More than a year and a half after the Securities and Exchange Commission (SEC) released its controversial and groundbreaking Proposed Rule for the disclosure of climate-related risks, its much-anticipated release of the Final Rule may be imminent. If the Final Rule is released this month, it will come at a time of both growing backlash and support for environmental, social and governance (ESG) disclosures.
Let us refresh your memory about what is included in the SEC’s Proposed Rule.
General Overview
“The Enhancement and Standardization of Climate-Related Disclosures for Investors” would require all publicly traded companies to include in their registration statements and annual reports any information on the company’s climate-related risks that are reasonably likely to have a material impact on its business, operations or financial condition. Generally, a risk is considered 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. Additionally, the Proposed Rule would require a company to disclose its levels of greenhouse gas (GHG) emissions including Scope 1 (direct emissions), Scope 2 (emissions for purchased electricity and other forms of energy) and Scope 3 (indirect emissions from upstream and downstream activities in a company’s value chain). An overview of GHG protocol scopes and emissions across the value chain is illustrated on page 5 of the Corporate Value Chain (Scope 3) Accounting and Reporting Standard, prepared by the World Resources Institute and World Business Council for Sustainable Development.
The Proposed Rule seeks to provide investors with consistent, comparable and reliable climate-related disclosures regarding:
- Material climate-related risks to a company and its business strategy.
- The impact of climate-related risks on a company’s business and financial statements.
- A company’s governance and oversight processes at the board and management levels to address climate-related-risks.
- A company’s processes to identify, assess, and manage climate-related risks and whether such processes are integrated into a company’s overall risk management system.
- The impact of climate-related events and transition activities on the line items of a company’s financial statements.
- A company’s Scope 1 and 2 GHG emissions, and Scope 3 GHG emissions if material, or if a company has set a GHG emissions target or goal that includes Scope 3 emissions. Emissions are required to be reported in both absolute terms and in terms of intensity (per unit of economic value or production).
A company’s disclosures under the proposed rule would be located in a separately captioned “Climate-Related Disclosure” section of a company’s registration statements and annual reports. The disclosure of climate-related financial statement metrics would be included in the notes to a company’s consolidated financial statements.
SEC Chair Gary Gensler, in his comments to Senate Banking Committee on Sept. 12, 2023, noted that the delay in issuing a final rule has been partly due to concerns raised by public comments on the Proposed Rule’s Scope 3 emission disclosures. Gensler declined to estimate when the SEC will adopt a final rule, but the SEC regulatory agenda identifies October 2023 as the date for final action on the Proposed Rule.
Who Does the Proposed Rule Apply to?
All publicly traded companies regardless of size, industry or operations. If approved as proposed, the compliance deadlines will vary depending upon the reporting size of a company; certain requirements would not apply to smaller reporting companies (SRCs).
What Are Climate-Related Risks?
The Proposed Rule would require a company to disclose any climate-related risks that are “reasonably likely to have a material impact on the registrant’s business or consolidated financial statements.” Climate-related risks include any actual or potential negative impacts of climate-related events on a company’s consolidated financial statements, business operations or value chains. A company would be required to disclose whether any climate-related risk is likely to manifest over the short, medium or long term, and to describe how it defines short, medium and long-term horizon. A company would also be required to include in the narrative discussion of its consolidated financial statements whether climate-related impacts are anticipated to manifest over the short, medium or long term. Climate-related risks include both physical risks and transition risks.
Physical climate-related risks are the risks to a company’s assets due to acute climate-related disasters and extreme weather events such as wildfires, hurricanes, tornadoes, floods and heatwaves. Physical risks also include chronic climate-related risks and gradual impacts from long-term temperature increases, drought, water scarcity and rising sea levels. The Proposed Rule would require disclosure of detailed and specific information relating to physical climate-related risks such as the location, by zip code (or similar subnational postal zone or geographic location), of properties, processes or operations subject to a physical risk that has had or is likely to have a material impact on the company’s business or consolidated financial statements. For example, if flooding presents a material physical risk to a company’s properties, a company would need to disclose the percentage of buildings, plants or properties, in square meters or acres, that are located in flood hazard areas in addition to their physical location.
Transition risks involve the impacts on a company’s financial statements, business operations or value chain that are attributable to regulatory, technological and market changes addressing the mitigation of, or adaptation to, climate-related risks. Transition risks may 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 that might trigger changes to market behavior, changes in consumer preferences or behavior or changes in a company’s behavior. The Proposed Rule would require a company to disclose exposure to any transition risks and its strategy to manage and address those risks.
Governance Disclosure
The Proposed Rule includes robust disclosures relating to a company’s governance of climate-related risks and opportunities at the board and management levels. With respect to board oversight, a company would be required to disclose:
- The board members and/or committees tasked with oversight of climate-related risks.
- A description of a board member’s climate-related expertise.
- The frequency by which the board or board committee discusses climate-related risks.
- Whether and how the board or board committee considers climate-related risks as part of its business strategy, risk management and financial oversight.
- Whether and how the board sets climate-related targets or goals and how it oversees progress against those targets or goals.
With respect to management oversight, companies would be required to disclose:
- Whether there are management positions or committees responsible for assessing and managing climate-related risks and the identities of the individuals in those management positions or committees.
- The relevant expertise of the individuals holding such management positions.
- The processes by which such management positions are informed about and monitor climate-related risks.
- Whether the responsible management positions or committees report to the board or board committee on climate-related risks and how frequently this occurs.
