Corporations have long grappled with the question of how to report the potential impact of climate-related risks on their business. Recent years have seen progress and in the reporting frameworks and consolidation of the standards setters promulgating them. The SEC’s recently released proposal on climate-related disclosures marks a watershed moment and may be the harbinger for mandated, uniform reporting in this area for U.S. corporations. The article takes an early look at the SEC’s proposal and contemplates the possible implications for business.
On March 21, 2022, the SEC released its proposal on climate-related disclosures, “The Enhancement and Standardization of Climate-Related Disclosures for Investors–Release Nos. 33-11042, 34-94478.” The proposal would require SEC registrants to provide information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition. It would also require “disclosure of a registrant’s greenhouse gas emissions, which have become a commonly used metric to assess a registrant’s exposure to such risks.” Furthermore, under this proposal “certain climate-related financial metrics would be required in a registrant’s audited financial statements.” This 500-page–long proposal is broad-ranging, and will have political, economic, financial, accounting, auditing, and tax implications. It will have a pronounced impact on companies’ financial reporting with respect to the climate-related risks they face and their efforts in addressing those risks. Consequently, it should provide more consistent, comprehensive, and reliable information for users.
The SEC argues that the existing disclosures of climate-related risks do not adequately protect investors. Companies often provide climate-related reporting outside of mandated SEC filings. The SEC has emphasized the need for updated climate-related guidance to fulfill its statutory authority and responsibility to promulgate disclosure requirements that are “necessary or appropriate in the public interest or for the protection of investors.”
Depending on which side of the political spectrum one stands on climate change, the SEC’s proposal may represent noble intentions, or costly regulatory overreach. In the words of longtime observer of the profession Jack Ciesielski: “This proposal has political divide baked into it right from the start. Republicans hate it because it will raise costs and its genesis seems to have been dictated by a few gargantuan index investors. Democrats call it too weak and whine that it doesn’t go far enough” (Weekly Reader, March 25, 2022).
Setting aside potentially political considerations, there are difficult questions to consider about just how to handle climate-related reporting and disclosure issues. The costs of climate-related risks are significant and growing. In 2021, the United States alone experienced 20 separate billion-dollar climate-related disasters (SEC Proposal, fn. 10, p. 10).
Climate-related risks for businesses are not a new phenomenon. Neither is the accounting profession’s attempt to provide useful information about climate-related risk. The SEC first addressed this topic in 1971 with Release 33-5170 (July 19, 1971), suggesting that registrants consider disclosing the financial impact of compliance with environmental laws, such as the National Environmental Policy Act of 1969, in their SEC filings (SEC Proposal, p. 15). On March 3, 1982, the SEC issued Release 33-6383, which mandate the disclosure of “information relating to litigation and other business costs arising out of compliance with federal, state, and local laws that regulate the discharge of materials into the environment or otherwise relate to the protection of the environment” (SEC Proposal, p. 16). Then, in 2010, the SEC issued Release 33-9106, “Commission Guidance Regarding Disclosure Related to Climate Change,” which provided guidance to public companies regarding disclosure requirements. Notwithstanding the current proposal, today all registrants are required to follow the guidance in Release 33-9106.
In 2021, the Financial Stability Oversight Council also issued “A Report on Climate-Related Financial Risk” and argued that climate change is an emerging threat to the financial stability of the United States (the council comprised representatives from major federal financial regulators, such as the Federal Reserve, SEC, FDIC, Office of the Comptroller of the Currency, as well as nonvoting members from state regulators). The report made a set of recommendations to build capacity and expand efforts to address climate-related financial risks. Furthermore, some banking and insurance providers have incorporated climate-related risk as part of their evaluation of potential borrowers and policyholders.
Environmentally conscious investors have long been vocal about the impact of corporate policy on the environment, demanding more disclosure about climate-related risk. This demand has since expanded; many investors consider these disclosures necessary to adequately assess climate-related risk. Like-minded investors have established various alliances and encouraged companies to provide better information about the impact of climate-related risks. Among these initiatives are the 2019 and 2021 “Global Investor Statements to Governments on Climate Change,” the U.N. Principles for Responsible Investment, The Climate Action 100+, and the Glasgow Financial Alliance for Net Zero (SEC Proposal, pp. 24–26). More generally, it is worth remembering the 2015 Paris Climate Agreement, which lays out a comprehensive set of climate-related measures to be taken by its 191 signatory countries.
