Climate disclosure regulations will directly impact nonpublic companies
Nonpublic companies would do well to heed the approach public companies may be required to take to address climate change.
On April 11, 2022, the Securities and Exchange Commission formally announced its proposal to require extensive disclosures concerning public companies’ investigation and evaluation of numerous subjects relating to climate change including governance, material effects on financial statements and business strategy, risk management processes and greenhouse gas emissions.
For many, the operative words in all of that are “public companies,” and where the many are not public companies, it remains business as usual. That is, climate change is something that can be addressed next year (if at all). In reality, the SEC’s requirements demonstrate quite emphatically that that is not the case because climate change risks are indifferent to a company’s ownership structure. Hurricanes and wildfires do not care how the stock is held. Accordingly, nonpublic companies would do well to heed the approach public companies may be required to take to address climate change.
The new proposed rule includes a section that is directly germane to the operations of both public and nonpublic companies: 17 C.F.R. § 229.1503: Item 1503, Risk Management. The provision requires the regulated entity (“registrant”) to describe its process for “identifying and managing climate-related risks.” Among other things, the registrant must disclose how it determines the relative significance of climate-related risks and how it determines whether to “mitigate, accept or adapt to a particular risk.”
Central to these obligations of course is the proposed definition of “climate-related risk.” The proposed regulation obliges with a definition. Climate-related risks include physical risks, described as “acute risks” such as wildfires, hurricanes, tornadoes, floods and heat waves, and “chronic risks”, which include long-term temperature increases, drought and sea level rise. Transition risks are those inherent in changing from a fossil-fuel economy to a world reducing greenhouse gas emissions. Transition risks include the steps a company takes to mitigate its risk going forward.
Everyone is aware of these risks, and it should come as no surprise that the Commodity Futures Trading Commission’s Climate-Related Market Risk Subcommittee found in 2020 that climate change affects or is expected to affect every part of the U.S. economy, including real estate and infrastructure. Companies identifying the climate change risks of concern to them must then make a decision either to accept or adapt to those risks, or to mitigate them.
Insurance is one form of mitigation considered by the SEC. More accurately, it is risk transfer, rather than risk mitigation; the risk remains the same – but someone else bears it. The SEC recognizes in the proposal that loss of insurance or increases in premiums may have material effects on registrants. It should be apparent that those more limited policies and higher premiums may also have material effects on nonpublic companies.
American International Group, Inc. (AIG), in its most recent (2022) 10-K, confirms the SEC’s perspective: “climate change presents significant financial implications for the insurance industry in areas such as underwriting, claims and investments” because, among other reasons, “losses resulting from actual policy experience may be adverse as compared to the assumptions made in product pricing.” In other words, the losses from the “increase in the frequency and severity of natural disasters” require that premiums rise or exclusions be added.
An example may make this clear. In 2012, Superstorm Sandy devastated New York City. A well-known medical center suffered a billion-dollar loss as the East River left its banks. The medical center turned to its property insurer for coverage and the insurer paid limits. Or rather, it paid sublimits, which were only $40 million. A different medical center with climate change, more severe storms and rising sea levels on its mind might not have been satisfied with such a low flood sublimit. Or it might have changed its operations by moving certain activities (like irreplaceable laboratory mice) to higher floors. Or at least the board of directors would have been aware of the exposure because it required briefing on climate change exposures.
To pick another example; have you heard of a Category 6 hurricane? Of course not; the Saffir-Simpson Hurricane Wind Scale is goes from a Category 1 (74 to 95 mph) to a Category 5 (above 157 mph). Yet some weather professionals offered that Hurricane Dorian’s 185 mile per hour winds in 2019 justified a Category 6. With such a threat, reexamining the procurement of windstorm coverage, or named windstorm coverage, may be prudent, even if the insured’s facility is in neither a Tier 1 nor Tier 2 location coverage classification.
Thus, if climate change risk is not incorporated into a company’s purchase of insurance, the company may be taking on significant exposures of which it is not aware. And by incorporated I do not simply mean purchasing adequate insurance in the 100-year flood plain as the company’s loan covenants require it to do. If, as AIG notes, severe storms are increasing, then that means the frequency of flooding is increasing. But, if flood plain maps are based on the historical record, as many are, then those maps are inaccurate as they do not account for the increase in storm frequency and consequent increase in flood volumes and expanse. Accordingly, a risk manager needs to be confirming her company has the requisite insurance by looking forward with modeling, not backward based on historical records.
The SEC’s climate change disclosure rule is only a proposal. It is possible that it will not be adopted, or, if adopted, modified significantly. Regardless, the issues framed by the proposal – risk management in a time of climate change – are unavoidable and, if not acknowledged, may put a company under water (figuratively, if not literally). Therefore, the proposal provides a prudent way forward for both public and nonpublic companies: Investigate and assess climate change risk, and then proceed accordingly.
J. Wylie Donald is a partner in the Washington, D.C. office of McCarter & English LLP. The views expressed herein are his own and may not represent the views of the Firm or its clients.