27 April 2022

The SEC's Climate Disclosure Requirements Are Heating Up

Jackson Walker LLP


Jackson Walker LLP
On April 11, 2022, the Securities and Exchange Commission (SEC) proposed to require public companies to disclose extensive climate-related information in registration statements...
United States Corporate/Commercial Law
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On April 11, 2022, the Securities and Exchange Commission (SEC) proposed to require public companies to disclose extensive climate-related information in registration statements and periodic reports (including Forms 10-K and 10-Q). If finalized as proposed, the requirements would represent a sea change with respect to public company climate-related disclosures. Specifically, public companies would be required to disclose to the public, among other things, information about (a) climate-related risks, (b) material business impacts related to climate-related risks, and (c) the registrant's greenhouse gas emissions.

Historical Context

In 1982, the SEC began mandating disclosure of information on litigation and other business costs arising out of compliance with federal, state, and local environmental laws.

In 2010, in response to increasing calls by the public and shareholders for public companies to disclose information regarding how climate change may affect a business and its operations, the SEC published guidance for registrants on how its existing SEC rules may require disclosure of the climate change impacts on a registrant's business or financial condition.

In recent years, investors and the public's interest in climate change and environmental, social, and governance (ESG) issues has intensified. In early 2022, the SEC indicated an intent to implement a mandatory climate-related disclosure regime, and the newly-proposed rules are a culmination of that effort. In the SEC's view, its new proposed rules augment and supplement the disclosures already required in SEC filings in order to permit investors to make more informed judgments about the impact of climate-related risks on current and potential investments.

Reasons for the Proposal

The subtext for the SEC's proposed rules appears to be

  1. a response to the investing public's growing interest in the impact of climate-related risks on companies' businesses and operations, and
  2. an effort to quash greenwashing.

Many investors are seeking more information about the effects of climate-related risks on businesses and the impact of business operations on the climate to better inform the investors' investment decision-making. Companies have been making commitments with respect to climate change, such as commitments to reduce greenhouse gas emissions or become net zero by a particular date. According to the SEC, "[c]ompanies may make these commitments to attract investors, to appeal to customers that prioritize sustainability, or to reduce their exposure to risks posed by an expected transition to a lower carbon economy," and, in response, "investors have demanded more detailed information about climate-related targets and companies' plans to achieve them in order to assess the credibility of those commitments and compare companies based on those commitments." But according to the SEC, while 90% of S&P 500 companies publish sustainability reports, only 16% include any reference to ESG factors in their SEC filings.

As such, the SEC's proposed rules reflect its concern that "existing disclosures of climate-related risks do not adequately protect investors" and its belief that "[c]onsistent, comparable, and reliable disclosures on the material climate-related risks public companies face would serve both investors and capital markets."

Key Takeaways

We've highlighted key takeaways from the SEC's proposed rules below. These takeaways are not a comprehensive summary of the SEC's proposed rules.

Identification of Climate-Related Risks

The SEC is proposing to require registrants to include a climate-related disclosure in registration statements and annual reports in a separately captioned "Climate-Related Disclosure" section and in the financial statements. Specifically, the proposed rules would require a registrant to disclose any climate-related risks reasonably likely to have a material impact on the registrant's business or consolidated financial statements. In line with existing SEC definitions and Supreme Court precedent, a matter is 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.

The SEC intends for "climate-related risks" to mean the actual or potential negative impacts of climate-related conditions and events on a registrant's consolidated financial statements, business operations, or value chains, as a whole. "Value chain" would mean the upstream and downstream activities related to a registrant's operations.

  • Upstream activities include activities by a party other than the registrant that relate to the initial stages of a registrant's production of a good or service (e.g., materials sourcing, materials processing, and supplier activities).
  • Downstream activities would be defined to include activities by a party other than the registrant that relate to processing materials into a finished product and delivering it or providing a service to the end user (e.g., transportation and distribution, processing of sold products, use of sold products, end of life treatment of sold products, and investments).

The SEC provided the following scenario as an example: Registrants that are heavily reliant on water for their operations, such as registrants in the energy sector, materials and buildings sector, or agriculture sector, could face regulatory restrictions on water use, increased expenses related to the acquisition and purchase of alternative sources of water, or curtailment of its operations due to a reduced water supply that diminishes its earning capacity. If the location of assets in regions of high or extremely high water stress presents a material risk, the proposed rules would require a registrant to disclose the amount of assets located in such regions in addition to their location, and to disclose the percentage of its total water usage from water withdrawn in those regions.

Description of Impacts of Climate-Related Risks

Once a registrant has described the climate-related risks reasonably likely to have a material impact on the registrant's business or consolidated financial statements, the registrant would be required to describe the actual and potential impacts of those risks on its strategy, business model, and outlook. And a registrant would be required to describe any processes the registrant has for identifying, assessing, and managing climate-related risks.

