United States: Assessing SEC Disclosure Requirements after Kyoto

Gregory A Bibler and Nathan J. Brodeur

On February 16, 2005, the Kyoto Protocol for reducing greenhouse gas (GHG) emissions took effect, obligating 37 industrialized countries, including Canada and all of the European Union (EU), to cut carbon dioxide (CO2) and other emissions by a combined 5.2% from 1990 emission levels by 2012. To implement Kyoto, EU and other industrialized countries are establishing national plans allocating CO2 emissions among private companies, which allocations then may be sold or bought in the new EU Greenhouse Gas Emissions Trading Scheme, the first international trading system for CO2 emissions.

The United States is not a signatory to the Kyoto Protocol, and although several bills that would regulate GHG emissions at the federal level have been proposed, none have been adopted. In the absence of national consensus, individual states have adopted their own legislation to limit GHG emissions, and regional coalitions of states have formed to establish their own allocation and trading systems.

The advent of mandatory controls on GHG emissions under Kyoto – and the gathering momentum toward such controls on the state, regional, and national levels here in the United States – pose an increasingly real threat of change. GHG controls may change how and where companies operate, what products they produce, and what they pay for fuel and raw materials. Moreover, the emergence of trading systems is creating currencies in CO2 emissions, based on which the impacts of GHG controls may be quantified.

For public companies, the uncertain but potentially substantial impacts of GHG controls on their future operations raise difficult questions concerning their SEC reporting obligations and their internal systems for identifying and quantifying environmental risks. These questions are particularly acute in the post-Sarbanes- Oxley era. The requirement that CEOs and CFOs certify to the contents of their companies’ reports and to the adequacy of the internal systems that produced them has made judgments concerning quantification and disclosure of environmental costs and loss contingencies more personal. The more recent requirement that auditors review and certify to the adequacy of a company’s internal controls also has put increased emphasis on identifying, analyzing, and documenting the financial impacts of environmental compliance and loss contingencies.

Moreover, environmental groups and institutional investors are using both Sarbanes- Oxley and the Kyoto Protocol as leverage to demand new transparency in GHG emissions reporting. They are pushing U.S. companies to evaluate and disclose the potential impacts of GHG controls on their operations, and to take the costs and opportunities arising, for example, from emerging markets in CO2 emissions into account in their long range strategic planning. Although they frequently recite SEC reporting requirements as a basis for demanding more analysis of climate change related risks, these environmentalist and shareholder initiatives typically seek information that is well beyond the borders of those requirements.

This article explores whether, and under what circumstances, public companies may be required or otherwise may choose to include disclosures concerning the potential impacts of climate change on their operations in their SEC reports. It first provides an overview of existing and emerging GHG controls, as well as shareholder initiatives demanding assessment and disclosure concerning the potential effects of GHG controls and climate change on public companies’ operations. It then summarizes the primary SEC reporting requirements that determine whether the potential impacts of GHG controls that have been adopted, and climate change related impacts on operations that are known, should be disclosed. Based on a published survey of SEC filings by public companies for 2003, it also illustrates how companies are addressing climate change in their annual reports – even if they have determined that the impacts on their operations may be speculative or immaterial.

On November 18, 2004, Russia ratified the Kyoto Protocol, triggering a 90-day countdown to the treaty’s entry into force. The treaty went into effect on February 16, 2005, without the United States, which withdrew from treaty negotiations in March 2001. Therefore, U.S. businesses with operations in countries that are signatories to the treaty, particularly in Canada and the EU, face the most immediate prospects for impacts on their operations.

The Kyoto Protocol is only one step in a progression toward global regulation of GHG emissions. The EU’s emissions trading scheme, which covers facilities in the energy, iron and steel, mineral, and pulp, paper and board industries, became effective in January 2005. It has been estimated that the program will cover approximately 46% of the EU’s CO2 emissions and lead to a market of carbon assets and liabilities worth billions of euros. The United Kingdom, which already has a voluntary trading program, is working to coordinate its program with the EU’s initiative.

