By now, most CPAs are aware that the SEC issued a landmark proposal that would require standardized disclosure of climate-related risks for companies, though they may not be aware of exactly what the proposal requires and when it takes effect. While the ultimate provisions remain uncertain—in large part due to the politically contentious nature of the SEC’s initiative—that does not mean corporate leaders and their financial advisors should sit still. The author outlines a five-step strategy companies can adapt to be prepared for the SEC proposal’s implementation, strengthening internal communications, reporting systems, and accountability in the process.
In March 2022, the SEC issued Release Nos. 33-11042 and 34-94478, collectively entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors” (https://bit.ly/3XYYjp6). This proposal would require registrants to provide information on certain climate-related risks and greenhouse gas (GHG) emissions in their SEC filings. Undoubtedly, climate-related risks disclosures entail many costs and will also prove to be complicated and controversial. They will have accounting, auditing, tax, and governance implications. Companies of all sizes will need to be prepared to comply with the SEC’s final rule and take advantage of opportunities to mitigate their exposure to such risks, reduce associated costs, and generate a positive image with investors. There are many steps companies need to take prior to the proposal’s final effective date. This article will review the provisions of the SEC proposal and provide a five-step strategy that companies can use as a roadmap to prepare for implementation.
Since its release, much has been written about the SEC’s proposal and its provisions (e.g., “An Overview of the SEC’s Proposed Climate-Related Disclosures: The Potential Enhancement and Standardization of Reporting for Investors,” Jalal Soroosh, The CPA Journal, July/August 2022, https://bit.ly/3Q6lVGC). Proponents argue that more consistent and reliable climate-related information is integral to investment decisions. The SEC argues that the existing climate-related information is inconsistent, incomparable, hard to find, and unreliable (SEC proposal, pp. 7–8). To overcome these concerns, the SEC proposes that registrants provide specific information about their climate-related risks, and how such risks impact their business, results of operations, or financial statements. The SEC expects this additional information will provide users with a set of consistent, comparable, and reliable information. Furthermore, because the information will be subject to attestation for accelerated filers, it will add reliability and confidence in the disclosed information. Supporters of the proposal consider this as a step in the right direction, because consistency, comparability, and reliability are considered to be the pillars of financial reporting as established by FASB’s Conceptual Framework.
The SEC’s proposal has political and societal implications—and it is not without its opponents. Opponents cite the cost of the proposal’s provisions, and question the need for such information. They dispute the legality of the process and reject the SEC’s authority to issue such a requirement. Indeed, the proposal has already become a political issue. In addition to private individuals, several members of Congress also have expressed their opposition to the proposal. Whether in its current language, or a modified final version, the SEC is expected to issue the final draft in the near future, after it finishes evaluating and considering the more than 15,000 comment letters it has received so far. Prudent companies will be proactive and start preparing for it as early as possible, particularly those companies that have not voluntarily provided such information in the past and do not have the necessary mechanisms in place to collect the required data.
One cannot overstate the potential implications of the SEC proposal for both financial and nonfinancial information systems. This proposal is broad ranging and includes quantitative disclosures about the impact of climate-related risk on financial statement line items, as well as qualitative disclosures about risks and data collection. There is also a governance disclosure requirement that covers the involvement of board of directors and management in identifying and managing climate-related risks. Consequently, being prepared is not only the responsibility of the finance function; it requires cooperation and participation by many individuals across the company.
A Rational, Methodical Approach
Similar to all project management attempts, the process a company must go through to prepare for the implementation of this proposal can be divided into a number of phases. The five steps described below will enable a company to identify, analyze, and report its climate-related risks and opportunities for mitigating them. The five steps introduced here are: Recognition, Education, Cooperation, Implementation, and Evaluation.
In this five-step strategy, the author identifies actions to be taken, and assigns them to the responsibility centers that can best perform the assigned tasks. For each step, a table summarizing the primary tasks and the appropriate responsibility centers is provided. The process outlined here can form the basis of a checklist for companies to follow. These steps can be modified based on an entity’s climate risk exposure and reporting experience.
There must be someone in charge of making sure that all these steps are followed, and the tasks are accomplished. As the old saying goes, “if everyone is responsible, no one is responsible!” The buck has to stop somewhere; in this case, it is either at the controllership or CFO level. If a company has a sustainability group in place, the leader of that group also is a good candidate to oversee the preparation process for this proposal. This individual needs to be well versed with the disclosure requirements and the extent of climate-related risks to which the company is exposed.
