That, in turn, will involve a reallocation of capital to support the transition to a ‘net zero’ economy on a scale that is unparalleled in modern history.
In market economies, capital allocation is driven by pricing mechanisms. Pricing mechanisms, however, cannot work when market players are not required to pay for the negative consequences of their actions: too much capital will flow into socially undesirable activities. A foundational question is therefore how the pricing mechanism can be made to work so that the social costs of carbon emissions are reflected in prices. Economists widely agree that pricing carbon emissions matched to their costs to society would be an effective way to enlist market forces. Unfortunately, enacting such policies has proven politically challenging: carbon pricing has to date only been applied sporadically and with a ‘price’ set far too low compared to the social cost of emissions. This is vastly insufficient to drive the capital reallocation that is required.
A second-best, but by-now widely endorsed, strategy to mobilise market forces to drive the net zero transition is to encourage bottom-up engagement by firms and investors. In our essay, forthcoming in the Columbia Business Law Review, we outline the implications of this strategy for corporate climate disclosures.
We first evaluate the incentives that firms and investors face to engage with the pricing of climate risks, which vary depending on the type of action that might be involved. Adaptation to climate change will directly reduce the costs of climate change at a firm level, so firms should internalise the benefits associated with such investments. However, investment in adaptation will not affect firms’ stock prices unless investors price the risks associated with climate change for individual firms, which requires them to have information about companies’ climate risk exposures. Firm-level incentives to mitigate climate change by lowering carbon emissions, the main goal of the Paris Agreement, are less obvious. A small number of firms are disproportionately responsible for a large share of overall emissions. For these firms, the emissions are externalities that do not affect their profits unless and until carbon taxes are introduced—which, as mentioned, currently seems unlikely. Engagement from investors who have an interest—financial or otherwise—in controlling these externalities may lead to such mitigation, but that engagement is again conditional on these investors having access to firm-level (as well as macroeconomic) information around climate risks.
Given the central role of firm-level information about climate risks, we ask whether such information is currently available. The answer, in short, is ‘no’. In part, this is because climate risk pricing is still in its infancy, which complicates efforts to define what types of information are needed for effective pricing by investors. For information we can agree to be within-scope, the follow-up question is how best to produce it. To be sure, much information can be disseminated without any action by companies. But the decision-relevant information set would be highly incomplete without private corporate information. Voluntary climate risk disclosure frameworks, most notably the one championed by the Task Force on Climate-Related Financial Disclosures (TCFD), have catalysed the thinking around climate disclosures. But despite widespread commitment to their adoption, investors still indicate they lack the information they say they need. The result is mispricing, and a resulting misallocation of capital, which hampers the transition to a net zero economy.
This situation demands a clear policy response: making corporate climate disclosures mandatory. The widely accepted rationales for mandating corporate disclosures in securities markets are two-fold. First, issuers and their agents, left to their own devices, lack incentives to disclose enough information: disclosure of more firm-specific information confers positive externalities on market participants, who are thus able to price all firms’ idiosyncratic risk more accurately. In addition, issuers fear that competitors will use their disclosures to erode their competitive advantage. Second, managers fear losing the rents made possible by information asymmetries. Hence securities law compels issuers to disclose extensive information.
These rationales apply to corporate climate disclosures as well: individual issuers’ climate risk disclosures help investors understand climate risks at other issuers, while managers may prefer not to disclose if markets are underpricing climate risks. The positive externalities stemming from climate-related disclosures are particularly relevant when it comes to transition risk, or the risk associated with adapting, or failing to adapt, a firm’s strategy to government policies, changes in customer behaviour, and technological advances. Impacts of the net zero transition on a firm’s business model are a function not just of firm-level factors, but also of the aggregate behaviour of other actors, including other issuers. Thus, the extent to which a firm needs to adjust its business model to accommodate the net zero transition—and the associated risk from failure to do so—is a function of the extent to which, and how, governments, consumers, and other firms themselves transition. In sum, firm-specific transition risks depend on each firm’s interplay with each other and with aggregate dynamics, which makes firm-level disclosures on these aspects more salient from a macro perspective.
What should such mandatory corporate climate disclosure regimes look like? To create a yardstick against which governments’ proposals can be evaluated, we conclude the essay by outlining several design principles that go beyond the emerging consensus. In short, we call for (1) the disclosure of asset ownership data that can provide insight into firms’ exposure to the physical impacts of climate change, (2) the coordination of transition risk scenario-setting by policymakers to aid comparability and credibility (much like a macroprudential policymaker setting out stress test scenarios), and, (3) for the largest emitters, the disclosure of carbon emission data and net zero transition plans. Coverage of such a regime will be key: if it applies only to listed firms, it creates incentives to ‘go dark’, so any regime should extend to large non-listed firms.
John Armour is Professor of Law and Finance at the University of Oxford.
Luca Enriques is Professor of Corporate Law at the University of Oxford.