Domestically, while efforts to pass federal legislation regulating GHG emissions have stalled in Congress, states and municipalities have moved forward with their own policies and programs for reducing GHG emissions, primarily by targeting power generating facilities. For example, in 2001, Massachusetts issued a rule capping total CO2 emissions from the six highest-emitting power plants in the state. Wisconsin, Oregon, and New Hampshire have adopted analogous rules requiring reductions or offsets of CO2 emissions from power plants. Similarly, under the auspices of the Regional Greenhouse Gas Initiative (RGGI), 11 northeastern states are working to establish a mandatory, market-based cap and trade program for CO2 emissions from fossil-fuel fired power plants.

While many of these domestic initiatives have focused on the energy industry, GHG emissions also are being targeted in other sectors, extending to industries that consume fossil fuels or produce products that do. For example, in July 2002, California enacted legislation restricting motor vehicle emissions of CO2 and other GHGs. The legislation requires the California Air Resources Board to adopt regulations by 2005 to achieve maximum feasible reductions in GHG emissions by passenger cars and light trucks. Despite ongoing litigation challenging California’s proposed standards, Governor Pataki has indicated that New York also plans to adopt them.

Coupled with government efforts to address GHG emissions is an increase in shareholder initiatives demanding that public companies disclose the potential impacts of GHG controls and climate change, and their strategies for addressing those impacts. A record number of GHG-related shareholder resolutions have been filed for the 2005 proxy season. Institutional investors collectively representing over $250 billion in assets – including state and municipal pension funds, labor unions, religious organizations, and private foundations – have filed at least 31 such resolutions this year. The targets of these resolutions include oil and gas companies, electric power producers, real estate firms, insurance companies, automakers, and other manufacturers. The 31 resolutions surpass the 22 global warming resolutions filed last year, although seven additional resolutions were withdrawn by filers last year after companies agreed to undertake climate change risk assessments. American Electric Power, Cinergy, and Southern were among those companies that agreed to prepare such assessments.

Many of the shareholder resolutions filed for 2005 seek greater disclosure on how companies are responding to and preparing for rising regulatory and competitive pressures to reduce GHG emissions. For example, ExxonMobil, which generates significant revenues in Kyoto-participating countries, has received resolutions that focus specifically on how the company plans to meet Kyoto GHG reduction targets. Ford and General Motors have been asked to report on how they plan to remain competitive given the growing regulatory push to reduce GHG emissions from motor vehicles.

Institutional investors and environmental groups also are pooling their resources essentially to pursue political reform through financial reporting initiatives. On February 14, 2005, the California Public Employees’ Retirement System (CALPERS) approved a shareholder initiative designed to force companies to consider economic risks related to global warming. CALPERS, the nation’s largest public pension fund with assets of more than $182 billion, intends to use its status as a major shareholder to encourage companies to sign on to the Global Carbon Disclosure Project, an international effort aimed at revealing the business risks associated with climate change and rising levels of GHG emissions. Similarly, the Investors’ Network on Climate Risk, a group launched by 10 institutional investors in 2003, has called for the SEC to ensure that companies properly disclose climate change related risks in their SEC filings.

In light of the rapidly changing landscape of GHG emissions regulation, and in response to investor demand, U.S. corporations have begun to wrestle with whether, and under what circumstances, climate change related risks must or, in any event, should be disclosed in their SEC reports. Given the increased scrutiny of financial reporting systems as a result of Sarbanes-Oxley, decisions regarding disclosure of climate change related risks also have taken on greater urgency.

Public companies are subject to myriad SEC and accounting rules which arguably may apply to the identification, estimation, documentation, and disclosure of environmental costs and loss contingencies, including costs of complying with GHG controls and the overall effect of such controls on a company’s financial condition and operations. This advisory focuses on two principal requirements.