Environmentally conscious investors have long been vocal about the impact of corporate policy on the environment, demanding more disclosure about climate-related risk.
The SEC’s proposal is based on its experience dealing with this topic over the last 50 years, and is designed to augment current disclosure requirements (under Release 33-9106). The advantage of the SEC’s proposal over existing disclosure requirements is improved consistency with respect to the content and location of information. According to the proposal, in the absence of well-established disclosure requirements, companies currently disclose climate-related risks in different formats, levels of detail, and locations, such as in their SEC filings and sustainability reports posted on their websites. The inclusion of climate-related information in SEC filings would make it more consistent, comparable, reliable, and easier for users to find. Furthermore, because the information filed with the SEC is subject to disclosure controls and procedures, it would enhance its accuracy, reliability, and thoroughness (SEC Proposal, p. 8).
According to the SEC, the impetus for the development of the proposed disclosure rule are the framework developed by the Task Force on Climate-Related Financial Disclosure (TCFD), created by the Financial Stability Board and supported by more than 2,600 organizations globally, and the Greenhouse Gas (GHG) protocol, created by a partnership between the World Resources Institute and the World Business Council for Sustainable Development. The SEC acknowledges that the proposed disclosure rule is modeled in part on the TCFD’s framework, which has been widely accepted by market participants around the world. The TCFD framework consists of 11 disclosure topics related to assessment, management, and disclosure of climate-related financial risks. These disclosures cover four areas: governance, strategy, risk management, and metrics/targets. The GHG protocol introduced the concept of “scopes” of emissions to differentiate between emissions that are directly and indirectly related to the reporting entity’s operations and activities (SEC Proposal, pp. 34–40).
Under the SEC proposal:
- Scope 1 emissions are direct GHG emissions from operations that are owned or controlled by a registrant.
- Scope 2 emissions are indirect GHG emissions from the generation of purchased or acquired electricity, steam, heat, or cooling that is consumed by operations owned or controlled by a registrant.
- Scope 3 emissions are all indirect GHG emissions not otherwise included in a registrant’s Scope 2 emissions, which occur in the upstream and downstream activities of a registrant’s value chain.
Summary of the Proposed Rules
The SEC proposal has two main parts. It would add the following:
- A new subpart to Regulation S-K, 17 CFR 229.1500–1507 (Subpart 1500 of Regulation S-K) that would require a registrant 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, and GHG emissions metrics that could help investors assess those risks. A registrant may also include disclosure about its climate-related opportunities. The proposed new subpart to Regulation S-K would include an attestation requirement for accelerated filers and large accelerated filers regarding certain proposed GHG emissions metrics disclosures.
- A new article to Regulation S-X, 17 CFR 210.14-01–02 (Article 14 of Regulation S-X) that would require certain climate-related financial statement metrics and related disclosure to be included in a note to a registrant’s audited financial statements. The proposed financial statement metrics would consist of disaggregated climate-related impacts on existing financial statement line items. 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). (SEC Proposal, pp. 40–41)
These proposed rules will undoubtedly be significant, costly, complicated, and controversial. In a brief, three-month comment period, the SEC has received more than 10,000 comments. Many comment letters have agreed with the proposal, but several members of Congress and other individuals have expressed their concern or opposition. Undoubtedly, the final version of the SEC’s disclosure requirements will reflect changes in response to the comments they have received from both critics and supporters.
Costs and benefits.
Many market participants indicate that they see benefits in having access to climate-related information as part of their investment decisions. Theoretically, there may be two separate types of benefits derived from the required disclosures: 1) the direct intended benefits that led the SEC to release its proposal; 2) the unintended and indirect benefits derived from possible changes in companies’ climate-related behavior. Regarding the first, the SEC argues that the proposed disclosure rule focuses on consistency, comparability, and reliability of climate-related disclosures, and should improve the usefulness of the existing disclosure scheme. In 2020, the SEC’s Investor Advisory Committee (IAC) noted inconsistencies and fragmentation in climate-related disclosures and recommended that the Commission take steps to improve the reporting and disclosure requirements. In 2020, the International Financial Reporting Standards (IFRS) Foundation, similarly questioning the quality of the existing sustainability reporting framework, established the International Sustainability Standards Board (ISSB). The ISSB is charged with developing climate-related disclosure standards based on the recommendations and the framework developed by TCFD. The benefits derived from such information may not be easy to quantify, but surveys of institutional investors reveal that they consider climate risk to be one of the most important issues driving their investment decisions (SEC Proposal, p. 336). The wide array of environmental and social factors—COVID-19, supply chain disruptions, climate-related disasters, human resources shortages, and political disruptions—has shown how vulnerable businesses are. Some argue that businesses need to be proactive to deal with these risks and disclose the related costs.
