Making Sense of the SEC's Climate Change Disclosure Proposal
Riddle us this – what's 500 pages long, asks over 800 questions, and is giving CFOs acid reflux before it even becomes official? If you said the SEC's recent proposal on climate disclosure requirements, we owe you a gold star.
Sure, it might be tempting to focus on the word proposal, knowing that any compliance date is not yet official and, consequently, you kick the regulatory can a bit further down the road. However, even though nothing will be official for months, the time is now to kickstart your ESG strategy and begin planning for the (not so distant) future.
So, on that note, let's take a high-level look at the recent proposal from the good folks at the US Securities and Exchange Commission, The Enhancement and Standardization of Climate-Related Disclosures for Investors, and think of it as a sneak preview of what's to come.
Background on the Proposed Disclosure Requirements
Obviously, climate change and the risks associated with it aren't exactly sneaking up on anyone at this point. However, environmental, social, and governance-related matters – ESG, collectively – now routinely dominate headlines across the globe.
Suffice it to say, investors and stakeholders alike want information regarding sustainability and the impact of climate change on an organization, both today and tomorrow. And that's where the recently proposed rules come into play, providing a set of guidelines registrants will follow to give financial statement users – and the capital markets themselves – the insights needed to make fully-informed investment decisions.
But this isn't the SEC's first foray into climate-related disclosures, having issued an interpretive letter on the topic back in 2010. That guidance never wielded too mighty of a sword, though, and was simply inadequate in providing the scope or level of detail and standardization investors now demand on a global issue whose severity has grown exponentially in recent years.
Therefore, this recent proposal on climate-related disclosure rules is a logical, unavoidable step for regulators, falling in line with a worldwide groundswell of demand for decisive action on environmental issues. In fact, the SEC borrowed heavily from the Task Force on Climate-Related Financial Disclosures (TCFD) and the GHG Protocol methodology – two already well-established global frameworks – to flesh out the proposal.
For greater context into some of these acronyms flying around, we recommend reading our previous thoughts on ESG and the risks it potentially carries for enterprises. But for now, let's focus on what's in front of us and distill the SEC's recent proposal on climate-related disclosures into its different components and how they might impact your business.
Key Components of the SEC's Climate Disclosure Proposal
As we said, the proposal currently sits at nearly 500 pages, so even providing a high-level summary can be a hefty task. So to save you some eye strain and keep everything as organized, informative, and concise as possible, we're going to break the proposal down into its meatiest components.
But before we jump in feet first, we want to mention who falls within the scope of the proposed rule. Much to the chagrin of CFOs from sea to shining sea – and beyond – the proposal includes:
- Large accelerated, accelerated, and non-accelerated filers
- Emerging growth companies (EGCs)
- Smaller reporting companies (SRCs)
- Foreign private issuers (FPIs)
- Companies filing registration statements, including IPOs and SPACs
In other words, pretty much all SEC registrants are within the proposal’s scope. Also, while the SEC rule doesn’t explicitly discuss private companies, the proposed requirements can impact them as well. For example, the rule would likely envelop private companies that have relationships with public registrants subject to the rule, whether it be as a subsidiary, equity method investment, customer, or supplier, to name a few.
When it comes to the actual disclosures, there are a number of ways to categorize the various proposed requirements. However, perhaps the most straightforward method involves just two categories:
- Disclosures outside the Financial Statements (Regulation S-K)
- Climate-Related Risks
- GHG Emission Disclosures (Scope 1, Scope 2, and Scope 3)
- Governance, Oversight, and Risk Management of Climate-Related Risks
- Financial Statement Disclosures (Regulation S-X)
Now that we’ve covered the highest level basics, let's take a closer look at each of these categories.
Investors want to know how climate change will affect your strategy, business model, and outlook, looking for information that is consistent, comparable, and reliable. Therefore, the proposal would require public companies to speak to potential risks a company faces due to climate change, separated into two categories of risk:
- Physical risks - Impacts of extreme weather events or conditions - wildfires, hurricanes, drought, heat, and others – both acute and chronic on operations.
- Transition risks - Impacts of transitioning to meet lower carbon commitments or requirements
Zeroing in further, companies would have to disclose the impact of such risks over the short, medium, and long term, as well as how these risks could affect strategy, planning, capital allocation, financial stability, and overall financial performance. Interestingly, these disclosures require a high level of granularity, such as ZIP Code level disclosure for assets located in areas subject to physical risks like a piece of machinery sitting in a flood zone. Now that’s specific.
GHG Emission Disclosures
This is where the SEC thankfully mirrored key aspects of the GHG Protocol, an already prevalent emissions disclosure framework that many companies are familiar with. Thus, like the GHG Protocol, the SEC's proposal would require registrants to disclose their Scope 1 – direct – greenhouse gas emissions from its operations, as well as their Scope 2 emissions – those from indirect sources like purchased or acquired electricity, steam, cooling, and heat used in its operations. Company offsets, whether purchased or generated, are excluded from the emissions disclosures and presented separately.
