[Insaf Ahmad TK and Mathangi K are third-year undergraduate law students at Gujarat National Law University, India]
The year 2019 witnessed the bankruptcy of Pacific Gas and Electric Corporation which the Wall Street Journal described as a “climate change bankruptcy”. The investors in Pacific Gas and Electric Corporation incurred losses worth millions of dollars due to a series of wildfires in California which pushed the corporation into bankruptcy. Climate change poses grave risks that impact the global economy as well as individuals, businesses and the market in which these operate. With a growing population and an agriculture-based economy, India is one of the most vulnerable countries to climate change. It has witnessed several climate change catastrophes in recent years such as floods, droughts and heat waves. This poses a unique threat to the Indian financial market, wherein India alone lost USD 80 billion over the last two decades due to climate change.
India finds itself in the top 20 countries with the highest per capita CO2 emissions while it forms the bottom three emerging economies in terms of greenhouse gas intensity along with South Africa and Russia. Further, according to a report released in March 2021 by CDP (a global environmental disclosure platform), climate change risks are likely to have a staggering financial impact of ₹7,138 billion (approximately $100 billion) on Indian firms in the next five years. The rising trend of climate change, marked by recurring physical damage and the energy market transformations arising out of climate change are highly likely to affect insurers, banks and investors and create cascading risks across the financial systems of the nations. This necessitates a sufficient response mechanism considered from varying perspectives, including how these enterprises disclose their climate risk and mitigation strategies to their stakeholders. In order to fully understand the disclosure regimes that are required, it is first essential to trace the kinds of financial losses posed by climate change.
Financial Risks Posed by Climate Change
The financial risk that climate change poses to the economy can be divided into a few broad categories. First, climate change increases the risk of physical damage to the assets owned by firms, or causes disruption to their supply chains and operations. These physical losses can be a result of long term changes, such a rise in global temperature or one time catastrophic events such as a hurricane or a tsunami. With the rise in the financial liabilities deeply intertwined with natural catastrophes, physical losses from climate change have become a major cause of concern in the corporate world. For instance, the upsurge in physical risks induced by climate change includes the direct effect it could have on the insurance sector. If these risks remain uninsured, it is likely to negatively impact the balance sheet of households as well as firms, in turn resulting in losses for their lender banks.
The second category is the risks that arise in the form of transition costs, imposed in order to move from a carbon-based economy to a greener economy. This risk associated with transition appears higher for emerging economies like India, where the pain seems more palpable. It is estimated that even a carbon price down to $50 per tonne and implementation of tax cuts is likely to reduce the annual returns by 0.2% p.a.
The third, yet often undermined category of risks, is the one associated with the increasing cost of compliance of firms in relation to environmental regulations and the incessant threat of lawsuits that maybe filed against a company upon its failure to comply to the regulatory standards. For instance, the regulation on stricter air control has the potential to impose an additional cost of USD 21 million on the manufacturing sector. Similarly, the prospect of imposing carbon tax, especially in an economy such as India, with companies emitting large amounts of carbon dioxide, seriously affects the financial viability of the industry.
The Need for Corporate Disclosures of Climate Change Risks
In light of such circumstances, it has become imperative to mandate corporate disclosures of climate change risks, thus empowering the investors to make informed choices while investing and thereby limiting the information asymmetry in the securities market. Corporate disclosure of risks has been a quintessential feature of securities regimes across the world. Disclosures ranging from financial to non-financial risks have been mandated across various financial centres around the globe.
For instance, upon the recommendations of the Task Force on Climate Change related Financial Disclosures (TCFD), the disclosure increased from 6 percent in 2018 to 25 percent in 2019. By the end of 2019, 930 supporter organizations, with a market capitalization of more than USD 11 trillion joined the movement for disclosure of these risks. While such voluntary disclosures and support for the same has increased over the years, the role of the principal regulators of countries has been limited. While the TCFD was established back in 2015, the regulators of most economies across the globe have remained silent on the enactment of laws mandating such disclosures.
In September 2020, New Zealand became the first country to mandate disclosures of climate change risks and mitigating strategies. The new law enacted in the country would require all entities operating in its jurisdiction to make disclosures on a “comply-or-explain” basis according to TCFD-aligned standards. This development in New Zealand is a reflection of the increasing calls for countries to “publish pathways to making climate-related financial reporting, based on TCFD recommendations, mandatory.” This is a key facet of the Building a Private Finance System for Net Zero, a set of priorities for private finance during the Green Horizon Summit in November. Following the initiative in New Zealand, the Financial Conduct Authority (FCA) of the United Kingdom announced that it would move towards the introduction of new listing rules for entities, requiring TCFD- aligned disclosures, following consultations in 2021.
Regulatory Mechanism in India
In India, both the voluntary as well as mandatory disclosures remain at a nascent stage. Looking at the current legal framework in India, Regulation 24 and 70 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) states that “draft offer document and offer document shall contain all material disclosures which are true and adequate to enable the applicants to take an informed investment decision”. Further, Schedule VI of the ICDR Regulations stipulates disclosures of “risk factors” and mandates the disclosure of material risk factors not in the present but also which can be material in the future. Furthermore, regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 states: “Every listed entity shall make disclosures of any events or information which, in the opinion of the board of directors of the listed company, is material”. Even though it can be argued that climate change risk disclosures come within the ambit of material disclosure, India is yet to see a clear cut policy emanating through the pronouncement of the Securities and Exchange Board of India (“SEBI”), the Securities Appellate Tribunal or the courts. Climate change risks have thus far not been considered as a material risk in the Indian securities law regime. While the mandatory disclosure regime regarding the reporting of climate change risk still remains at a nascent stage, the reporting on environmental social and governance (ESG) has gained considerable momentum in India.
ESG reporting requires organisations to demonstrate assimilation of sustainable development practices in their operations. The disclosures on climate related issues of the entity have been significantly enhanced and made more granular in the ESG regime in India. In February 2021, the SEBI Chairman, Mr. Ajay Tyagi, stated that SEBI is in “active discussion” with various stakeholders to introduce guidelines on ESG. He noted that the “proposed guidelines are aimed at achieving a much higher level of transparency and accountability from listed entities in the ESG arena.” He indicated that there has been an increasing demand from investors for these disclosures, especially in the wake of the pandemic. This will encourage corporate to improve sustainable practices which can derive long-term benefits for them and also create a broader impact. But at the same time, while it certainly increases transparency for all stakeholders, it only indicates how a firm manages the climate risk and not how much it is exposed to the risk.
Conclusion
While the regulatory bodies in India are moving towards regulation of climate change disclosure with the SEBI introducing ESG requirements and the Reserve Bank of India flagging concerns over climate change and the financial impact, this seems highly inadequate in tackling the risk today. The ESG standards address only one leg of the issue, i.e., how the firms manage climate change. There still exists a lacuna in firms disclosing the impact and the risks faced by them due to climate change. This could be due to several reasons, including the lack of data availability, the disclosure being a cumbersome, expensive and time consuming compliance requirement. Unfortunately, these factors contribute to the reasons why regulators across the globe display reluctance in taking adequate measures for mandatory disclosure. While acknowledging the difficulties associated with climate change disclosures, it is time that regulators, on realising the financial impact of the risk, enact mandatory disclosure of climate change risks, thus aiding the investor in making an informed choice as well as fostering sustainable development practises of enterprises across the globe.
– Insaf Ahmad TK & Mathangi K