Direct participation of high-level executives and the board of directors adds more urgency to the issue and responds to the governance requirements part of the proposal. At the macro level, the SEC proposal makes the board of directors responsible for the oversight of climate-related risks (SEC Proposal, p. 94). The leader in charge of the implementation process, whether it is the CFO or someone else, will then assemble a team of experts to accomplish the goal of identifying climate-related risks and reporting accordingly.
Step 1: Recognition
The first step, Recognition, is probably the most important, as it sets the stage for the following actions. Step 1 includes the research needed to become familiar with and understand the provisions of the proposal when it is finalized and becomes effective. In this step, a company needs to take inventory of its existing climate-related risk data gathering and reporting processes, as well as the information already provided under other disclosure requirements such as the SEC’s 2010 guidance (“Commission Guidance Regarding Disclosure Related to Climate Change,” Release Nos. 33-9106; 34-61469; FR-82), and match those against what will be needed under the SEC’s 2022 proposal. The companies’ external auditors or other external service providers may be able to help with this process. In many cases, companies may realize that they actually have much of the information they need.
Also, in Step 1, the extent to which a company is exposed to the provisions of the disclosure requirements needs to be established. For example, a company that is only subject to scopes 1 or 2 emissions will have less work to do than a company exposed to scopes 1, 2, and 3. These scopes defined below (SEC Proposal, pp. 34–40):
- ▪ Scope 1 emissions are direct GHG emissions from operations that are owned or controlled by a company.
- ▪ 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 company.
- ▪ Scope 3 emissions are all of the indirect GHG emissions not otherwise included in a registrant’s scope 2 emissions, which occur in the upstream and downstream activities of a company’s value chain.
The SEC acknowledges that “the reporting of scope 3 emissions may present more challenges than the reporting of scopes 1 and 2 emissions” (SEC Proposal, p. 174). In its current language, the SEC proposal does not establish a bright-line quantitative threshold for determining materiality (p. 165). Instead, it suggests that when assessing the materiality of scope 3 emissions, “registrants should consider whether scope 3 emissions make up a relatively significant portion of their overall GHG emissions.” (SEC proposal, page 165)
In Step 1 (Exhibit 1), the in-charge officer should identify individuals in the company who can contribute to this project. The accounting department and the controller/chief accounting officer will be very involved in all five steps, especially in Steps 1, 4, and 5. The experience, education, and expertise of other individuals will also be essential in this process. For example, an individual with environmental engineering education and background can be very helpful in identifying the company’s climate-related risks. Human resources can help identify these individuals. It is also worth mentioning the tax effects: The recent passage of the Inflation Reduction Act includes $369 billion for tax subsidies and other measures designed to encourage a transition to clean energy. Furthermore, companies with international operations and subsidiaries may be subject to other international reporting rules such as those required by the International Accounting Standards Board (IASB) and International Sustainability Standards Board (ISSB).
The IT department is also a main player in this endeavor. Data collection is challenging, especially for companies that have not been reporting any climate-related disclosure, either voluntarily or as part of other disclosure requirements. IT leaders need to become involved in preparation, so that appropriate data is collected and fed to the information systems and its databases.
There is, however, a pitfall here that companies need to be aware of. Individuals have their own notions about climate-related issues that may impact their judgement. For example, a person who believes in climate change and climate-related risks will see those risks differently (possibly more clearly) than a denier of climate-related issues. A careful and honest discussion amongst team members, coupled with education, is crucial. Education and awareness will be discussed in Step 2.
Furthermore, a company may lack the internal expertise to properly identify and analyze its climate risk exposure, especially a company subject to scope 3 emissions. In that case, the company may have to outsource this service, which requires careful evaluation of outside service providers to ensure accurate and reliable data are collected at reasonable costs for reporting purposes. In the future, as more companies find themselves subject to the SEC’s disclosure requirements, or decide to disclose the information voluntarily, demand for these service providers may also increase the cost or decrease the quality of service they provide. These arrangements with outside service providers may also engender third-party risk; for example, the nature of an outside vendor as a service organization versus an external expert may have audit implications to consider. Early shopping for such services can be beneficial in the long run. Companies’ external auditors may be able help with this process.
Step 2: Education
Education is necessary to ensure that appropriate climate-related risk data are collected and reported. This education process could go either top-down or bottom-up. A proactive management team can include climate-related risk management as part of the company’s mission and strategic goals and objectives, and educate employees on implementing it. In other cases, it may be lower-level individuals with the proper knowledge and expertise who can educate top-level management to achieve their buy-ins. In any case, all related parties need to be on the same page when understanding the company’s climate-related risks and develop the mechanisms to report it accurately and completely (see Exhibit 2).
