What’s Worth Understanding: The SEC Proposes a Mandatory Climate Disclosure Regime for Public Companies
Last week, the Securities and Exchange Commission (SEC) revealed its much-anticipated proposal to require that public companies disclose climate-related information. The proposed rule is significant because, for the first time, the SEC would mandate that companies (including foreign companies) publicly traded in the US disclose climate-related risk and greenhouse gas (GHG) emissions information beyond the risk information currently required by existing SEC rules applicable to registration statements and annual reports.
The proposed rule would define “climate-related metrics” and impose related governance, risk management, attestation, and strategy, business model, and outlook disclosure requirements, among others. In other words, the proposal is aimed at requiring companies to disclose how they integrate climate risks and opportunities into their governance and corporate strategy along with a significant amount of related qualitative and quantitative information.
Nominally, the new proposed disclosures would be based on pre-existing voluntary guidelines and standards (namely, the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol). While some companies have partially relied on these guidelines and standards to prepare and publish climate-related disclosures in the past, those companies have still exercised discretion as to what disclosures they have made and their content. Moreover, those disclosures have usually been found in stand-alone reports posted on the company’s website and have not been subject to the level of comprehensive, prescriptive rigor represented by the pages on pages of intricate and detailed new regulatory requirements contemplated by the SEC’s proposal. These new regulatory requirements will require even the most dedicated and well-resourced public companies to expand and enhance their climate reporting. For the many companies that have not yet even started their climate reporting “journey” on a voluntary basis, the undertaking would be even more substantial.
Compliance deadlines would be quick, as described in more detail below. The net result would be that, starting as early as their annual report for next year, the largest companies listed in the United States would have to disclose detailed information about their vulnerabilities from and contributions to climate change in a separately captioned “Climate-Related Disclosure” section in certain securities filings. Under the SEC’s vision, within four years of the rule’s effectiveness, all companies publicly traded in the US would be required to report, and obtain third party assurance on, their own direct GHG emissions (Scope 1, and the GHG emissions associated with their purchase of electricity (Scope 2). Moreover, most would also ultimately be required to report their indirect GHG emissions associated with their suppliers and customers (Scope 3).
The SEC is seeking public comments by May 20, 2022, or 30 days after publication in the Federal Register, whichever is later.
Why Issue the Proposal?
The following key statement from the proposal offers perspective on what the three (out of four) SEC commissioners who voted in favor seek to accomplish.
Investors need information about climate-related risks—and it is squarely within the Commission’s authority to require such disclosure in the public interest and for the protection of investors—because climate-related risks have present financial consequences that investors in public companies consider in making investment and voting decisions. Investors have noted that climate-related inputs have many uses in the capital allocation decision-making process including, but not limited to, insight into governance and risks management practices, integration into various valuation models, and credit research and assessments. Further, we understand investors often employ diversified strategies, and therefore do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across companies.
This is important because the proposal forces the consideration of climate change outside of the federal regulatory agencies of traditional jurisdiction for such issues (such as EPA, Interior, and DOE) as well as state environmental regulators, without directly invoking the expertise of those agencies. This will place a significant new burden on substantive experts at (or consultants hired by) companies to make relatively complex decisions on how to comply.
The notion that the existing voluntary reporting infrastructure supports and minimizes the economic impact of the proposed regulations has been questioned. For example, in writing on this topic last year, the Wall Street Journal noted that the ratings services that rank companies based on ESG issues and rely on the TCFD and other voluntary rubrics for analysis produced inconsistent results. Specifically, the newspaper’s analysis showed that nearly two-thirds of companies evaluated were graded differently by different rating services – with a third of the companies being labeled as leaders by one service and laggards by another.
What Are the Core Elements of the Proposed Regulations?
The SEC proposes to add a new Article 14 to Regulation S-X (the SEC rules related to the contents of financial statements) and a new Subpart 1500 to Regulation S-K (the SEC rules related to disclosures other than financial statements required in registration statements, proxy statements, and annual reports). The new proposed rules are summarized briefly below.
Governance: Companies will be required to describe the board of directors’ oversight of climate-related risks and, where applicable, climate-related opportunities. Proposed Regulation S-K Item 1501(a)(1)-(2). Core board oversight elements include:
The identity of board members or committees responsible for oversight of climate-related risks,
Identification of board member expertise in such risks, with disclosure to “fully describe the nature of the expertise,”
Processes for board evaluation of climate risks as part of the business strategy, risk management, and financial oversight, and
Whether there are targets or goals, and how those are monitored and evaluated.
With respect to opportunities related to climate, if applicable, the proposed rule states that the company may describe its board oversight of these matters.