The SEC provided the following scenarios as examples:

  • An oil company might determine that a likely change in demand for fossil fuel-based products would require it to modify its business model or alter its product mix to emphasize advanced diesel gas and biofuels in order to maintain or increase its earning capacity, thereby requiring disclosure under the proposed rules.
  • If, as part of its net emissions reduction strategy, a registrant uses carbon offsets or renewable energy credits or certificates (RECs), the proposed rules would require it to disclose the role that carbon offsets or RECs play in the registrant's climate-related business strategy. A registrant that relies on carbon offsets or RECs to meet its goals might incur lower expenses in the short term but could expect to continue to incur the expense of purchasing offsets or RECs over the long term. It could bear the risk of increased costs of offsets or RECs if increased demand for offsets or RECs creates scarcity and higher costs to acquire them over time. A registrant that purchases offsets or RECs to meet its goals as it makes the transition to lower carbon products would need to reflect this additional set of short and long-term costs and risks, including the risks that the availability or value of offsets or RECs might be curtailed by regulation or changes in the market.

Oversight and Governance of Climate-Related Risks

The SEC's proposed rules would also require a registrant to disclose its oversight and governance of climate-related risks in order to enable the investing public to evaluate the extent to which a registrant is adequately addressing material climate-related risks. A registrant would be required to disclose the following:

  • Board Oversight: (1) description of the processes and frequency by which the board discusses climate-related risks; (2) identification of board committees responsible for oversight of climate-related risks, and (3) identification of any board members with expertise in climate-related risks and descriptions of such expertise.
  • Management Governance: description of management's role in addressing and managing climate-related risks.
  • Strategy: (1) whether and how the company (board and management) considers climate-related risks as part of the company's strategy and operations and (2) whether and how the company sets climate-related targets or goals and how it measures progress towards the targets or goals.
  • Risk Management: the processes the company has for identifying, assessing, and managing climate-related risks.

Disclosure of Greenhouse Gas Emissions

The SEC also proposes to require registrants to disclose its greenhouse gas emissions for its most recently completed fiscal year, as follows:

  • Scope 1 emissions: Registrants would be required to disclose direct greenhouse gas emissions from operations that are owned or controlled by the registrant.
  • Scope 2 emissions: Registrants would be required to disclose indirect greenhouse gas emissions from the generation of purchased or acquired electricity, steam, heat, or cooling that is consumed by operations owned or controlled by the registrant.
  • Scope 3 emissions: Certain larger registrants would be required to disclose indirect emissions not otherwise included in a registrant's Scope 2 emissions that occur in the upstream and downstream activities of a registrant's value chain – such as greenhouse gas emissions associated with use of the registrant's products.

To complicate matters, the Wall Street Journal recently reported that the Greenhouse Gas Protocol coalition is reviewing its "scope" standards and may adjust them to (a) address how companies use RECs to report Scope 2 emissions and (b) align with accounting rules under development. And while some companies are already calculating and publicizing their Scope 1 and 2 emissions, calculating and reporting peripheral Scope 3 emissions is and will be a challenge. The proposed rules would require disclosure of Scope 3 emissions only if those emissions are material or if the registrant has set a greenhouse emissions reduction target or goal that includes its Scope 3 emissions. But the SEC hasn't provided a bright line, instead indicating that it expects Scope 3 emissions to be material "for many registrants," and is directing 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 greenhouse gas emissions." Although the SEC has not proposed a quantitative threshold, it did note that "some companies rely on a threshold such as 40 percent." Even so, the SEC has expressed that Scope 3 emissions may be material even below that threshold: "Scope 3 emissions may make up a relatively small portion of a registrant's overall greenhouse gas emissions but still be material where Scope 3 represents a significant risk, is subject to significant regulatory focus, or if there is a substantial likelihood that a reasonable investor would consider it important."

Attestation Requirements

Certain larger registrants (accelerated filers and large accelerated filers) would be required to include in their registration statements and annual reports a third-party attestation report covering the disclosure of its Scope 1 and Scope 2 emissions. The proposed rules set forth minimum standards for experience, expertise, and independence for an attestation provider.

The attestation report must be at a "limited" assurance level for the first two years of attestation reports, and then a "reasonable" assurance level beyond that time. The "reasonable" assurance attestation would be more akin to the level of assurance required for the audit of the company's financial statements.

Financial Statements Disclosure

The SEC also proposed additional financial statement disclosures related to climate-related risks. More specifically, the SEC has proposed that registrants disclose in the footnotes to their consolidated financial statements the impact of climate-related events (such as severe weather events and other natural conditions) on the line items of the registrant's consolidated financial statements along with the financial estimates and assumptions used in the financial statements that are impacted by such climate-related events.

Potential Uncertainty

An open question is whether the SEC's emissions-reporting regime exceeds its jurisdictional mandate, especially considering that other federal environmental agencies (such as the Environmental Protection Agency) already oversee greenhouse gas reporting programs. That question will need to be answered, because compliance will be expensive. Third-party companies specializing in calculating Scope 1, 2, and 3 emissions estimate that calculating a registrant's emissions could cost $125,000. With respect to the attestation reports concerning Scope 1 and Scope 2 emissions data, the SEC estimates that certain registrants could incur associated costs of up to $235,000 for such reports.

The comment period on the SEC's proposed rules ends on May 20, 2022. Affected companies should consider carefully reviewing the proposed rules and submitting comments. We expect a high volume of comments on the proposed rules, and the proposed rules remain subject to further consideration and change by the SEC. Final rules are not expected before December 2022. If finalized, it is expected that these requirements would apply to SEC filings beginning in 2024. Affected companies should consider how the proposed rules would impact the company's future public disclosures and operations and consider reviewing and shoring up their sustainability report pledges, refining their processes for identifying, assessing, and managing climate-related risks, and studying how to augment existing processes for generating and reporting emissions 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.

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