Participation and involvement by top management and the board of directors is also crucial for success. Their participation is also required by the SEC’s proposal, which “would require a registrant to disclose, as applicable, certain information concerning the board’s oversight of climate-related risks, and management’s role in assessing and managing those risks” (SEC Proposal, p. 93). These board members may need education to stay informed and involved with the process. At this stage, the CEO and the board should receive a comprehensive analysis of the impact the SEC’s proposal will have on the company’s operations and finances, including a preliminary budget and cost-benefit analysis coordinated and summarized by the controller/CFO with input from IT.
IT employees may also need education. The finance employees on the team may need to educate the IT group about the specific financial statement line items that will be impacted by climate-related risk disclosure requirements so that proper processes are designed to collect and report the data. In addition, employees of other non-financial units of the company, such as physical plant or facilities, should be educated about climate-related risks in case an inventory of vehicle fleets and usage becomes necessary.
There is another important aspect of the education process: learning about the opportunities available to manage climate-related risks, in order to reduce those costs and make the entity more efficient and innovative. As a starting point, the SEC proposal allows a registrant to disclose management’s role in, and its board’s oversight of, assessing and managing climate-related opportunities (SEC Proposal, pp. 97–100). Companies must educate themselves to identify those opportunities and benefit from them. A company that may have high initial climate-related risks and costs can seize the opportunity to reduce those costs. The SEC proposal identifies the following opportunities:
- The production of products that facilitate the transition to a lower carbon economy, such as low emission modes of transportation and supporting infrastructure.
- The generation or use of renewable power.
- The production or use of low waste, recycled, or environmentally friendly consumer products that require less carbon intensive production methods.
- The setting of conservation goals and targets that would help reduce GHG emissions.
- The provision of services related to any transition to a lower carbon economy. (p. 109)
In the long term, any combination of these steps can significantly reduce a company’s climate-related costs. The sooner these opportunities are identified and imbedded in a company’s mission and strategic plans and operations, the sooner it can benefit from them.
Companies also need to educate themselves about investors’ needs and expectations about climate-related risks and its transparency in disclosing them. Investors are calling for reliable and consistent climate-related information to use in their investment decisions. Companies with lower climate change footprints are more attractive to investors, especially to “green” investors. In addition to reducing climate-related costs, proactive steps taken by companies in reducing their GHG emissions will generate goodwill with such investors.
Step 3: Cooperation
Cooperation refers not only to internal parties, but also external business partners. Broad cooperation is especially essential for companies with scope 3 emission concerns: “These emissions are a consequence of the company’s activities but are generated from sources that are neither owned nor controlled by the company. These might include emissions associated with the production and transportation of goods a registrant purchases from third parties, employee commuting or business travel, and the processing or use of the registrant’s products by third parties” (SEC Proposal, pp. 39–40).
Employees’ activities are part of a company’s climate-related risk. To accurately measure and mitigate these risks and costs, it is necessary to have employees’ cooperation and willingness to change their habits. For example, as part of their sustainability steps, following the Toyota Production System (https://bit.ly/3Dky6b6), Under Armour pursues “continuous improvement to advance sustainability in areas such as worker safety, electricity and water consumption, and material wastage” (https://undrarmr.co/46VaZBv).
In this step of preparation (Exhibit 3), team leaders need to evaluate the level of employees’ cooperation and identify areas of improvement. One option, for example, would be to include this topic as part of the company’s balanced scorecard (if one is in place), or other evaluation scheme—that is, individuals and departments can set goals for reducing their climate-related risks and be evaluated, based on their success in achieving those goals.