Although the SEC proposal is not explicitly intended to change corporate behavior, it may provide incentives for companies to be more mindful of their climate footprint.
A recent survey of 300 finance, accounting, sustainability, and legal executives at public companies with over $500 million in revenues by Deloitte revealed that more than two-thirds currently do not have an environmental, social, and governance (ESG) council or working group (Deloitte, “Heads Up,” vol. 29, no. 2, March 21, 2022).
A shift in companies’ behavior in dealing with climate change is particularly dear to environmentally conscious stakeholders. Although the SEC proposal is not explicitly intended to change corporate behavior, it may provide incentives for companies to be more mindful of their climate footprint. When forced to acknowledge the nature and the costs of their climate-related risks more accurately and clearly, companies may find it necessary to become more proactive. A shift in companies’ behavior with respect to climate change is the ultimate benefit many corporate social responsibility (CSR) advocates are looking for.
The disclosures envisioned by the SEC’s proposal are neither costless nor simple. As outlined below, it requires specific—and possibly uncertain—information that might be subjective and costly to produce. The proposal discusses direct and indirect costs, including the paperwork burden of the proposed rules. The primary direct costs are associated with compliance, which may require the re-allocation of registrants’ existing resources, hiring of additional staff, or use of third-party services to collect the required information. The indirect costs may include additional litigation risk or the disclosure of proprietary information, making them difficult to compare.
Content of the Proposed Disclosures
The SEC proposal would specifically require registrants to disclose information about the following:
- The oversight and governance of climate-related risks by the registrant’s board and management;
- How any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short, medium, or long term;
- How any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook;
- The registrant’s processes for identifying, assessing, and managing climate-related risks and whether any such processes are integrated into the registrant’s overall risk management system or processes;
- The impact of climate-related events (severe weather events and other natural conditions as well as physical risks identified by the registrant) and transition activities (including transition risks identified by the registrant) on the line items of a registrant’s consolidated financial statements and related expenditures, and disclosure of financial estimates and assumptions impacted by such climate-related events and transition activities.
- Scopes 1 and 2 GHG emissions metrics, separately disclosed, expressed:
- Both by disaggregated constituent greenhouse gases and in the aggregate,
- In absolute and intensity terms;
- Scope 3 GHG emissions and intensity, if material, or if the registrant has set a GHG emissions reduction target or goal that includes its Scope 3 emissions; and
- The registrant’s climate-related targets or goals, and transition plan, if any (SEC Proposal, pp. 41–43).
As proposed, the disclosure requirements will have a specified location in a registrant’s reporting documents, making it easier for users to find the information they need.
These are demanding disclosures. The current requirements under Release 33-9106 follow a principle-based approach, while this proposal, in its current language, is more rule-based. Some disclosures are financial statement-related, some deal with GHG emissions from the registrants’ operations, and others are more qualitative, such as those dealing with the processes and assumptions utilized in identifying, assessing, and managing climate-related risks. Again, the SEC argues that some registrants are already collecting and reporting some of this information. The SEC proposal would simply change how and where the information is presented.
Presentation of the Proposed Disclosures
Registrants (both domestic and foreign private issuers) are required:
- To provide the climate-related disclosure in its registration statements and Exchange Act annual reports;
- To provide the Regulation S-K mandated climate-related disclosure in a separate, appropriately captioned section of its registration statement or annual report, or alternatively to incorporate that information in the separate, appropriately captioned section by reference from another section, such as risk factors, description of business, or management’s discussion and analysis (MD&A);
- To provide the Regulation S-X–mandated climate-related financial statement metrics and related disclosure in a note to the registrant’s audited financial statements;
- To electronically tag both narrative and quantitative climate-related disclosures in Inline XBRL;
- To file rather than furnish the climate-related disclosure (SEC Proposal, pp. 43–44).
In the SEC’s view, the guidance above will add value in terms of consistency, comparability, and reliability concerning climate-related risk for the investment community. As proposed, the disclosure requirements will have a specified location in a registrant’s reporting documents, making it easier for users to find the information they need. The location of the climate-related disclosure has been a point of disagreement among those who have submitted comments to the SEC.
