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 greenhouse gas emissions (GHG), 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, 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.
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 including the phase in compliance schedule (see HERE.) The third blog in the series discussed the disclosures of climate-related risks (see HERE.) This week I will move on to disclosures regarding climate-related impacts on strategy, business model and outlook.
Disclosure Regarding Climate-Related Impacts on Strategy, Business Model, and Outlook
Disclosure of Material Impacts
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 climate related impacts on a company’s strategy, business model, and outlook. New proposed Item 1502(b) builds on the disclosure of climate-related risks requiring a discussion of the actual and potential impact of those risks.
The proposed rules would require disclosure of the impacts on:
- Business operations, including the types and locations of its operations;
- Products or services;
- Suppliers and other parties in its value chain;
- Activities to mitigate or adapt to climate-related risks, including adoption of new technologies or processes;
- Expenditures for research and development; and
- Any other significant changes or impacts.
A company would also be required to disclose the time horizon (short, medium or long term) for each impact. The disclosure would include both current and forward-looking statements focusing on how the company is considered the climate-related risks in its business model or strategy, including how resources are being used to mitigate the risks.
The SEC rule release includes a few examples including a hypothetical entity that operates in a jurisdiction that imposed or is likely to impose limits on GHG emissions in support of the Paris Agreement. Such a company would need to set goals to reach net zero emissions including short-, medium- and long-term reductions. Disclosures would be required related to the transition risks and estimated costs of the operational changes to achieve the goals. Other examples include considerations related to reducing the use of fossil fuels, increasing the use of renewable energy, and utilizing new technologies.
In addition to a company’s business strategy, consideration must also be given to outside factors such as drought, heat, fires and extreme weather. Again, the rule release provides several examples such as an agricultural company facing a drought, a mining company losing operations due to extreme heat, a coastal real estate company dealing with rising sea levels, an oil company adjusting reserves, and an automobile company revamping for electric cars.
The discussion would not be limited to a qualitative narrative but must also include the quantitative affect or reasonably likely affect on financial statements. As touched on in Part 2 of this blog series, the SEC is proposing new Article 14 to Regulations S-X which would require certain climate-related financial statement metric disclosures. The discussion of risks and the impact of risks would also need to include any of the applicable financial statement metrics disclosed pursuant to proposed Regulation S-X Rule 14-02.
Disclosure of Carbon Offsets or Renewable Energy Credits
If, as part of its net emissions reduction strategy, a company uses carbon offsets or renewable energy credits or certificates (“RECs”), the proposed rules would require it to disclose the role that carbon offsets or RECs play in its climate-related business strategy. The definition of REC mirrors the EPA’s definition to mean a credit or certificate representing each purchased megawatt-hour (1 MWh or 1000 kilowatt-hours) of renewable electricity generated and delivered to a registrant’s power grid.
Carbon offsets and RECs are used to mitigate GHG emissions. A company can use the offsets or RECs to meet 100% of a GHG reduction goal or couple them with operational changes and modifications to products or the development of renewable energy sources. The SEC release illustrates several examples of risks associated with carbon offsets or RECs, including: (i) the more a company uses them in place of operational changes, the more the company will be impacted by increased prices (which may be caused by increased demand) and decreased credit per offset or REC; and (ii) changes in laws eliminating or reducing the use of offsets or credits.
Disclosure of a Maintained Internal Carbon Price
Some companies may use an internal carbon price when assessing climate-related factors. Under the proposed definition, an internal carbon price is an estimated cost of carbon emissions used internally within an organization. Where a company sets an internal carbon price, it must disclose: (i) the price of the company’s reporting currency per metric ton of carbon equivalent (“CO2e”); (ii) the total price, including how the total price is estimated to change over time, if applicable; (iii) the boundaries for measurement of overall CO2e on which the total price is based; and (iv) the rationale for selecting the internal carbon price applied.
A company would also need to disclose how it uses its carbon price to evaluate and manage climate related risks including assumptions about future events.
Disclosure of Scenario Analysis, if Used
The SEC is proposing to require a company to describe its resilience of its business strategy in light of potential future changes to climate-related risks. When discussing these “what if” scenarios, a company will also need to describe any analytical tools used to make the assessment. The rule defines “scenario analysis” as a process for identifying and assessing a potential range of outcomes of future events under conditions of uncertainty. Moreover, scenario analysis is a tool used to consider how, under various possible future climate scenarios, climate-related risks may impact a company’s operations, business strategy, and consolidated financial statements over time. The rule does not require the use of scenario analysis, just a disclosure if it is used.
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