What a difference a year makes – or should I say – what a difference an administration makes! Back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s disclosure based regulatory regime. Enter Chair Allison Herron Lee and in a slew of activity over the past few weeks, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; Corp Fin has called for public comment on ESG disclosures and suggested a framework for discussion on the matter; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and the SEC issued a statement calling for public comment on climate related disclosures including a detailed list of questions to consider.
The ESG activity coming out of the SEC is so constant, I had to go back and add to this blog three times after I thought it was finished.
It seems that the SEC must answer the call from investors for valuable ESG disclosures. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
Net zero refers to operating such that global warming is limited to below 2o Celsius with net zero greenhouse gas emissions by 2050. But like all things ESG, there is a lot of disagreement on the best path forward. On March 10, 2021, the UK’s Institutional Investors Group on Climate Change, representing $35 trillion Euro in assets under management, published a Net Zero Investment Framework 1.0 specifically discouraging the use of carbon market offsets in achieving net zero goals. The problem is that many large companies use carbon offsets as an integral part of their stated net zero plans. Disclosure of plans may satisfy the SEC, but it is no guarantee that investors or stakeholders will approve of any course of action.
Back in 2010 the SEC issued guidance to public companies regarding disclosure requirements as they apply to climate change matters. Reviewing compliance with these guidelines is top of list for both Corp Fin and the Enforcement Taskforce. The Enforcement Task Force is also focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
In a series of blogs I will discuss ESG related matters including this first blog, which is focused on the climate change initiatives, a second discussing ESG investing, ratings and the role of a Chief Sustainability Officer and a third on ESG disclosures in general.
SEC Recent Climate Related Disclosure Initiative
As indicated, in the past 6 weeks, the SEC has issued a slew of statements and started numerous initiatives related to climate disclosures and environmental matters. Climate change is a top priority for the Biden administration. On February 1, 2021, the SEC announced that Satyan Khanna was named its first ever Senior Policy Advisor for Climate and ESG. Mr. Khanna was a former agency attorney and ex-adviser to Biden.
On February 24, 2021, acting SEC Chair Allison Herren Lee directed the Division of Corporation Finance to enhance its focus on climate related disclosures in public company filings. In her announcement, Chair Lee indicated that Corp Fin will review the extent to which public companies address the topics identified in the SEC’s 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The SEC staff has been directed to also update the 2010 guidance for present day efficacy. Then on March 15, 2021 the SEC solicited public comment on climate change disclosures with specific questions to consider.
The directive is not surprising as Chair Lee has always been vocal about her desire for increased climate and environment related disclosures. Stepping up initiatives for climate disclosure regulations, in March, Chair Lee, speaking at a virtual conference, stated that the SEC wants to implement a global framework for climate disclosures working in collaboration with global stakeholders and climate authorities. Certainly our markets are global and the SEC has made other recent disclosure changes to align with global practices, such as mining disclosure requirements (see HERE. New Corp Fin Director John Coates is fully on board. He is a former Harvard Law School professor who has pushed the SEC to update is corporate disclosures requirements on climate change and ESG matters.
On March 4, 2021, the SEC announced the creation of a Division of Enforcement Climate and ESG Task Force made up of 22 members from various offices. The task force will be focused on “ESG-related misconduct” including reviewing compliance with the 2010 climate disclosure guidelines and focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
I would also think that the Task Force will spend time reviewing the numerous ESG related financial products including high-yield debt instruments that have flooded the market. As one Wachtell Lipton memo pointed out, “[M]assive inflows into ESG-oriented investment funds and seemingly insatiable demand for ESG-related issuances have led to ‘greenium’ pricing (i.e., a lower cost of capital for issuers) of many ESG-related issuances. Moreover, credit rating agencies are increasingly factoring ESG risks – including related regulatory risks – into their ratings, as are credit committees at banks into their determinations.”
Also, on March 4, SECers Hester M. Peirce and Elad L. Roisman issued a joint statement questioning the practical meaning of the SEC’s climate and ESG related activities. As noted in the statement, Corp Fin has been reviewing companies’ disclosures, assessing their compliance with disclosure requirements under the federal securities laws, and engaging with them on climate change and a variety of issues that fall under the ESG umbrella, for decades. The concern is that the new initiative should be limited to reviewing public disclosures against the existing backdrop of regulation and not suddenly holding companies to a new undisclosed standard. The commissioners also questioned the timing of the enforcement task force, pointing out that it would be more prudent to wait until Corp Fin had completed its assessment on existing rules and until the Division of Examinations has completed this examination cycle. With that said, the statement concludes with a supportive call for adequate guidelines and rules resulting from input from SEC staff, investors, issuers and practitioners.
Request for Public Input on Climate Change Disclosure
On March 15, 2021, SEC Chair Allison Herren Lee issued a statement requesting public input on climate change disclosures. On the same day Ms. Lee gave a speech to the Center of American Progress outlining the SEC’s initiative on climate change matters. The request for public comment outlined specific questions for consideration and in particular:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant)? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)? Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
SEC 2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures. In 2010 and the few years prior, climate change was not only a global topic of discussion, but a regulatory hotspot as well. The EPA passed regulations requiring the reporting of and reduction of greenhouse gases by the largest pollutants; internationally the Kyoto Protocol was passed; the European Union Emissions Trading System became effective; international climate change conferences became the norm; official and un-official groups banded together on the subject; and the insurance industry revamped its actuarial and risk assessment system to account for climate change.
For some public companies, the regulatory changes could have a significant impact on operating and financial decisions including capital expenditures to reduce emissions and compliance with new laws, including those requiring reporting. Also, companies not directly impacted by the changes could be indirectly impacted by changes in costs for goods and services and impacts on their supply chain. The SEC release also notes that changes in weather patterns, increased storm intensity, sea level rise, melting of permafrost and temperature extremes at facilities could affect operations and financial disclosures. Likewise, changes in the availability or quality of water or other natural resources can have impacts on machinery, equipment and operations. Climate can also impact consumer demand such as reduced demand for heating fuels and warm clothing in warmer temperatures.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures HERE. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading).
The 2010 release delineated areas that could require such disclosure.
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business both historically and intended (see HERE for recent amendments to Item 101 including the addition of ESG related human capital disclosures). Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Like Item 101, Item 103 has recently been amended – see HERE.
Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 503 has also been amended – see HERE. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A- is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. Like the others, MD&A has been amended since 2010 – see HERE.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate related information.
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