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 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 greenhouse gas 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, and all aspects of the industry are weighing in. Other than the small but powerful group of environmental activists and institutional investors that influenced the proposed rule, the vast majority of the commenters believe the SEC is overreaching its authority. The rules are clearly driven by “investor demand” as opposed to “investor protection” and once passed will likely face constitutional challenges from the plaintiff’s bar for years to come.
Although the exact cost to public companies and investors is a topic of huge debate, with almost everyone agreeing the SEC’s published estimates are likely on the low side, it is universally agreed that this regulation is expensive, very expensive. Compliance is likely to increase the annual public company compliance costs by over 50% or more, the most expensive regulatory change since the Sarbanes-Oxley Act of 2002.
In the first blog in this series, I provided some background and an introduction to the rules (see HERE.) The second provided a high-level summary of the proposed rules (see HERE.) This week, I cover disclosures of climate-related risks. Next week I will move on to disclosures regarding climate-related impacts on strategy, business model and outlook.
Disclosure of Climate-Related Risks
The SEC is proposing to add new Subpart 1500 to Regulation S-K that would require a company to disclose certain climate-related information, including information about its climate-related risks that are reasonably likely to have material impacts on its business or consolidated financial statements. In particular, a company would be required to disclose risks that (i) had or are likely to have a material impact on its business or financial statements; and (ii) affected or are likely to affect the company’s strategy, business model and outlook.
As proposed, “climate-related risks” means the actual or potential negative impacts of climate-related conditions and events on a company’s consolidated financial statements, business operations, or value chains, as a whole. “Value chain” would mean the upstream and downstream activities related to a company’s operations. Upstream activities are those by a third party that relate to the initial stages of a company’s production of goods or services (for example, materials sourcing, processing and supplier activities). Downstream including activities by a third party relating to processing materials into a finished product and delivering it or providing a service to the end user (e.g., transportation and distribution, processing of sold products, use of sold products, end of life treatment of sold products, and investments).
Climate events can pose financial risks to companies including resulting from climate-related disasters such as wildfires, hurricanes, tornadoes, floods and heatwaves. In addition, companies may face indirect risks such as complying with potential carbon reducing regulations in the U.S. and abroad climate-related litigation; changing consumer, investor, and employee behavior and choices; changing demands of business partners; long-term shifts in market prices; technological challenges and opportunities, and other transitional impacts. The SEC categories these different risks as “physical risks” and “transition risks.”
As proposed, “physical risks” is defined to include both acute and chronic risks to a registrant’s business operations or the operations of those with whom it does business. “Acute risks” is defined as event-driven risks related to shorter-term extreme weather events, such as hurricanes, floods, and tornadoes. “Chronic risks” is defined as those risks that the business may face as a result of longer-term weather patterns and related effects, such as sustained higher temperatures, sea level rise, drought, and increased wildfires, as well as related effects such as decreased arability of farmland, decreased habitability of land, and decreased availability of fresh water.
The proposed rules would define “transition risks” to mean the actual or potential negative impacts on a registrant’s consolidated financial statements, business operations, or value chains attributable to regulatory, technological, and market changes to address the mitigation of, or adaptation to, climate-related risk. Transition risk would include increased costs attributable to climate-related changes in law or policy, reduced market demand for carbon-intensive products leading to decreased sales, prices, or profits for such products, the devaluation or abandonment of assets, risk of legal liability and litigation defense costs, competitive pressures associated with the adoption of new technologies, reputational impacts (including those stemming from a registrant’s customers or business counterparties) that might trigger changes to market behavior, changes in consumer preferences or behavior, or changes in a company’s behavior.
A company would be required to categorize a risk as either physical or transition and if physical whether it is acute or chronic. A disclosure of a physical risk must include the geographic location of the properties, processes or operations subject to the risk. If flooding presents a material physical risk, the proposed rules will require a company to disclose the percentage of buildings, plants, or properties (square meters or acres) that are located in flood hazard areas in addition to their location.