A company’s outside business partners also need to cooperate for the company to be able to accurately report its climate-related risks and costs, as well as to take steps to mitigate them. For example, consider the relationship between a lessor and a lessee in dealing with the proposal’s disclosure requirement. The two may need to share information to accurately evaluate their climate-related costs. Or, if the lessee identifies a change in the leased property that may reduce its climate-related risk and its cost in the long run, but requires additional cost up front, is the lessor willing to cooperate? Are upstream and downstream partners willing to cooperate in transitioning to lower GHG emissions, despite initial costs? Under Armour, for example, strives to improve its cooperation with its business partners:
We challenge our factories to invest in cleaner and more efficient operations that create less waste and reduce our environmental footprint. We see this challenge as an industry-wide opportunity to drive scalable change. We invite collaboration among our competitors, with whom we share some of our third-party suppliers, on accelerating the industry’s convergence around a common assessment methodology. This effort streamlines and reduces the assessment burden on our manufacturing partners: less time spent reporting, more time and resources devoted to setting and implementing their sustainability strategy. We’re building closer partnerships with manufacturers who share our vision, and we’ll continue to engage actively with suppliers as we set our goals and targets. (https://undrarmr.co/46VaZBv)
Finally, because these disclosure requirements are subject to attestation for accelerated filers, there is a need to have an understanding and agreement with the external auditor with regard to data collection and reporting. Securing comprehensive cooperation amongst all parties will not happen easily. Controllership/CFO, sustainability group leaders, and other team leaders should start early and develop a communication process to keep internal and external parties informed and involved in order to secure their buy-in. Involvement and support from top-level management is necessary in this process as well.
Step 4: Implementation
In this stage of the process (Exhibit 4), a plan for collecting and reporting all significant relevant information is developed and implemented. The implementation team leaders and officers understand the financial and nonfinancial impact of the proposal, the scope of the effort, the costs, and benefits. In this step, the controllership/CFO may have to do the heavy lifting. The financial and nonfinancial managers and key personnel in all relevant segments of the company are trained. Internal and external auditors are in agreement with the plan of action and have concurred with the accounting conclusions and the impact over financial reporting. Companies with a strong internal audit department may assign it as a responsibility center for this purpose to help with the design and implementation of controls to prepare for attestation of the information. External service providers, if any, are included as part of the plan to provide all relevant information. In this step, the IT team leader plays a crucial role to ensure all appropriate changes to information flows and processes are made and tested. Top management is fully engaged and understands the financial and nonfinancial consequence of the proposal and are willing to try to mitigate the company’s climate-related risks.
Step 5: Evaluation
The fifth and final stage (Exhibit 5), is very much a continuation of Step 4: full implementation of the plan with ongoing testing of quality and accuracy. Enterprise risk management and other strategic processes are adjusted in light of the new disclosure requirements to ensure the accuracy and reliability of the information. In particular, the services rendered by external third parties should be evaluated for quality and cost. External auditors will be key in this step through the attestation function.
By this time, the company should have a good understanding of its climate-related risks and costs. A cost-benefit analysis should be performed to help develop a continuous improvement strategy to identify actions to mitigate risk. Measuring benefits may prove to be challenging, because they are mostly indirect and do not translate into measurable incremental revenues or income, but this step should not be ignored. The obvious benefit is compliance with disclosure requirements, but there are also indirect benefits that should be considered. A transparent and clear disclosure of climate-related risk will establish a favorable impression with investors and the public as a whole. Furthermore, recognizing climate-related opportunities can reduce future costs.
Consider a Forward-Looking Approach
The SEC has not yet specified when its proposal will become effective, but according to press reports, a final rule may be issued in the fall of 2023 (“SEC Delays Climate Change Disclosure Rulemaking,” Soyoung Ho, Thomson Reuters, June 15, 2023, https://tmsnrt.rs/44KgaT0). Early preparation is a key for success. An early start could also reduce stress because, by taking an inventory of the existing processes in place, companies may learn they are better prepared than they anticipated.
The five-step process outlined above, followed by a continuous improvement strategy regarding climate-related risks, can provide a roadmap for companies to meet the SEC’s disclosure requirements and develop a positive image with the public. The implementation of the proposed rules may have a significant financial and nonfinancial impact on companies. But there can be a lot to gain as well.
In addition to meeting SEC requirements, companies need to accept the fact that the public is expecting an honest and transparent report of their climate-related risks: “Going green is the latest corporate trend—but it can be tough to separate the companies that are actually making major environmental commitments from those that are just giving lip service to the cause” (“How to Keep Companies Honest About Fighting Climate Change,” Justin Worland, February 23, 2016, https://bit.ly/3PZhgpQ). Investors favor companies that are transparent about their climate footprint and have a plan to mitigate it: “Companies are increasingly starting to understand that they’re losing their grip on the public relations hit of announcing a climate ambition and then doing nothing about it” (“The Truth Behind Corporate Climate Pledges,” Jocelyn Timperley, Guardian, July 26, 2021 https://bit.ly/3rDJ2y3).
Companies need to develop models to project the tangible and intangible benefits they will receive in the future for any costs incurred in mitigating their climate-related risks today. CEOs and boards of directors will be the driving force in taking advantage of climate-related opportunities.