On March 21, 2022, the SEC proposed rules that would require publicly reporting companies to include certain climate related disclosures in their registration statements and periodic reports. Among other information, the new disclosures would require information about climate-related risks that are reasonably likely to have a material impact on a company’s business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to its audited financial statements.
The proposed rule changes would require a company to disclose information about (i) the company’s governance of climate-related risks and relevant risk management processes; (ii) how any climate-related risks identified by the company have had or are likely to have a material impact on its business and consolidated financial statements, including over the short, medium, or long term; (iii) how any identified climate-related risks have affected or are likely to affect the company’s strategy, business model, and outlook; and (iv) the impact of climate-related events (severe weather events and other natural conditions) and climate transition activities on the line items of a company’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements.
The proposed rules also would require a company to disclose information about its direct greenhouse gas (GHG) emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2). In addition, a company would be required to disclose GHG emissions from upstream and downstream activities in its value chain (Scope 3), if material or if the company has set a GHG emissions target or goal that includes Scope 3 emissions. The proposed rules would provide a safe harbor for liability from Scope 3 emissions disclosure and an exemption from the Scope 3 emissions disclosure requirement for smaller reporting companies. The SEC believes the proposed disclosures are similar to those that many companies already provide based on broadly accepted disclosure frameworks, such as the Task Force on Climate-Related Financial Disclosures and the Greenhouse Gas Protocol.
Under the proposed rule changes, accelerated filers and large accelerated filers would be required to include an attestation report from an independent attestation service provider covering Scopes 1 and 2 emissions disclosures, with a phase-in over time, to promote the reliability of GHG emissions disclosures for investors.
The proposed rules would include a phase-in period for all registrants, with the compliance date dependent on the registrant’s filer status, and an additional phase-in period for Scope 3 emissions disclosure.
The proposed rules, which are heady and complex, initially only allotted for a 39-day comment period. Considering the size (490-page rules release), scope, complexity and ramifications, the marketplace pushed back on such a short window. On May 9, 2022, the SEC extended the comment period through June 17, 2022.
Although it is likely that the final rule release will make some changes based on comment letter feedback, it is uniformly believed that the rules will be enacted, and that the time and cost for compliance will be burdensome on human capital and expensive all around. Accordingly, companies should start assessing a path for compliance right away. Although the rules are likely to pass in some reiteration, the proposed rules are firmly partisan with over 40 Republican members of Congress and 19 Republican Senators having signed letters asking the SEC to table the proposal. Despite the dissenters, Gary Gensler is pushing forward using the climate and SPAC rule changes as his 2022 platform (so far).
I will be dissecting these dramatic proposed rule changes over several weeks, including the lengthy dissent from my favorite Commissioner, Hester M. Peirce. This blog provides a background and introduction to the proposed rules. Next week’s blog will provide a summary of the rules and the following weeks will include a deep dive into each aspect of the proposed rule.
The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value climate information in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of financial 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. 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.
The last official SEC guidance on climate-related guidance was published in 2010; however, in March 2021 the SEC published a statement and request for public input on climate change disclosures (see HERE and HERE). Later in October 2021, the SEC published a sample comment letter providing companies with guidance as to the regulator’s current focus and expectations under the existing rules (see HERE).
Under political and activist pressure, many companies voluntarily provide climate disclosure, and the SEC believes that its rule proposal will result in “consistent, comparable, and reliable—and therefore decision-useful—information to investors to enable them to make informed judgments about the impact of climate-related risks on current and potential investments.” I believe that may be true, at least in part, and will comment further in detail throughout this blog series.
The SEC also states that “existing disclosures of climate-related risks do not adequately protect investors.” I simply cannot get behind this statement. I think the proposed rules represent a response to a social calling and have nothing to do with investor protection. The SEC is concerned that many climate-risk and expense related disclosures are made outside of SEC reports and thus lack comparability and of course liability associated with reporting obligations. As noted above, the current rules related to climate disclosure require the disclosure of all financially material information. Although I agree with some of the new rule requirements, I suggest the new rules go well beyond the scope of the Regulation S-K and Regulation S-X parameters, and instead provide investors with information in which to judge a public companies culture and reputation, as well as its financial performance.
The rule release includes several introductory pages on the need for climate risk related disclosures, the concept of which I agree with completely. Severe and frequent natural disasters can damage assets, disrupt operations, and increase costs. Transitions to lower carbon products, practices, and services, triggered by changes in regulations, consumer preferences, availability of financing, technology and other market forces, can lead to changes in a company’s business model. How a company assesses and plans for climate-related risks may have a significant impact on its future financial performance and investors’ return on their investment in the company. Some changes to the current rule structure will help make this information more readily available and consistent, but again, the vast scope of the proposal is well beyond minimally invasive; it is a complete upheaval.
Moreover, small and micro-cap companies may find compliance costly to the point of impossible. I believe the SEC has vastly underestimated the enormous compliance challenges to smaller companies. As I will detail throughout this blog series, many of the provisions should be reduced and a longer phase-in schedule allowed for smaller reporting companies.