Disclosure of risks related to extreme water stress, such as restrictions on water use, would also be required. If the location of assets in regions of high or extremely high-water stress presents a material risk, the proposed rules would require a company to disclose the location of and amount of assets (e.g., book value and as a percentage of total assets) located in such regions in addition to their location. The company would also be required to disclose the percentage of its total water usage from water withdrawn in those regions.
The proposed rules would require a company to describe the nature of transition risks, including whether they relate to regulatory, technological, market (including changing consumer, business counterparty, and investor preferences), liability, reputational, or other transition-related factors, and how those factors impact the company. For example, an auto manufacturer should describe the risks associated with consumer demand for fuel efficient or electric vehicles and how that will impact its production choices, operational capabilities, and future expenditures.
A company may also voluntarily disclose opportunities presented related to climate conditions and a transition to a lower carbon economy. The proposed rules would define “climate-related opportunities” to mean the actual or potential positive impacts of climate-related conditions and events on a company’s consolidated financial statements, business operations, or value chains as a whole. Opportunities could include cost savings associated with the increased use of renewable energy, increased resource efficiency, the development of new products, services, and methods, access to new markets caused by the transition to a lower carbon economy, and increased resilience along a company’s supply or distribution network related to potential climate-related regulatory or market constraints.
Time Horizons and Materiality of Risks
The proposed rules require disclosure of material risks over the short, medium and long term. The proposed rules do not define time frames, rather a company will be required to disclose how it defines short-, medium-, and long-term time horizons, including how it takes into account or reassesses the expected useful life of its assets and the time horizons.
Thankfully, the SEC does not try to re-define materiality, but rather defers to the long-standing definition set by the U.S. Supreme Court in TSC Industries, Inc. v. Northway, Inc. That is, information is material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision. Likewise, an omitted fact is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available. In talking about climate, a company will need to consider the materiality of a future events, including assessing the probability of the event occurring and its potential magnitude or significance.
Obviously, it is not easy for any company to assess forward-looking information and most likely, companies will have to employ third parties to complete climate modeling and forward-looking assessments to comply with these rules. Moreover, although the forward looking statements safe harbor under the Private Securities Litigation Reform Act (“PSLRA”) will be available to climate-related disclosures in periodic reports, it is not available for disclosures in registration statements for initial public offerings, and if the proposed SPAC rule changes come into effect, would not be available for de-SPAC or other reverse merger transactions (see HERE).
Particular Issues Related to Value Chain Disclosures
Although most Fortune 500 companies currently include climate risk disclosures, the new rules are much more granular. The biggest pushback to this section of the proposed rules relates to the need to make upstream and downstream value chain disclosures, a requirement that is likely to tax an already strained supply chain. Both upstream and downstream disclosures require gathering, analyzing and reporting data on third parties. From a top level, disclosure can be broad based such as, for example, the impact on supply chain issues from utilizing a supplier in California during wildfire season.
For a larger reporting company, compliance becomes much more arduous with a requirement to provide GHG emission data on third parties. Any supply chain related emissions disclosures are encompassed by the term “Scope 3 emissions,” which as noted above, are defined as indirect emissions, not otherwise included in a company’s Scope 2 emissions (i.e., emissions generated from the electricity, steam, heating and cooling consumed by the company), which occur in the upstream and downstream activities of a company’s value chain. These emissions stem from the use of the company’s products, transportation of products (for example, to the company’s customers), end of life treatment of sold products, investments made by the company, the transportation of goods in the company’s downstream supply chains and employee business travel and commute. Disclosure of Scope 3 emissions would only be required if those emissions are “material,” i.e., if there is a substantial likelihood that a reasonable investor would consider them important when making an investment or voting decision, or if the company has set a GHG emissions reduction target or goal that includes its Scope 3 emissions.
Not only will public companies require the timely cooperation of its private company partners, but as a natural consequence of the rules, be required to choose partner relationships based on that partner’s ability to provide the necessary information, on a timely basis. It is likely the requirement to provide third-party information will be challenged in court, but it illustrates a recent trend toward requiring more private company disclosures (for example, in December 2021 FinCen proposed new ownership reporting rules for private companies.) The challenges of meeting these requirements are immense.
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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