Wall Street takes on the SEC’s climate disclosure rule

Wall Street takes on the SEC’s climate disclosure rule

June 23, 2022

Lobbyists see plenty wrong with the US regulator’s proposal to mandate climate risk reports

Wall Street isn’t a fan of the climate risk disclosure proposal from the US Securities and Exchange Commission (SEC). Quite the opposite, in fact. 

Comment letters sent by bank lobby groups to the SEC are loaded with criticisms and calls for the proposal to be “recalibrated.” As it stands, they say the rule is “overly broad”, “prescriptive”, “highly expensive”, and even “inoperable.” Their words matter, as the SEC has said it will consider public feedback when writing a finalized version of the rule — one that could be imposed on US public companies as soon as 2023.

In addition, the political fight over the disclosure rule is hotting up. Rival comment letters from Republican and Democratic state attorneys-general to the SEC illustrate the divisiveness of the rule, with the Republican letter going so far as to call it “an ill-advised misadventure into environmental regulation.” Each political party will seek to claim their position on the SEC proposal is supported by US businesses— including banks.

Putting politics and the regulatory process to one side, however, the substance of the bank lobby’s criticisms can be organized into four broad categories: the proposal’s interpretation of “material information”; the quantity and complexity of the requested disclosures; the practicality of putting the disclosures together; and the climate risk data and capabilities gaps that face the industry today.

Each category deserves an article of its own. But a few examples from the comment letters can help bring the lobbyists’ major concerns into focus. Specifically, examples from the letters sent by the Financial Services Forum (FSF) and the Bank Policy Institute (BPI).

The FSF represents the eight US global systemically important banks — which include Wall Street heavyweights JP Morgan, Wells Fargo, and Goldman Sachs. Its letter calls for the SEC proposal to be stripped back and phased in over a longer time horizon, and identifies a number of provisions they claim are effectively impossible to implement given the current state of climate risk management:

“The current difficulty with quantifying climate-related information presents extra challenges when coupled with the possibility of U.S. securities law liability for disclosures based on that information, particularly the proposed financial statement metrics and GHG emissions disclosures. The data necessary for identifying, measuring and assessing climate-related risks is currently incomplete and unreliable”

The FSF has many gripes about the proposal, but those that stand out concern banks’ own capabilities. One major objection is around the SEC’s call for firms to disclose disaggregated climate-related financial statement metrics. Among other things, this would force companies to report the financial impacts of “severe weather events, other natural conditions, transition activities, and identified climate-related risks” for each line item on their financial statements — unless said impacts represent less than 1% of the given line item.

The aim of this provision is to make companies produce meaningful, quantitative information on the financial consequences of their climate risks and opportunities. However, The FSF says it’s “unworkable”, claiming that accounting standards that capture “transition activities” would be needed and that “there is not currently sufficient guidance regarding how to implement these disclosures in practice.”

A similar view is expressed in the letter from the BPI, a lobby group that represents dozens of US banks and foreign lenders operating in the US. In its comment letter, the BPI says that disaggregating climate impacts by line item would be difficult “given the nascent and evolving state of climate risk management capabilities and the challenges around modeling a type of risk that is inherently uncertain.”

“A bank’s balance sheet is much more complex than a general corporate’s, so doing that sort of analysis on a line-by-line basis, for each individual financial instrument, it’s just an exponentially more complex task,” says Lauren Anderson, Senior Vice President and Associate General Counsel for Regulatory Affairs at BPI. “That’s particularly true when you start looking at traded instruments. These complexities were not taken account of whatsoever by the SEC.”

These arguments are not without merit. Separating out the impacts of climate change from those caused by other risks may well prove impossible for banks when it comes to tallying the financial performance of specific activities, as so many intertwined factors contribute to these calculations. Take a bank’s provision for credit losses. Provisions increase as a borrower’s creditworthiness declines. However, as the BPI explains, such a decline could have many reasons. While some could be climate-related, the point is that it would be tricky to disaggregate these impacts from other factors “absent the occurrence of a specific, observable event” — like a hurricane or flood.

Banks’ existing accounting models are also not set up to do this kind of granular disaggregation. For example, lenders use Current Expected Credit Loss (CECL) models to calculate their provisions in line with US accounting rules. These models project future credit losses using a “reasonable and supportable forecast period.” As the FSF letter notes, this may be much shorter than the time horizons banks use to gauge their climate-related risks:

“Because CECL does not require climate-related risks to be isolated as a significant factor, our member institutions do not currently have the capabilities to disaggregate the impacts of climate-related risks and would have to build out the systems and processes to do so”

On the other hand, the field of climate risk management and measurement is growing, and banks can already call on a wealth of products and services to help them crack the disaggregation challenge. Furthermore, while it is true that the SEC’s financial statement requirements push up against the frontier of corporate accounting, it’s not as if banks and other firms have to start from scratch. The US accounting standard-setter, FASB, confirmed last year that its existing standards encompass climate risk, and even provided illustrative examples of how climate and other ESG matters intersect with financial accounting.

Furthermore, the International Sustainability Standards Board (ISSB) is forging ahead with its own climate-related disclosure standards, which similar to the SEC proposal ask for the reporting of climate impacts on financial performance. The ISSB has and will continue to produce guidance to help reporting entities grapple with this challenge. Banks could draw on other voluntary climate-related disclosure frameworks to assist them, too.

However, the BPI’s Anderson doesn’t think these efforts have matured enough to be helpful to banks within the disclosure timeline set by the SEC. “Some of the work that’s been happening in the industry is useful. But there’s obviously a lot more debate and analysis that has to happen, and it’s not an overnight process. Progress is being made and there are areas where consensus is developing, but it’s certainly not to the level that the SEC would suggest.”