Certainly investors and individuals have the right to decide that they want to conduct business with or not, buy products from or not, or engage with or not, any company based on social factors. My concern is that the new rules are not only extremely costly, thus negatively impacting the financial performance of these companies, but that they are written in a way to advance very particular activist groups’ viewpoints. It reminds me of the pop-up ads on the internet prompting me to hit a button that says, “No, I like to pay more” to get rid of the screen, only in this case I already paid more for the information, and it isn’t even information I necessarily need.
Investor Demand for Climate-Related Risk Disclosure and Related Information
As touched on above, several major institutional investors, which collectively have trillions of dollars in investments under management, have demanded climate-related information from the companies in which they invest because of their assessment of climate change as a risk to their portfolios, and to investments generally, and also to satisfy investor interest in investments that are considered “sustainable.” In addition to forming investor initiatives, these activist groups have lobbied the SEC for additional disclosure rules.
The SEC includes a discussion of the investor demand in its rule release, and it is clearly a decisive factor in the rule proposal. From a broad perspective, although the activist investors wield a great deal of power, it is a small group. For instance, the SEC points out that in more than 630 investors collectively managing more than $37 trillion signed the Global Investor Statement to Governments on Climate Change urging governments to require climate-related financial reporting. That is just one example; most institutional investors include ESG in making investment related decisions, and climate is one of the largest ESG factors.
Third Party Data, Voluntary Disclosure Frameworks and International Disclosure Initiatives
Over the years there has been a rise in third party data providers offering differing reports and information on climate risk and other ESG matters. The type of information as well as methodologies for aggregating and reporting data is fragmented. The need for material, comparable and consistent information is clearly valid. In this regard, I completely agree with the premise of the proposed rules.
Many groups have developed climate-reporting frameworks, including the Global Reporting Initiative (“GRI”), CDP (formerly the Carbon Disclosure Project), Climate Disclosure Standards Board (“CDSB”), Value Reporting Foundation (formed through a merger of the Sustainability Accounting Standards Board (“SASB”) and the International Integrated Reporting Council (“IIRC”), and the TCFD. However, the form and content are not consistent among the groups or the companies voluntarily reporting under one standard or another.
The increased fragmentation of climate reporting resulting from the proliferation of third-party reporting frameworks has motivated several recent international efforts to obtain more consistent, comparable, and reliable climate-related information for investors, including formation of the International Sustainability Standards Board (“ISSB”). The ISSB is expected to engage in standard setting to build on the prototype, including developing climate-specific disclosure standards based on the recommendations of the TCFD. Also, several jurisdictions, including the European Union, are developing or revising mandatory climate-related disclosure regimes.
Development of a Climate Related Reporting Framework
The SEC’s proposed climate related reporting rules stem from the reporting framework developed by the TCFD and the Greenhouse Gas Protocol (“GHG Protocol”). Both the TCFD and the GHG Protocol have developed concepts and a vocabulary that are commonly used by companies when providing climate-related disclosures in their sustainability or related reports. The TCFD framework establishes eleven disclosure topics related to four core themes that provide a structure for the assessment, management, and disclosure of climate-related financial risks: governance, strategy, risk management, and metrics and targets.
According to the SEC rule release, as of October 2021 more than 2,600 organizations globally, with a total market capitalization of $25 trillion, have expressed support for the TCFD. Further, 1,069 financial institutions, managing assets of $194 trillion, also support the TCFD. Many other countries are also building out disclosure frameworks based on the TCFD.
The SEC believes that GHG data can help investors assess a company’s exposure to climate-related risks, including regulatory, technological, and market risks driven by a transition to a lower-GHG intensive economy. This data also could help investors to assess the progress of companies with public commitments to reduce GHG emissions, which would be important in assessing potential future capital outlays that might be required to meet such commitments. The GHG Protocol is the most widely used global greenhouse gas accounting standard.
The GHG Protocol’s Corporate Accounting and Reporting Standard provides uniform methods to measure and report the seven greenhouse gasses covered by the Kyoto Protocol – carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulfur hexafluoride, and nitrogen trifluoride. The GHG Protocol introduced the concept of “scopes” of emissions to help delineate those emissions that are directly attributable to the reporting entity and those that are indirectly attributable to the company’s activities.
Under the GHG Protocol, Scope 1 emissions are direct GHG emissions that occur from sources owned or controlled by the company. These might include emissions from company-owned or -controlled machinery or vehicles, or methane emissions from petroleum operations. Scope 2 emissions are those emissions primarily resulting from the generation of electricity purchased and consumed by the company. Scope 3 emissions are all other indirect emissions not accounted for in Scope 2 emissions. These emissions are a consequence of the company’s activities but are generated from sources that are neither owned nor controlled by the company. Examples include emissions associated with the production and transportation of goods, employee commuting and travel and the processing or use of a company’s products by third parties.
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