The first, Item 101 of Regulation S-K, 17 C.F.R. § 229.101, requires a company to disclose material effects of compliance with environmental laws. The second, Item 303 of Regulation S-K, 17 C.F.R. § 229.303, concerning Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A), contains a general requirement to disclose "any known trends, demands, commitments, events or uncertainties" that are reasonably likely to have a material effect on a company’s operations.

Whether a company is required to make any disclosure at all concerning environmental costs or loss contingencies under Item 101 or Item 303 turns on whether they are considered "material." Generally, an item is material if there is a substantial likelihood that its disclosure would be viewed by a "reasonable investor" as having significantly altered the "total mix" of information based on which he or she determines whether to invest. See TSC Industries Inc. v. Northway, Inc., 426 U.S. 438, 448 (1976).

In the environmental context, what constitutes information material to a reasonable investor has long been subject to debate. To date, the SEC has rejected attempts to import subjective judgments concerning the inherent value of undegraded or nonrenewable natural resources into the financial concept of "materiality." Nonetheless, the SEC also has made clear that there is no bright-line financial test for what is material, and environmentalists continue to push for greater recognition in the equation establishing materiality – both in who is a reasonable investor and in what information should be considered significant in the total mix of information.

Inherent in the question of whether a prospective environmental cost or loss contingency will have sufficient impact on a company’s operations or financial condition to be material are the further questions of whether and when it is likely to happen at all. Given the nascent state of GHG regulation, and depending on the geographic and industrial sector of a given company’s operations, the risks associated with such regulation may not arise, assuming they do, for a number of years. Likewise, although there is emerging consensus that climate change is real, no one pretends to be able to predict exactly what new weather patterns will emerge when and where. As a result, even though Kyoto is in effect in the EU, Canada, and many other industrialized nations, companies still may not have sufficient information now to determine what emissions allocations and controls ultimately may be adopted, how the climate may change, or how these future developments may affect their operations.

As explained below, Item 101 and Item 303 extend both to the effects of presently existing regulations and to the expected impacts of presently known trends and uncertainties. This further complicates the determination, for example, as to whether a potential compliance cost is substantial enough to be material and therefore to be disclosed. Whether GHG regulations that have already been enacted or adopted are material and therefore should be disclosed under Item 101 may be a much easier question than whether proposed or emerging controls on GHG emissions constitute a known trend or uncertainty that is material and therefore should be disclosed under Item 303.

Under Item 101, disclosure shall be made "as to the material effects that compliance with [environmental laws] which have been enacted or adopted … may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries." (emphasis supplied). Item 101’s focus therefore is on the impact of existing regulations on a company’s operations.

Now that the Kyoto Protocol has become effective, many companies with operations in Canada, the EU, and other industrialized countries that signed the Protocol will be subject to mandatory GHG emissions controls as part of those countries’ national allocation plans. In the United States, states and regions continue to adopt and implement laws and regulations allocating GHG emissions or dictating standards for products to reduce GHG emissions. As these new regulations are adopted, they may give rise to disclosure obligations under Item 101. Already, power producers are disclosing that carbon dioxide reductions may affect their operations in Massachusetts, for example, and auto manufacturers are reporting that, if not overturned in the federal courts, California’s new emissions standards may affect the designs, available options, or models for the vehicles they produce.

In sum, for purposes of complying with Item 101, companies in industry sectors that may be targeted for GHG controls need to track emerging GHG controls, evaluate whether compliance with new requirements may require capital expenditures or entail other impacts that will be material to the company’s operations or financial condition, and be prepared to disclose any such material effects in their SEC filings.

The overall intent of an MD&A disclosure is to allow investors to see the company’s operations and financial condition through the eyes of its internal management. Item 303 looks beyond the specific effects of existing regulatory requirements to events and uncertainties that are known to management and are expected to be material but may not yet be reflected in current financial statements. Specifically, Item 303 calls for a description of "any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."