But things get especially interesting when the proposal discusses Scope 3 emissions. Such a disclosure would require many registrants to disclose indirect emissions occurring throughout the value chain, including vendors and supply chain partners.
Now, according to the GHG Protocol, Scope 3 disclosures are voluntary. However, with the SEC's recent proposal, a company would have to disclose this information if it's material – more on that can of worms in a few minutes – or discussed in any GHG emissions reduction target or goal of the registrant.
It's important to note that Scope 3 emissions are usually the most complex and challenging to calculate since companies must rely on outside parties for the information. Fortunately, companies can take some comfort knowing Scope 3 disclosures would fall under safe harbor provisions, meaning no fraud would occur as long as the company acts in good faith. Also, SRCs have the additional benefit of being exempt from disclosing Scope 3 emissions.
Similarly, if actual reported data isn’t reasonably available for Q4 emissions, the registrant can make a reasonable estimate. That said, once the actual Q4 data is available, the registrant would need to disclose any material difference in a subsequent filing.
Governance and Oversight
The proposal would also require a company to disclose any assessment and risk management efforts from leadership on climate-related risks, along with the role the board plays in overseeing such risks. Further, a company would need to disclose which committee or board members are providing the oversight, as well as anyone sitting on the board with expertise in a specific climate-related area.
As we said above, Scope 3 disclosures are not mandatory for all registrants. This isn't the only example of a conditional disclosure in the proposal, however. In fact, companies with more mature ESG programs and processes – climate-related, specifically – must provide additional disclosures.
For example, if an organization uses analytical tools like scenario planning and analysis to gauge the financial impact of climate-born risks, it needs to disclose that information in its consolidated financial statements, discussing the potential impact on operations.
Likewise, if a company establishes any climate-related targets or goals – emission reductions, fossil fuel usage, water conservation, and others – it would need to disclose such transition plans, including important metrics and project timelines. This would include discussing how any carbon offsets or renewable energy credits (RECs) factor into an emission reduction strategy, as well as any associated costs and financial risks.
Lastly, if a company internally prices the cost of carbon, it must disclose information about such pricing, including the price in units per metric ton of carbon dioxide equivalent, and the reason for selecting the pricing used.
Financial Statement Disclosures
Of course, finance organizations should pay particularly close attention to what the proposal says about Regulation S-X requirements and how they’ll impact the financial statements. As things stand, registrants would include the climate-related financial statement disclosures in a new footnote, speaking to three specific areas:
- Financial impact metrics – Quantitative disclosure on impacts of climate-related events, conditions, and transition activities on each financial statement line item where aggregate impact to the line item exceeds a 1% threshold
- Financial expenditure metrics – Quantitative disclosure on costs expensed or capitalized related to both positive and negative impacts of climate-related events or transition activities where aggregate impact exceeds a 1% threshold
- Financial estimates and assumptions – Qualitative disclosure of how climate-related matters impact key estimates and assumptions
Also, since companies are including these proposed disclosures in the financial statements, they would be subject to an organization’s audit and internal controls over financial reporting (ICFR).
You know those 1% bright-line materiality thresholds we just referenced in the Financial Statement Disclosures section? Well, other areas of the proposed requirements don’t provide such specific parameters. This is where the prior precedent on materiality comes into play:
A matter is material if there is a substantial likelihood that a reasonable investor would consider it important when determining whether to buy or sell securities or how to vote.
But there's some wiggle room in that definition, isn't there? For instance, what might have a material impact for one company or industry might not for others, especially when differing financial conditions and environments are involved, especially when thinking about short, medium, and long-term impacts. Thankfully, the proposal acknowledges this particular hurdle, so this is likely an area where we'll get more specific language closer to actual adoption.
Transition and Attestation
The SEC understands this is a massive undertaking for companies. Thus, the proposal includes phased requirements so registrants can get their house in order and implement the systems, controls, and procedures they'll need for compliance.
Further, accelerated and large accelerated filers will be able to phase in outside attestation requirements on their Scope 1 and Scope 2 emissions. Just to keep everything as straightforward as possible, however, it's probably best to summarize the transition and attestation report requirements in a neat and tidy table:
Action Planning for the Future
Granted, compressing a 500-page document into a bite-sized morsel is bound to leave a gigaton of information behind. However, our intention wasn't to get you completely up to speed on everything the proposal contains since, if that was the case…well…it would no longer be bite-sized.
Instead, we wanted to provide some high-level guidance to demonstrate what issuers are likely facing on the regulatory front. As the requirements get closer to hitting the Federal Register, we'll continue to publish our insights and handy best practices to make the transition as smooth and seamless as possible for you.
That said, the time to start preparing for these inevitabilities is now. Remember, this is just the tip of the ESG iceberg, so there will be plenty of additional regulatory requirements coming down the pike in years to come. Therefore, you want to start preparing your people, fine-tuning your processes, and implementing the technologies you will need to stay compliant, no matter what the regulators might throw at you. Thankfully, our ESG implementation team is at the ready, capable of getting your ESG strategy up and running in no time.