Another grievance expressed by the BPI and FSF concerns the SEC’s proposal on greenhouse gas (GHG) emissions disclosures — specifically the agency’s demand that a company report its indirect Scope 3 emissions if they are material, or if they have set a GHG emissions reduction target or goal that includes Scope 3. 

For banks, Scope 3 emissions are “financed emissions”, meaning the gases produced through their lending and investing activities. Many US banks have set GHG emissions reduction targets, some of which factor in Scope 3. Furthermore, the vast bulk of banks’ overall emissions are financed emissions, which suggests that all lenders would be covered by the Scope 3 disclosure mandate under the SEC’s materiality condition.

Bank lobbyists argue this is too big an ask. The FSF writes that Scope 3 emissions are “the most difficult to measure reliably” for banks and that much of the data they would need to complete the disclosure “is incomplete or unreliable and includes many estimates and assumptions.” The BPI agrees, arguing that “requiring Scope 3 emissions disclosure before calculation methodologies and data collection are more mature would result in inconsistent, noncomparable, and unreliable disclosures.”

There’s a touch of circular reasoning to these critiques, however. Certainly, right now Scope 3 data is “incomplete or unreliable” — but that should change with the implementation of the SEC proposal. If the public companies that banks lend to and invest in are mandated to source and disclose their Scope 3 emissions, then lenders will have the raw data they need to count up their financed emissions.

When it comes to financed emissions calculation methodologies, firms can turn to the Partnership for Carbon Accounting Financials (PCAF), an industry-led initiative that counts a number of BPI and FSF members among its supporters. True, the PCAF financed emissions accounting standard is currently incomplete. For example, it is yet to establish rules for calculating financed emissions linked to derivatives or capital markets activities. But PCAF promises methodologies for additional asset classes are forthcoming. It also provides guidance for financial institutions on how to deal with Scope 3 data gaps and limitations when calculating their financed emissions.

The bank lobby isn’t wrong to say that extracting emissions data from private companies would be a big challenge, though. Entities not covered by the SEC disclosure rule would not be forced to report their GHG footprint, after all. However, private companies don’t operate in a vacuum. They would come under pressure to report Scope 1, 2, and 3 data from the public companies they interact with. Why? Because without this data, public companies won’t be able to produce their own emissions reports. The SEC is also exploring making private companies produce enhanced disclosures. The agency could include an emissions disclosure mandate as part of this rulemaking to ease the strain on banks trying to calculate their financed emissions.

A third major gripe the lobbyists have concerns the SEC’s proposal on climate scenario analysis disclosure. The draft rule would require firms that use scenario analysis to describe the scenarios used, and to specify the “parameters, assumptions, and analytical choices, and the projected principal financial impacts on the registrant’s business strategy under each scenario.” As the BPI’s Anderson notes, that’s a lot of information — especially for bank filers. She argues that the long list of required disclosure would make them virtually unintelligible to users.

“It’s important that investors know that you undertake scenario analysis and whether you are using standard scenarios, and maybe what portions of your portfolio you are conducting scenario analysis on. But beyond that, when you start getting to specific outputs, it’s really giving investors a sense of precision that just isn’t reality. If you had to write up all of the assumptions that went with these scenario analysis exercises, you’d be talking 35 pages-plus of disclosures. I think there’s a possibility that this information could potentially be very misleading to investors without really giving them a whole lot of benefits,” says Anderson.

The BPI and FSF see another problem with these disclosures, too. US bank regulators have already issued guidance on climate scenario analysis, and the Federal Reserve is expected to run a climate scenario analysis exercise covering the largest lenders in 2023. By putting out its own disclosure requirements on this topic, the bank lobbyists say the agency is front-running these watchdogs’ efforts and could create confusion for investors. The FSF letter says:

“Because our member institutions have begun conducting exploratory scenario analysis exercises and will soon likely be required to do so by the federal banking regulators, the Proposal would require our member institutions to disclose details regarding these exercises. As risk management tools, scenarios considered are specific to each company and its unique risk exposures, so these disclosures are unlikely to be comparable across companies” 

It adds that US banking regulators are better positioned to understand banks’ climate risks than the SEC, and that mandating disclosure right now “may result in banks disclosing scenario analysis information that could change in the near future as guidance is developed and finalized.”

It’s undeniable that climate scenario analysis for banks is a tricky task — more so than for a non-financial corporation that operates a single line of business. The number of inputs, assumptions, and financial impacts are also far greater for lenders. However, this does not in and of itself make the SEC’s ask unreasonable. Yes, there is a trade-off to be made between transparency and brevity, and it’s one the SEC may need to revisit if a finalized version of its rule is to withstand legal challenges. But investors do need to understand how the scenarios that banks use to assess their climate risks work — otherwise they won’t be able to assess the credibility of these analyses.

As to the potential clash between regulator-set scenario analyses and banks’ own in-house efforts, it is not unfair to ask firms to disclose information on both. In fact, it would arguably be helpful for stakeholders to compare and contrast how regulators and banks approach this challenge. 

With the close of the public comment period on the SEC proposal, the first round in the debate between the agency and industry over climate risk disclosure has come to an end. The SEC’s challenge now is to produce finalized disclosure requirements that make sense for all kinds of public companies without depriving investors of meaningful climate-related information. The idiosyncrasies of the banking business, as laid out by the BPI and FSF, show just how hard this will be. 

How the SEC incorporates this feedback into its finalized rule remains to be seen. But the tone of the comment letters from the bank lobby suggests that if the agency doesn’t address their issues, it could be in for a fight.