Strategy, Business Model, and Outlook: Companies must describe climate-related risks “reasonably likely” to have a “material impact” on the company, including on its business or consolidated financial statements, which may manifest over the short-, medium-, and long-term. Again, the SEC proposes that the company may also disclose such information about opportunities. The proposal then categorizes and dictates the types of risks and how they are to be disclosed and discussed, together with characterizations of the short-, medium-, and long-term horizons, as well as impacts on useful life of assets, including:
Physical risks (like flooding), whether such risks are acute or chronic, and location and nature of properties, processes, and operations subject to such physical risk, and
Transition risks (e.g., changing regulatory, technological, or market regimes).
The company must then evaluate these impacts on the company strategy, business model, and outlook. Proposed Reg S-K Item 1502(b). And the company must discuss whether such impacts, so described, are part of business strategy, financial planning, and capital allocation. This would include both current and forward-looking disclosures that “facilitate an understanding of whether the implications” of the risks identified are integrated into the business model or strategy and how the climate-related metrics as defined and the company’s targets relate to the business’s model/strategy. Further, there must be a narrative discussion of how the climate-related risks and metrics are reasonably likely to affect financial statements and whether they have had a material impact on reported financial condition or operations. Proposed Reg S-K Item 1502(c)-(d). For companies that maintain an internal carbon price, information on the pricing must be disclosed, including the rationale for deriving it. Finally, companies must “describe the resilience of the business strategy in light of potential future changes in climate-related risks,” Proposed Reg S-K Item 1502(e), and scenario analyses must be disclosed (with the SEC including as examples 3 ºC, 2 ºC, 1.5 ºC scenarios).
Risk Management: Companies must describe any processes the company has for identifying, assessing, and managing climate-related risks. Proposed Reg S-K Item 1503. If applicable, a company may also describe any processes for identifying, assessing, and managing climate-related opportunities when responding to any of the provisions in this section. Key in this section are requirements to describe “any processes” for identifying and assessing climate-related risks, and to disclose how the relative significance of climate-related risks compared to other risks was determined and to consider “existing or likely regulatory requirements or policies,” “shifts in customer or counterparty preferences, technological changes, or changes in market prices in assessing potential transition risks,” and “materiality” of climate-related risks. Companies must also describe their process for how to decide whether to mitigate, accept, or adapt to a particular risk, prioritize whether to address climate-related risks, and determine how to mitigate any “high priority” risks, among other things.
GHG Emission Metrics: The SEC would require disclosure of GHG emissions (as defined) for the most recently completed fiscal year and for historical fiscal years in the consolidated financial statements. Proposed Reg S-K Item 1504. The definitions in Proposed Regulation S-K Item 1500(h) will be key to how these disclosures are made and surely a significant potential source of comments (as the SEC does not use definitions that reference other federal agencies’ regulations that also use such terms). Disclosure of “total” Scope 1 and Scope 2 emissions is mandatory and they must be disclosed “separately” after calculating them from all sources “included in the [company’s] organizational and operational boundaries” (a defined term).
As to Scope 3 emissions, which in general are the emissions resulting from the use of a company’s products (such as gasoline being utilized to power a motor vehicle) or emissions from a company’s suppliers (such as parts used to make a motor vehicle), the company must describe its data sources. Scope 3 GHG emissions would be required for all companies except smaller reporting companies (generally companies with <$250 million market cap or <$100 million in annual revenues), if material, or if the company has set a GHG emissions reduction target or goal that includes its Scope 3 emissions. Once the emissions are calculated, the proposal would also require a “GHG intensity” determination. Since different GHGs have different potential to cause global warming, typically called the Global Warming Potential (GWP), a company with predominantly carbon dioxide emissions (GWP of 1) would reflect a lower GHG intensity than a company for which the primary emissions are methane (GWP of 28-36). Yet the proposal states that a company must include GHG emissions from outsourced emissions that it previously conducted as part of its own operations, which will require complex and ongoing evaluations. Proposed Regulation S-K Item 1500(e)(8).
Further complicating matters for Scope 3 disclosures, the SEC recognizes the potential overlap between Scope 1, 2, and 3 emissions that can result in double counting of the same emissions. It is unclear if there is any sunsetting of this provision (e.g., how long it will be since the outsourcing that the base operation no longer includes those emissions). And, with respect to overlap, the proposal requires that companies “describe the overlap, how it accounted for the overlap, and the effect on its disclosed Scope 3 emissions.” Proposed Regulation S-K Item 1500(e)(9).
Interestingly, the Proposed Regulation S-K Item 1500(f) provides a safe harbor for “liability for Scope 3 emissions disclosures,” as follows:
A statement … [of Scope 3 emissions] that is made by or on behalf of a [company] is deemed not to be a fraudulent statement …, unless it is shown that such statement was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.
Proposed Regulation S-K Item 1500(f)(1).
