The Securities and Exchange Commission (SEC) just published its anticipated climate-related disclosure rule. Publicly traded companies must now shift from mostly voluntary to mandatory disclosures. They will also have to provide information on how they calculate, assess and manage climate-related risks that, in many instances, go well beyond any prior disclosures.
The SEC repeatedly emphasized its aim of "consistent, comparable and reliable disclosures" so that investors can make informed judgments about how climate-related risks impact investments. The proposed rule is largely modeled on the existing reporting framework of the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol.
This alert is not meant to summarize the entire proposed rule, the highlights of which are covered in the SEC's Fact Sheet. Our focus is on the SEC's decision to—in certain instances—require disclosure of Scope 3 emissions. These are the most far-reaching and difficult to ascertain. Scope 1 emissions are direct greenhouse gas (GHG) emissions from operations a company owns or controls. Scope 2 covers indirect GHG emissions from the generation of purchased electricity, steam, heat or cooling that is consumed by company operations. The proposed rule defines Scope 3 as "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." "Value chain" is defined as the "upstream and downstream activities related to a registrant's operations."
The SEC's listed examples of upstream activities include a registrant's purchased goods and services, capital goods, waste generated from operations, as well as employee business travel and commuting. Examples of downstream activities include transportation and distribution of a registrant's sold products, a third party's use and end-of-life treatment of those products, and a registrant's investments. Because Scope 3 emissions are so wide-ranging, difficult to calculate, and will often involve gathering data from third parties up and down the value chain, their inclusion in the proposed rule will leave many companies facing a significant undertaking. As the SEC stated, "...the task of calculating Scope 3 emissions could be challenging." Private companies that are in a public company's supply chain may feel the pinch when they are in turn asked to provide emission data.
The proposed rule would require disclosing Scope 3 emissions if material or if the registrant set a GHD reduction target or goal that includes Scope 3 emissions. In addition to the usual materiality standard of whether there is a substantial likelihood a reasonable investor would consider a matter important, "registrants should consider whether Scope 3 emissions make up a relatively significant portion of their overall GHG emissions."
No quantitative threshold was proposed, although the SEC noted that some companies use a 40% quantitative materiality threshold for Scope 3 emissions. Looking at materiality strictly through a quantitative lens isn't enough. The determination "would ultimately need to take into account the total mix of information available to investors, including an assessment of qualitative factors." For companies that set GHG emission reduction targets, the SEC asserted that disclosures would allow investors to better understand how feasible it is for a company to meet those targets and what it will take to do so. Specific disclosure requirements include:
- For required Scope 3 disclosures:
- Disclosing the emissions both separately by each constituent GHG and in the aggregate, excluding the impact of offsets
- Identifying the categories of upstream or downstream activities included in the calculation
- Describing the data sources used to calculate Scope 3 emissions, including the use of emissions reported by parties in the value chain, whether such reports are verified and if so, by whom
- When Scope 3 emissions are disclosed, separately disclosing GHG intensity (metric tons per unit of total revenue and per unit of production for the fiscal year) using Scope 3 emissions only
- In addition to using reasonable estimates, a registrant may present its estimated Scope 3 emissions in a range if it discloses the reasons for using the range and the underlying assumptions
The proposed rule does offer certain "accommodations" related to Scope 3 emission disclosures. Notably, the SEC proposed an exemption from Scope 3 disclosures for "smaller reporting companies" or "SRCs." The proposed rule incorporates existing regulations that define an SRC as "an issuer that is not an investment company, an asset-backed issuer, or a majority-owned subsidiary of a parent that is not a smaller reporting company" and that meets one of these standards:
- Had a public float of less than $250 million
- Had annual revenues of less than $100 million and either no public float or a public float of less than $700 million
This proposal would likely exempt a large number of companies from Scope 3 reporting, since the SEC estimates that approximately 50% of filers are SRCs.
The SEC also included a safe harbor for Scope 3 emission disclosures. Statements regarding these disclosures in SEC filings are deemed not to be fraudulent statements unless it is shown that the statements were made or reaffirmed without a reasonable basis or were disclosed other than in good faith. The safe harbor provides some form of protection, but also room to challenge what constitutes "a reasonable basis."
Additionally, the SEC noted that existing rules that "provide accommodations for information that is unknown and not reasonably available, would be available for the proposed Scope 3 disclosures." But it also stated that it expects registrants that require emissions data from other registrants in the value chain to be able to obtain the data without unreasonable effort or expense because of post-rule increased availability of Scope 1 and 2 data.
Interested companies can submit public comments through at least May 20. The SEC's over 200 requests for comments included several on the nature and extent of the Scope 3 disclosure requirements. Importantly, the SEC suggested that one reasonable alternative may be to exempt SRCs from the entirety of the proposed rule. The SEC acknowledged that the "main benefit of this alternative is that it would avoid imposing potentially significant compliance costs on smaller registrants, which are more likely to be resource-constrained." However, it concluded that "this alternative would also considerably undermine one of the primary objectives of the proposed rules, which is to achieve consistent, comparable, and reliable disclosures of climate-related information."
If the rule is adopted, it would take effect no earlier than fiscal year 2023. It would apply to SEC filings in 2024, assuming the rule is adopted with a December 2022 effective date. The SEC's Fact Sheet includes a table with phase-in periods. Scope 3 requirements would take effect no earlier than fiscal year 2024 and apply to 2025 filings. A combination of extensive public comments and potential litigation challenging whether the rule exceeds the SEC's authority could considerably delay implementation. One commissioner's published dissent addresses potential regulatory overreach and understated implementation costs.
There is a long way to go before a final rule is in place, but the reach of the Scope 3 disclosures is one key reason to begin planning. Private and smaller companies should pay close attention and can expect to receive increased demands for emissions data from public company partners, with increased emphasis on the reliability of that data.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
