What Companies Need to Know About The SEC’s Upcoming ESG & Climate Risk Disclosure Regulation
In March 2022, the Securities & Exchange Commission (SEC) proposed an extensive climate disclosure regulation as part of President Biden’s overall climate risk policy. The proposal would require companies to disclose data and other information “about its direct greenhouse gas (GHG) emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2),” as well as certain types of GHG emissions “from upstream and downstream activities in its value chain (Scope 3).” In addition, companies would be required to report on climate risks that are “reasonably likely to have a material impact on their business, results of operations, or financial condition”.[1]
While many expected that the almost 500-page proposal would have been finalized in 2022, it has been delayed due to considerable industry and political pushback on several provisions, including Scope 3 emissions reporting and the thresholds for which companies would be required to disclose climate costs in their financial reporting. We anticipate the regulation will be finalized sometime in 2023, possibly as early as April, although it is likely that the financial reporting aspects of the final rule will be somewhat watered down from the original proposal.
The anticipated SEC regulation represents a need to prepare proper data management and climate disclosure systems for a large number of companies who do not fully account their carbon emissions or consider the impacts of material climate-related matters in preparing their financial statements. Accurate disclosure of climate risk and emissions data will require companies to collect and analyze massive amounts of data, and in many cases, develop novel methods of risk actualization to incorporate these new considerations.
Calculating Carbon Emissions
The discussion surrounding greenhouse gas (GHG) emissions is far from novel, but to date, the calculation and disclosure of just how much carbon an individual company is responsible for discharging into the atmosphere has been a mostly voluntary activity. Although many large public companies publish environmental and sustainability reports, where they publicly announce their carbon emissions and set emissions targets, the lack of federal regulation means that companies are free to account for and disclose information calculated however the company itself deems appropriate.
The forthcoming SEC regulation will solidify reporting frameworks and dictate what must be reported. The requirement for large companies to calculate and disclose Scope 3 emissions (which appears likely to remain in the final rule), will cause not only public companies, but private companies within the value chain of reporting companies, to understand and calculate their own carbon emissions.
The complexity of calculating GHG emissions differs between industries, and even individual companies within specific industries. Scope 1 emissions are often minimal for services-based industries, who do not create physical products and thus do not have many point-source emissions. In many cases, a firm only needs to account for emissions from its owned fleet vehicles, or any on-site energy generation it may produce. On the other end of the spectrum, companies that produce products can have very high Scope 1 emissions. In most cases, facilities generating significant emissions are required under various federal and state statutes to monitor and report these emissions. However, these data may still be in disparate sources that need to be compiled, and/or better tracking systems may be needed to comply with the proposed SEC reporting requirements.
Scope 2 emissions are the greenhouse gases released into the atmosphere from the consumption of purchased electricity, steam, heat, and cooling. A simplified example of how to track this would be for a company to identify how much electricity it buys monthly and/or annually. However, the source of the electricity (the utility) is key in the amount of Scope 2 emissions a company would report. A typical method of calculating emissions would involve multiplying the amount of energy purchased by an emissions intensity factor (a measure of how much carbon and other GHGs are released into the atmosphere during the generation of power), which can be widely different across utilities. Generally, utilities with relatively greater non-carbon electrical production have lower emissions factors than those sources with more carbon-based electrical generation.
Scope 3 emissions are indirect emissions that can be attributable to a company at any point in the value chain. The complexity of modern-day global value chains can make the calculation of Scope 3 emissions a daunting task. The GHG protocol lists standards for estimating 15 categories of Scope 3 emissions, but accuracy of this task can be improved by fostering open communication channels with all partners in a company’s value chain. The Scope 3 emissions disclosure requirement in the SEC proposal appears likely to remain in the finalized regulation, although it has received considerable pushback from industry groups and other commentors during the public comment period.
As the calculation of Scope 3 emissions relies heavily on understanding Scope 1 emissions of all entities in one’s value chain (which are many times private companies and thus not subject to SEC regulation), one could argue that the inclusion of a Scope 3 disclosure requirement represents a de facto regulation of private companies by the SEC. It remains to be seen if this will be challenged in court upon finalization of the regulation, and how this requirement may be affected by litigation. Calculation of all emissions requires large-scale data collection and management, along with intimate knowledge of what data to collect and how to attribute them.
Climate Risk
In addition to the disclosure of GHG emissions, the SEC proposal would require public companies to disclose information about how they estimate and plan to account for the physical risk of climate change within their business. The SEC lists four main areas for which a registrant must disclose information:[2]
- The registrant’s governance of climate-related risks and relevant risk management processes;
- How any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements over the short-, medium-, and long-term;
- How any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook; and
- The impact of climate-related events (severe weather events and other natural conditions) and transition activities on the line items of a registrant’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements.
This would include how the management of the company believes climate change will impact their business strategy and/or outlook, how the board discusses climate risk, and the impact of climate change on a company’s financial statements. Specifically, the proposal would require companies to estimate and disclose any climate-related costs that would be 1% or more of each financial statement line item total, known as the bright-line test. This is a major departure from the current climate reporting standards, where only costs or risks that the reporting entity judges to be material for investors are reported.
The climate risk portion of the SEC proposal, and in particular the bright-line test, has received some of the strongest and most critical feedback to be leveled at the proposed regulation. As written, the regulation would require companies to include extensive climate data along with their existing financial statements. They would be required to disclose lost revenues due to climate regulation, costs associated with natural disasters, financial hedging mechanisms engaged to protect against rising costs of climate change, and much more. Many large public companies and asset managers voiced opposition to the level of disclosure proposed, noting that these requirements would create extreme compliance costs, inaccurate disclosures, and force reporting companies to undertake difficult and speculative analyses.
Although it is anticipated that the climate-related financial disclosure portion of the regulation will be watered down by the time the regulation is finalized, climate risk is still a worthwhile endeavor for companies to evaluate. The scope of these disclosures is daunting to even large companies with already well-established climate and emissions data reporting initiatives. It is critical then, that executives and boards of directors delve deeper into these considerations when charting a course through these new regulations.
Those companies who are, as of now, unable to disclose relevant quantitative climate-related assumptions and estimates used to prepare financial statements, or who have not considered the impacts of material climate-related matters in the preparation of these statements, will need to move quickly to comply with the anticipated regulation. It is likely, therefore, that even with a less stringent climate risk disclosure rule, companies will need to devote significant effort and resources to enhancing data collection and management systems, and understanding how to quantify and report these figures.
Regardless of which disclosure rule is ultimately implemented, it is important for companies to perform an environmental compliance audit and better understand the risk and resiliency of their operations associated with climate change so they can plan, prepare, and execute sound business strategies.
[1] U.S. Securities and Exchange Commission. SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors. Press Release, March 21, 2022.
[2] U.S. Securities and Exchange Commission. SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors. Press Release, March 21, 2022.