Increasingly, the SEC has targeted MD&A disclosures under Item 303 for review and comment. In December 2001, the SEC announced that it would monitor the annual reports filed by all Fortune 500 companies in 2002 as part of its process of reviewing financial and non-financial disclosures of public companies. Following that review, comment letters were sent to more than 350 of the Fortune 500 companies, asking those companies to amend their current filings or to incorporate SEC comments into future filings. The SEC issued more comments on the MD&A disclosures than on any other topic, and specifically sought increased disclosure regarding the existence of known trends, uncertainties or other factors affecting company operations. Since 2002, letters from the SEC requesting more particularized disclosures in the MD&A discussion regarding environmental costs and loss contingencies have become increasingly common.

According to SEC instructions for Item 303, "[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition." Although this disclosure requirement necessitates an examination of future events, the focus is on "presently known data" (emphasis added) which must be disclosed to warn investors that material changes not reflected in the currently reported financial information are expected to affect the company’s financial operating results and condition. The SEC distinguishes such mandatory disclosures from "forward-looking information," the disclosure of which is optional and is expressly covered by the safe harbor rule for future projections. Notably, the SEC’s instructions for Item 303 specifically state that the information a company must provide "need only include that which is available to the registrant without undue effort or expense." (emphasis added).

The SEC has developed a two-part test to aid companies in determining whether MD&A disclosure is required. Management must first determine whether the trend or event is not reasonably likely to occur, in which case, no disclosure is required. If management cannot make that determination, then disclosure is required unless management can determine that, assuming it occurs, such trend or event is not reasonably likely to be material. Under the "reasonably likely" standard, doubts about the likelihood that an event or uncertainty will occur, or will be material, should be resolved in favor of disclosure.

Because regulatory policies and requirements regarding GHG emissions are evolving, for most companies it still is very difficult to determine what controls each country or jurisdiction will impose or when they will be implemented, or the likelihood that such controls will be material to the company’s operations. Even more difficult, and speculative, are determinations concerning the future effects of local weather changes on a company’s operations. The touchstone for any disclosure, of course, is that it must provide information that is sufficiently clear and concrete to be of use to a "reasonable investor." Pure speculation concerning uncertain events that may have unquantifiable impacts in the indefinite future is not of much use to investors.

The probability that controls will be imposed and will be material to a company’s business will depend on multiple factors, including where its operations are conducted, whether it is in one of the industrial sectors to be targeted first for GHG controls, whether its operations rely heavily on products likely to increase in cost due to GHG controls (e.g., fossil fuels, petroleum derivatives, and energy), and the extent to which its own products generate, or may be useful in reducing, GHG emissions. Given the discontinuity that is emerging not only among different regions of the United States but also among nations, the magnitude of the impacts of GHG controls on any company also may depend on whether and to what extent operations or sources of supply for raw materials may be shifted to less regulated jurisdictions.

In a survey that Friends of the Earth (FOE) conducted of SEC filings for fiscal year 2003, it concluded that there was a clear trend toward increased climate change reporting during the first three years of the new millennium. Based on FOE’s methodology, 92% of electric power generating companies surveyed provided climate disclosures, compared, for example, with 26% for the automobile industry and 47% for the integrated oil and gas sector. See FOE, Third Survey of Climate Change Disclosure in SEC Filings of Automobile, Insurance, Oil & Gas, Petrochemical, and Utilities Companies (July 2004).

Given FOE’s declared purpose to "empower[] citizens to have an influential voice in decisions affecting their environment," its goal to reform disclosure rules as a tool for promoting aggressive management of climate risks, and its tendency to grade public companies’ disclosures based on FOE’s political views as to what future carbon constraints are necessary and will be material, both its methodology and its conclusions must be considered skeptically. In its report, however, FOE also provides excerpts directly from 2003 SEC 10-K filings and other annual reports for 113 U.S. and foreign companies that have registered stock for sale in the United States. These excerpts provide a good snapshot of what public companies in the sectors likely to be most directly affected by GHG controls were reporting as of the 2003 reporting cycle – two years before Kyoto became effective.