Risk Management Disclosure and Climate-Related Impacts on Strategy, Business Model and Outlook
Part of the mandated disclosures in the Proposed Rule would require companies to describe their processes of identifying, assessing and managing climate-related risks, as well as how the company plans to mitigate or address those risks. When describing the processes for identifying, assessing and managing climate-related risks, companies would be required to disclose:
- How the company determines the significance of climate-related risks and how the company measures its climate risk against other risks to the company.
- How the company determines the materiality of climate-related risks, including the size, scope and potential impact of such risks.
- How the company prioritizes addressing climate-related risks.
- How the company determines how it will mitigate its climate-related risks.
- The extent to which the company considers evolving legal and regulatory requirements, as well as shifting demands in the marketplace and changes in technology, when identifying and assessing its climate-related risks.
If a company relied upon insurance to help manage and mitigate its exposure to climate-related risks, the company would be required to disclose its reliance on insurance products if, for example, the loss of that insurance would have a material impact on the company.
If a company has adopted or implemented a transition plan aimed at reducing its climate-related risks, the Proposed Rule would also require the company to describe its transition plan, including the metrics and targets used to identify, manage and mitigate physical and transitional climate-related risks. When describing its transition plan, a company would need to include a discussion of how it will address or mitigate specific transition risks including, but not limited to:
- Laws or regulations that restrict GHG emissions or products with significant GHG footprints or impose land or natural resource conservation.
- The imposition of a carbon price.
- Shifting and changing demands among the company’s relevant stakeholders (such as customers, investors, employees and business partners).
The Proposed Rule indicates that different companies will face different physical and transition risks, and that the required disclosures must be relevant, specific and meaningful, so that investors can better understand and evaluate how a company will address, mitigate and adapt to its specifically identified climate-related risks. A company’s transition plan disclosures would require updates on an annual basis. The updates would include descriptions of a company’s actions taken during the prior year to achieve the company’s targets and goals.
GHG Emission Metrics Disclosures
The Proposed Rule establishes requirements for the measurement and reporting of GHG emissions to promote comparability across companies. GHG emissions encompasses carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), nitrogen trifluoride (NF3), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulfur hexafluoride (SF6). These gases would be expressed in terms of metric tons of carbon dioxide equivalent (CO2e).
All companies, regardless of size, would be required to report their Scope 1 and Scope 2 emissions. Larger companies would be required to disclose Scope 3 emissions only if they are material to the company or if the company has set a target to reduced emissions that includes Scope 3 emissions. SRCs would be exempt from the requirement to report Scope 3 emissions.
The Proposed Rule would require the disclosure of GHG emissions data for a company’s most recently completed fiscal year and for the historical fiscal years included in a company’s consolidated financial statements as set forth in the applicable filing, provided that such emissions data is reasonably available. According to the SEC, this information would enable investors to track emissions data over time and assess a company’s management of climate-related risks.
Scope 3 Materiality Assessment
Under the Proposed Rules, several factors would be used to assess the materiality of Scope 3 emissions. Materiality factors would include whether a company’s emissions make up a significant percentage of its overall GHG emissions (e.g., greater than 40%), the total mix of information available to investors including qualitative factors, and the probability and magnitude of potential and unrealized transition risks.Determining whether Scope 3 emissions are material will be a fact-specific inquiry and will likely present challenges for some companies because it will involve collecting information from third-party sources. Given the comments of SEC Chair Gensler, many observers anticipate that the final rule will have changes to the Proposed Rule’s requirements regarding Scope 3 emissions.
To balance concerns about reporting Scope 3 emissions, the Proposed Rule included the following accommodations for Scope 3 emissions disclosure:
- An exemption for SRCs from the Scope 3 emissions disclosure provision.
- A delayed compliance date for Scope 3 emissions disclosure. All companies, regardless of their size, would have an additional year to comply initially with the Scope 3 disclosure requirement beyond the compliance dates set out in the Proposed Rule.
- A safe harbor for Scope 3 emissions disclosure from certain forms of liability under the federal securities laws.
The safe harbor would be a limitation on the liability that would deem Scope 3 emission disclosures not fraudulent unless such disclosures were made or reaffirmed without a reasonable basis or disclosed other than in good faith. The safe harbor would extend to any statement regarding Scope 3 emissions disclosed pursuant to the Proposed Rule or made in documents filed with the SEC. The Scope 3 safe harbor is intended to address concerns of reliance on Scope 3 emissions data that would be derived largely from third parties in a company’s value chain.
Disclosure of Climate Related Opportunities, Targets and Goals
While much of the Proposed Rule is focused on the disclosure of climate-related risks, the Proposed Rule also includes voluntary disclosures related to climate-related opportunities. Climate-related opportunities would be defined as 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. Examples of climate-related opportunities would 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. Under the Proposed Rule disclosure of climate-related opportunities is voluntary in order to avoid requiring companies to divulge competitive business information.
Conclusion
Regardless of whether the SEC adopts the Proposed Rule as drafted or a modified version of the Proposed Rule, all publicly traded companies should be focused on how they plan to satisfy these complex disclosure requirements. For companies that are not publicly traded, it’s important to keep in mind that many stakeholders, including private lenders and investors, will use these requirements of the Final Rule as a proxy when making investment and other decisions. All companies should be considering how to incorporate the requirements from the Final Rule into their overall business and operational strategies.
Stay tuned for the SEC’s announcement on the Proposed Rule. If you have questions regarding the Proposed Rule, please do not hesitate to contact us.
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