A fraudulent statement is proposed to be defined as:
a statement that is an untrue statement of material fact, a statement false or misleading with respect to any material fact, an omission to state a material fact necessary to make a statement not misleading, or that constitutes the employment of a manipulative, deceptive, or fraudulent device, contrivance, scheme, transaction, act, practice, course of business, or an artifice to defraud as those terms are used in the Securities Act of 1933 or the Securities Exchange Act of 1934 or the rules or regulations promulgated thereunder.
Proposed Regulation S-K Item 1500(f)(3).
The broadness of this definition is an issue that commenters should consider closely in preparation of their submittals to the SEC regarding the implications of, and potential revisions to, the proposal in any final action. The proposal does not provide a similar safe harbor for Scope 1 and 2 emissions and GHG intensity disclosures or any of the other mandated disclosures.
It is also critical to recognize that all of this (Scope 1, 2, and 3 disclosures) will require a description of the methodology, significant inputs, and significant assumptions made in the calculations, including organizational boundaries, operational boundaries, calculation approach, and calculation tools. Proposed Regulation S-K Item 1504(e)(4) allows for use of “reasonable estimates,” but only if the underlying assumptions and reasons are described. Moreover, companies must disclose “to the extent material” any use of third-party data when calculating GHG emissions. And, if methodology and assumptions change year over year, such changes must also be described (and could provide future fodder for enforcement scrutiny). Proposed Regulation S-K Item 1504(e)(6). A company must disclose, to the extent material and as applicable, any use of third-party data when calculating its GHG emissions, be it for Scope 1, 2, or 3 emissions. Proposed Regulation S-K Item 1504(e)(5).
Attestation of Scope 1 and 2 Emission Disclosures: The attestation provisions address what level of assurance of the information from an independent third party is required. For large accelerated filers (generally companies with >$700 million market capitalization) and accelerated filers (generally companies with between $700 million and $75 million market capitalization), there must be an attestation report in the applicable SEC filings covering Scope 1 and Scope 2 emissions disclosures. The attestation must at a minimum be at a “limited assurance level” (i.e., equivalent to the level of review applied to unaudited quarterly financial statements) through the third fiscal year after the compliance date. After that it must be at a “reasonable assurance level” (i.e., equivalent to the level of review applied to audited annual financial statements). Proposed Regulation S-K Item 1505(a). The attestation report from the independent third party must be titled “Climate-Related Disclosure” in a separate section of the SEC filing. Non-accelerated filers (generally companies with a <$75 million market cap or that have been public for less than 1 year) and smaller reporting companies would not be required to provide attestation reports.
Targets and Goals: The SEC would require a company to disclose if it has set any targets or goals related to reduction of GHG emissions “or any other climate-related target or goal (e.g., regarding energy usage, water usage, conservation or ecosystem restoration, or revenues from low-carbon products).” Proposed Regulation S-K Item 1506(a)(1). This will implicate a host of previously generated reports and goals that have rolled out from companies over the past several years in response to international meetings on climate change (e.g., COP26). Where carbon offsets or renewable energy credits (RECs) have been used as part of a company’s plan to achieve targets or goals, the company will have to disclose the amount of carbon reduction represented by the offsets or the amount of generated renewable energy represented by the RECs, the source of such offsets or RECs, a description and location of underlying projects, any registries or other authentication of the offsets or RECs, and the cost of same. Proposed Regulation S-K Item 1506(d).
Financial Statement Disclosure Requirements: Quantified impacts of climate-related events and transition activities on line items in consolidated financial statements and related expenditures will need to be disclosed, as well as disclosure of financial estimates and assumptions impacted by these events and activities. Proposed Regulation S-X Article 14. The quantitative and qualitative disclosures provided in response to this requirement would, unlike the other disclosures contemplated by the proposed rules, be included in the company’s financial statements and therefore would be subject to the same level of review and audit by the companies’ independent auditors as other information in the company’s financial statements.
The proposed rule provides for phased-in compliance. Assuming (1) an effective date in December 2022, and (2) that filers have a fiscal year-end of December 31:
Large Accelerated Filers: All proposed disclosures, excluding Scope 3 emissions, would be phased in during fiscal year 2023 for inclusion in the annual report to be filed in 2024, with Scope 3 emissions being phased in during fiscal year 2024 for inclusion in the annual report to be filed in 2025. Required limited assurance of Scope 1 and Scope 2 emissions disclosures would also be phased in during fiscal year 2024 for inclusion in the annual report to be filed in 2025, with reasonable assurance required beginning in fiscal year 2026 for inclusion in the annual report to be filed in 2027.
Accelerated Filers would have an additional year more for compliance than large accelerated filers in all respects.
Non-Accelerated Filers would have the same compliance dates as accelerated filers, but would be permanently exempt from the assurance requirements.