The proposal applies to both the Securities Act of 1933 and the Securities Exchange Act of 1934 by adding Article 14 to Regulation S-X, and subpart 1500 to Regulation S-K, and amending Forms S-1, S-11, S-4, F-4, 10-F, 20-F, 6-K, 10-Q, and 10-K.
Timing and Attestation
If this proposal becomes effective in December 2022, the compliance dates for the proposed disclosures in annual reports would be as follows:
- For large accelerated filers, fiscal year 2023;
- For accelerated and non-accelerated filers, fiscal year 2024; and
- For smaller reporting companies (SRCs), fiscal year 2025.
Registrants subject to the proposed Scope 3 disclosure requirements would have one additional year to comply with those disclosure requirements. SRCs are exempt from the Scope 3 emissions disclosure requirement.
Accelerated filers and large accelerated filers, including foreign private issuers, will have to provide attestation reports that will cover only Scope 1 and Scope 2 emissions. Under the proposal, however, they will have one fiscal year to transition to “limited assurance,” and two additional fiscal years to provide “reasonable assurance.” Large accelerated filers would need to provide limited assurance starting in fiscal 2024 and reasonable assurance for fiscal 2026. Accelerated filers would need to do so one year later. Nonaccelerated filers are exempt from providing an attestation report, but can do so voluntarily.
An attestation requirement is one factor distinguishing this proposal from the current rules. Attestation will add consistency and reliability, which many argue are lacking currently. The attestation process will be costly and complicated, however. To attest to the Scope 1 and 2 emissions disclosures, “a GHG emissions attestation provider would need to include in its evaluation relevant contextual information. In particular, the attestation provider would be required to evaluate the registrant’s compliance with the following:
(i) proposed Item 1504(a), which includes presentation requirements (e.g., disaggregation by each constituent [GHG]); (ii) the calculation instructions included in proposed Item 1504(b); and (iii) the disclosure requirements in proposed Item 1504[e] regarding methodology, organizational boundary, and operational boundary” (SEC Proposal, fn. 561, p. 215).
Many companies and auditors do not have the necessary background or expertise to comply with the requirements if they were effective today. This is particularly true for those companies that have not been proactive in the past in preparing the information needed to satisfy the disclosure requirements. Preparation in advance of any effective deadlines will be crucial.
If the SEC’s proposed disclosure regime becomes effective, compliance will require substantial preparation. A Deloitte survey found that more than half of participants indicated that data availability and data quality are their greatest challenge with respect to environmental, social, and governance (ESG) disclosures. The vast majority (82%) of their survey participants indicated that they will need additional resources to generate ESG disclosures that meet the information needs of critical stakeholders (Deloitte, “US Public Companies Prepare for Increasing Demand for High Quality ESG Disclosures,” March 14, 2022). Given the costs and the challenges involved in the preparation of climate-related risk disclosures, registrants should start early to establish the necessary processes and mechanisms to collect the needed data.
If and when final guidance is issued by the SEC, registrants and their advisors will need to read the final language to make sure they understand the relevant provisions.
This preparation will be challenging. If and when final guidance is issued by the SEC, registrants and their advisors will need to read the final language to make sure they understand the relevant provisions. Companies will need to take steps in the following five areas to become prepared.
- Recognition. Companies need to review and recognize the extent and nature of their current climate-related risk exposure. They then need to evaluate their readiness to manage those risks.
- Education. Knowledge should then be shared with key employees to educate them about the issue and identify those with relevant expertise. Involvement of top-level executives, including board members, and their appreciation of the issue will be critical. A long-term view is needed, because short-term adverse financial impacts are likely.
- Cooperation. Cooperation among key employees, and between a company and its suppliers and other business partners, is crucial for collecting and reporting the data needed.
- Implementation. Preparing and implementing a comprehensive plan of action to mitigate climate-related risks is a critical step.
- Evaluation. Finally, the outcome of the plan and the effectiveness of the reporting process should be evaluated to ensure its accuracy and completeness.
All companies can benefit from starting early to prepare and disclose climate-related risks. The most obvious benefit will be compliance with the expected SEC disclosure requirements. Another benefit is the goodwill it will generate with investors interested in transparency about climate-related activities and risks. Furthermore, non-SEC registrants will also benefit from having a model to follow in identifying climate-related risks, because they are subject to similar risks and associated costs.