Generalizations concerning the contents of climate-related disclosures in these companies’ 2003 annual reports are dangerous. Nonetheless, a few clear themes are apparent. First, even within the same industrial sectors, the extent, qualitative and quantitative content, and bottom-line conclusions among different companies’ disclosures vary widely. These variations reflect the geographic disparity in GHG controls and their potential impacts, as well as differing corporate philosophies concerning disclosure of future events and uncertainties.

Second, where companies are disclosing climate-related risks, they are likely to describe Kyoto and other emerging regulatory programs, but unlikely to address climate change itself. That companies are not attempting to forecast the impacts of future weather events is hardly surprising. Even FOE acknowledges that financial risks associated with global warming itself still may be beyond the reporting horizon from a capital markets perspective.

Third, in their 2003 SEC 10-K reports, U.S. companies generally did not attempt to quantify the impacts of GHG controls on their future operations and financial condition. Many stated that the effects were difficult to predict but were expected to be "substantial." Others affirmatively stated that any quantification of future financial impacts would be "speculative."

Fourth, many public companies included information in their MD&A disclosures even if they determined, for example, that the impacts of GHG controls on their future operations and financial condition would not be material, or that any predictions concerning the potential liability or benefit associated with climate change issues would be speculative. Even though not mandated by Item 303, in other words, disclosures were included, often to highlight a company’s voluntary efforts to reduce GHG emissions. BP, for example, concluded that the impacts of GHG controls on its operations were expected to be small, in part because it already "had succeeded in reducing . . . direct, equity share, GHG emissions by 10% and set a target to maintain . . . net emissions at 2001 levels through the next decade."

Similarly, Dow Chemical stated that predicting the outcome of worldwide political debate concerning GHG controls would be pure speculation, but that it "is not waiting for the resolution of the debate":

Dow is committed to reducing its GHG intensity (lbs of GHG per lb of product), developing climate-friendly products and processes, and, over the longer term, implementing technology solutions to achieve even greater climate change improvements. Since 1995, Dow has reduced GHG intensity by 25 percent. Total direct emissions of GHG have also been significantly reduced.

The disclosures exemplified by Dow’s and BP’s reports may be part of a growing trend. As a result of both shareholder pressure and internal strategic planning, and in anticipation that mandatory programs to reduce GHG emissions will exist in the future, public companies are implementing voluntary GHG management plans and disclosing the results – without regard to whether implementation or disclosure are mandated under currently existing law.

Cinergy Corporation is another notable example. Responding to concerns from shareholders, including the Committee on Mission Responsibility Through Investment of the Presbyterian Church USA, in December 2004 Cinergy published its Air Issues Report to Stakeholders analyzing the likely impacts of GHG controls on its business and outlining its own voluntary GHG management program. In its SEC 10-K report for 2004, released two months later, Cinergy again stated its belief that GHG controls would be adopted, and described its comprehensive program to reduce GHG emissions by 5% below its 2000 level.

Both climate change related regulatory requirements and SEC disclosure obligations are evolving rapidly. Public companies should have systems in place now for tracking regulatory developments in those jurisdictions where they operate to determine: (i) what GHG controls are being proposed, and to what extent their direct participation in the political and legal process for formulating such controls may be warranted; (ii) what GHG legislation has been adopted, and how and when it will be implemented; (iii) what the company’s alternatives are for complying with new GHG controls, including changes in operations or equipment, purchase of GHG emissions credits, or investment in environmental or joint development projects in developing countries; and (iv) when sufficient information is available, what the estimated costs and other potential impacts of alternative compliance strategies will be, including, for example, capital investments, changes in operating costs, or transformations that will result for their products or markets for those products.

Public companies likely to be affected by GHG controls also should be mindful that similarly situated companies already are implementing GHG management plans and promoting the results of those plans in their SEC filings. As these initiatives show, whether and how companies disclose and describe the potential impacts of climaterelated risks may be determined, at least in part, by factors beyond the literal requirements of SEC rules.

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