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 are heady and complex (490-page rules release) presenting an enormous scope, complexity and ramifications. As such, like the SPAC rules, I am breaking down the proposal in detail in a series of blogs.
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). The fourth moved on to disclosures regarding climate-related impacts on strategy, business model and outlook (see HERE). The fifth blog in the series delved into risk management and transition plan disclosures (see HERE).
This sixth blog, in a series that could be my largest yet, provides an overview of the extremely complex financial statement metrics requirements. As I like to leave the accounting to the accountants, this section will not be as detailed as those covering the proposed narrative disclosures.
Financial Statement Metrics
The SEC is also proposing to add new Article 14 to Regulation S-X that would require certain climate-related financial statement metrics and related disclosure to be included in a note to a company’s audited financial statements. The proposed rule would require companies to disclose, in a footnote to the financial statements, the financial statement impacts of (i) climate-related events, including severe weather events and other natural conditions such as flooding, drought, wildfires, extreme temperatures, and sea level rise, and (ii) transition activities, including efforts to reduce GHG emissions or otherwise mitigate exposure to transition risks.
The proposed financial statement metrics would consist of disaggregated climate-related impacts on existing financial statement line items. These would include: (i) climate-related financial impact metrics; (ii) expenditure metrics; and (iii) a discussion of climate-related impacts on financial estimates and assumptions. As part of the registrant’s financial statements, the financial statement metrics would be subject to audit by an independent registered public accounting firm and come within the scope of the registrant’s internal control over financial reporting (“ICFR”).
A company would be required to consistently apply the same set of accounting principles it applies to other categories in its financial statements. Likewise, the disclosure will need to be for the same period as other financial disclosures – i.e., either a two- or three-year period depending on whether the company is a smaller reporting company (or emerging growth company), accelerated filer or large accelerated filer. A company will have a grace period for the reporting of historical information after the rule is implemented where such historical information is not readily available (i.e., because there was no requirement to calculate it in the past).
As the financial information would necessarily require the application of judgments and assumptions, the underlying metrics, significant inputs, and assumptions would also need to be disclosed as would accounting policies utilized.
Also, companies would of course need to implement processes, procedures and internal controls to track the information and provide the line-item analysis. As the disclosures are in the financial statements, they will be subject to audit by the company’s independent registered public accounting firm. Many industry participants are concerned that it will be very difficult determining whether some expenses are climate-related as opposed to a result of other factors. For example, a company may not be aware that increased insurance premiums are a result of overall climate factors, and the insurance company may not, and would not be obligated to, inform the company of same.
Financial Impact Metrics
The proposed rule would require a company to provide a narrative discussion of whether and how any of its identified climate-related risks have affected or are reasonably likely to affect its consolidated financial statements. The term “climate-related risks” would be defined, in part, as the actual or potential negative impacts of climate-related conditions and events on a company’s consolidated financial statements. “Climate-related risks” would also be defined to include physical risks, such as extreme weather events, and transition risks.
The SEC rule release contains numerous examples of potential financial impacts of both climate-related events and transition activities. Examples of climate-related events that would require financial statement disclosure include: (i) changes to revenue or costs from disruptions to business operations or supply chains; (ii) impairment charges of assets including inventory, intangibles, and property, plant and equipment; (iii) changes to loss contingencies or reserves, such as environmental reserves or loan loss allowances; and (iv) changes to total expected insured losses due to flooding or wildfire patterns.
Examples of transition activities that would require financial statement disclosures include: (i) changes to revenue or costs due to new emissions pricing or regulations resulting in the loss of a sales contract; (ii) changes to cash flows from changes in upstream costs, such as transportation of raw materials; (iii) changes to the carrying amount of assets due to the reduction of the asset’s useful life or a change to the asset’s salvage value; and (iv) changes to interest expense driven by financing instruments such as climate-linked bonds issued.
Companies would be required to separately disclose all negative and all positive impacts of climate-related events as well as separately disclose all negative and all positive impacts of transition activities. These disclosures would be required for each affected financial statement line item if, on an aggregated basis, the absolute value of all such impacts (i.e., the absolute value of both negative impacts and positive impacts for both climate-related events and transition activities) exceeds 1% of the related line item. Since the disclosure is a bright line 1% threshold, a company will need to have appropriate processes, procedures and internal controls for tracking the information and developing the required disclosure.
Absolute value is not calculated as a net value but rather an aggregation of all impacts. For example, if a company has an impairment expense as a result of damaged inventory from a severe weather event in the amount of $2 million, but also has expense savings of $2.5 million as a result of a reduction in manufacturing costs from energy conservation, the absolute effect would be $4.5 million. This $4.5 million would be measured against the appropriate cost of goods sold line item to determine if it exceeds 1% or not. If it does exceed 1%, then both the positive and negative effect would be disclosed in the notes to financial statements.
The proposed expenditure metrics would refer to the positive and negative impacts associated with the same climate-related events, transition activities, and identified climate-related risks as the proposed financial impact metrics. As proposed, the expenditure metrics would require a company to separately aggregate amounts of (i) expenditure expensed and (ii) capitalized costs incurred during the fiscal years presented. For each of those categories, a company would be required to disclose separately the amount incurred during the fiscal years presented (i) toward positive and negative impacts associated with the climate-related events (i.e., severe weather events and other natural conditions and identified physical risks) and (ii) toward transition activities, specifically, to reduce GHG emissions or otherwise mitigate exposure to transition risks (including identified transition risks). A company may also voluntarily disclose the impact of climate-related opportunities.
Like financial impact metrics, the SEC rule release contains numerous examples of expenditures a company may incur to mitigate exposure to climate-related events and related to transition activities. Examples of expenditures as a result of climate-related risks include: (i) increasing the resilience of assets or operations; (ii) retiring or shortening the estimated useful lives of impacted assets; and (iii) relocating assets or operations that are at risk.
Examples of expenditures related to transition activities include: (i) expenditures related to reducing GHG emissions, increasing energy efficiency, offsetting emissions including the purchase of carbon offsets and RECs, and improving other resource efficiency; (ii) research and development of new technologies; (iii) the purchase of assets, infrastructure and products; and (iv) increase expenditures related to the new climate disclosures.
If the total amount expensed for climate-related events and transition activities or the total amount capitalized for such events and activities exceeds 1% of the company’s total expenditures or capitalized costs, respectively, separate disclosure of those amounts would be required, disaggregated by climate-related events and transition activities. A company would perform this calculation relative to total expenditures and capitalized costs, regardless of the financial statement line items in which the amounts are included.
As an example, a company incurred $2.5 million in relocation expenses and $2.5 million of training expenses related to new equipment that reduces GHG emissions and also capitalized $10 million in costs for same new equipment. The same company had $350 million in total expenses and $50 million in total capitalized costs. In this case, the aggregate $5 million in relocation and training would be 1.4% of total expenses and the $10 million in equipment capitalization would be 20% of total capitalized costs. Because the expenses and capitalized costs exceed 1% of total expenses and total capitalized costs, respectively, the company would disclose the expenses related to both climate-related events and transition activities and capitalized costs related to transition activities in a footnote to its financial statements.
Financial Estimates and Assumptions
Under the proposed rule, companies would need to provide disclosures about whether risks, uncertainties, or known factors associated with climate-related events and transition activities, including the company’s own climate-related targets or goals, affected the estimates and assumptions reflected in its financial statements. If applicable, a company must qualitatively disclose how the estimates and assumptions were affected. For example, a company that establishes a specific climate target may plan to retire certain assets early to reduce GHG emissions. Any change in the useful life associated with these assets would represent a financial estimate affected by transition activities
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