Smaller Reporting Companies would have an additional year for compliance more than accelerated filers, but they would be permanently exempt from Scope 3 emissions and assurance requirements.
Commissioner Peirce, the sole Republican commissioner, issued a dissenting statement criticizing the legal basis and the policy objectives of the rule and expressing serious concerns about the potential adverse consequences of the rule to investors, the economy, and the SEC itself. Commissioner Peirce believes that the SEC’s existing principles-based disclosure mandates already cover material climate risks. She also extensively analyzes ways that the proposal seems to either dispense with the concept of materiality as a bound on required disclosures, which she considers to be a dangerous precedent, or distorts the concept of materiality in ways that she considers potentially damaging. She questions whether the SEC would be achieving its stated goal of providing useful, comparable, consistent, and reliable disclosures, which are essential to investors to evaluating investment risks. While acknowledging that existing climate-related disclosures may lack clarity and be otherwise problematic, she does not believe that the “mandatory … reams of climate information” contemplated by the proposal will help in this regard. In fact, she thinks it will make the situation worse to the extent that “faulty quantitative analyses” will appear to investors to be more reliable than they actually are.
Commissioner Peirce expresses concern about the SEC’s legal authority to propose the rule. Specifically, she notes that the proposed rule exceeds the SEC’s statutory authority and mission to “protect investors and facilitate capital formation,” noting that Congress did not grant the SEC “plenary authority over the economy.”
She also fears that the costs of proposed rule are understated and suggests, given the complexity and speculative nature of the proposed requirements, that the rule could eventually “rival our existing securities disclosure framework in magnitude and costs and probably outpace it in complexity.”
She ultimately concludes that, while the proposed rule may be a boon for the “climate-industrial complex,” it will hurt investors, the economy, and the SEC by pushing capital allocation toward “politically and socially favored ends” when the regulators designing the framework have no expertise in “capital allocation, political and social insight, or the science used to justify these favored ends.” She further notes that investors saving for retirement need to earn real financial, rather than “psychic,” returns on their money, and she fears that implementation of the proposal will lead to investors receiving diminished financial returns from the public markets over time.
Areas of Likely Importance for Comment
The SEC adopts numerous definitions that will define and bound the reporting obligations. Several of the definitions appear to be issued independent of definitions provided by other federal agencies, for example, Scope 1, Scope 2, and Scope 3 GHG emissions definitions. Moreover, the line between permissive and mandatory elements of reporting could be more clearly defined. Some may also seek clarification of the liability safe harbor with respect to Scope 3 emissions and further safe harbors. While the long-standing securities law safe harbor protecting forward-looking statements would apply to some of the disclosures required by the proposed rules, there is still risk of significant litigation and potential liability for changing information over time, given the complexity of the calculations that are at issue here. While the preamble repeatedly states that reasonable estimates may be used, the introduction of attestation requirements necessarily involves levels of assurance that makes the use of estimates more difficult, and the proposal itself refers to explanations of changes in methodology or assumptions.
Consistent with Commissioner Peirce’s dissent, the SEC’s interpretation and reliance on the applicable statutory authorities will likely be challenged for potentially exceeding the SEC’s core mission of protecting investors and facilitating capital formation.
The most certain things about the proposal are that it will require creation of an infrastructure to comply that will involve in-house environmental professionals, consultants for companies, in-house and outside environmental and governance lawyers, and third-party independent verifiers.
From a logistics standpoint, the timeline for implementation is very aggressive. While companies have prepared numerous climate reports, with these new regulations, the inputs to such reports will have to be measured against the regulatory requirements before they can be submitted. The SEC references requirements of the TCFD in support of the view that many of these requirements are already being used in practice, but the proposal contemplates a regime that is far more detailed and otherwise deviates in important respects from the TCFD, including to the extent that basically all elements of the SEC’s requirements are mandatory, while the TCFD’s are voluntary. Moreover, the elevation of the directive to disclose climate information to a regulatory requirement changes the work that companies will practically need to undertake to report. An official submittal to the SEC is subject to greater internal and public scrutiny in all respects, as well as additional potential liability under US federal securities laws.
The SEC proposal represents a major escalation in the Biden Administration’s whole-of-government approach to addressing climate change. These regulatory expansions will also come with significant legal risks as the Administration seeks to arm, if not repurpose, existing statutory authorities to address climate. In addition to these significant legal risks, the proposed rule will also impose significant new costs and compliance challenges on businesses in translating the rule’s general requirements into actual reporting information and on the SEC in assuring consistent and reliable information that informs investors. The proposal will also be viewed by many as putting increased regulatory pressure on energy production in the US at the same time that the US and its Western allies face significant energy challenges as part of the crisis gripping Ukraine and Western Europe.