By Britt Harter, Ted Kowalsky, Kathryn Rock
Climate change is positioned to reshape the 21st century. Accordingly, climate risk, as a substantial threat to financial market stability and long-term value, has become increasingly important over the past two decades.
Investors representing more than $130 trillion have been making increasingly forceful requests1 for Environmental, Social, and Governance (ESG) information, including climate data as a risk assessment tool. Investors have also been calling to standardize that data through regulation. This has given rise to a burgeoning set of beyond-compliance standards and frameworks, and fragmentary data disclosures from those who access the capital markets.
In parallel, climate-related damage has been accelerating, as climate-driven weather events become more frequent and have material financial impacts on firms, markets, and investors. Munich Re, the German global insurer, found that natural disasters caused some $280 billion in damages2 globally in 2021 alone. About $120 billion involved assets3 covered by insurance—an increase from $82 billion and $57 billion in 2020 and 2019, respectively.
In concurrence with the view that more comprehensive and standardized climate data is valuable to overall financial stability, the United States Securities and Exchange Commission (SEC) proposed disclosure rules that would require enhanced disclosures of climate risk information from registered entities. This represents the culmination of a decade’s worth of analysis since the SEC first promulgated voluntary climate disclosure guidance in 2010. The proposed rule passed by a 3 to 1 vote on March 21, 2022, and has now entered the period for public comment. In terms of timeline, the SEC is optimistic that the disclosure rules will be adopted with an effective date of December 2022.
The proposed rules apply to “domestic and foreign registrant” firms. The timelines for disclosure are phased based on size of the registrant—larger companies could have to disclose as early as 2024 (with data from FY 2023), while smaller companies would have until 2026 (with data from FY 2025) and would be exempt from certain categories of disclosures, such as Scope 3 greenhouse gas (GHG) emissions.
The disclosure rules would require companies to report climate-related information designed to increase transparency about how they are addressing climate risks:
Climate risks — A headline topic is the disclosure of both physical and transition risks for the firm. The proposed rules require significant detail about identified risks over the short, medium, and long term, and actual/likely material impacts on business, strategy, and outlook. The rules also provide examples of ways in which climate risk may impact a business, including impacts to operations, products, and services, a business’s value chain, activities to mitigate climate risk, and research and development, and notes that disclosures should be both current and forward-looking. Along with material impacts, companies would be required to disclose information such as carbon offsets or renewable energy credits (RECs) used as part of their emissions reduction strategy, the use of an internal carbon price, and details relating to any scenario analysis performed. Finally, the proposed rules also provide companies with the option to report on climate-related business opportunities.
Governance of climate risks — The rules propose a series of new disclosure requirements related to the overall governance of climate-related risks, inclusive of relevant risk management processes, and oversight and governance by a firm’s board and management. For example, with respect to board governance, the rulemaking requires registrants to disclose the board members or committees charged with oversight of climate risk, the level and nature of climate risk expertise among the board of directors, and the way in which the board takes climate risk into consideration in its decision-making. The rules will also require similar information regarding management’s role in addressing climate-related risks, as well as the process for reporting climate-related risk to the board.
Greenhouse gas emissions — Firms would be required to disclose their GHG emissions. The rulemaking specifies that firms may not include carbon offsets in their footprint.
Climate targets, goals, and transition plan — Companies with public climate targets would need to provide additional information about the scope of those targets, including the activities involved, the unit of measurement and baseline time period, the timeline for meeting the target, and any interim targets set. In addition, companies would need to disclose details regarding their plan to meet the targets, including the use of offsets or RECs to meet the targets, as well as progress against targets annually.
As appropriate, companies should disclose relevant information in their registration statements and Exchange Act annual reports (i.e., Form 10-K). In addition, they should include disclosure of climate-related information, including climate-related risks reasonably likely to be material (or, if desired, opportunities) as a separately captioned section in Regulation S-K filings. Certain climate-related financial impact metrics should be included as a note in Regulation S-X consolidated financial statements.
The SEC was not prescriptive with respect to specific methodologies for reporting climate risks, giving latitude for firms to use their preferred methods, so long as they are transparent about their process. However, the proposed rulemaking includes suggestions for established approaches that align with the frameworks on which the proposed rules were modeled.
Task Force on Climate-related Financial Disclosures
The proposed rules acknowledge its alignment in large part with the Task Force for Climate-related Financial Disclosures (TCFD) Framework, a framework created by the Financial Stability Board that has rapidly become the most commonly applied international standard for reporting climate-related risk and opportunities. The framework asks reporting organizations to describe their approach to identifying, assessing, monitoring, and managing climate-related financial risks for different climate scenarios. The SEC rulemaking aligns to TCFD, and while TCFD is not prescriptive in how organizations should approach each recommended action, it provides structure for standardized climate-related disclosures.
The proposed rulemaking’s GHG emissions disclosure requirements are modeled on the GHG Protocol, which it notes has become the leading standard for accounting and reporting GHG emissions. The proposed rules acknowledge the necessity of use of emission factors, or ratios that typically relate GHG emissions to a proxy measure of activity at an emissions source, where direct data is unavailable.
Partnership for Carbon Accounting Financials
The SEC recognizes that for many FIs, Scope 3 emissions disclosures are likely to include financed emissions and require FIs to describe the methodology used to measure their financed emissions. Although the proposed rulemaking does not require a particular methodology, it specifically calls out the Partnership for Carbon Accounting Financials (PCAF) as a methodology that aligns with the GHG Protocol and can serve as a useful complement for FIs to calculate their financed emissions.
Science-Based Targets Initiative
The SEC rulemaking also proposes a strategy for companies to report to shareholders and investors the approaches they are taking to transition operations toward lower-carbon strategies for the purpose of climate risk mitigation. Again, the rulemaking does not endorse any specific approach, but references the role that RECs and Science-Based Targets—such as those established in accordance with the Science-Based Targets initiative (SBTi)— play in helping facilitate a firm’s transition planning.
The proposed rules will be phased in between FY 2023 and FY 2027. Large accelerated filers are required to adopt disclosures first. Smaller firms are required to adopt disclosures in later years. Additionally, the smallest firms are exempt from certain types of disclosure and assurance.
The new SEC disclosure rules have precedent within the G20. Countries including New Zealand, the UK, Japan, and France have passed rules requiring TCFD-aligned disclosures. The scope of required disclosures vary, however. For example, the UK’s rule goes into effect in April 2022 and applies to fewer entities (approximately the 1,300 largest companies) than will the SEC’s proposed rulemaking.
The European Union is also increasing pressure on ESG disclosure, but with a slightly different approach. Rather than a TCFD-aligned focus on climatological financial risks, the EU is requiring disclosure on broader ESG and sustainability topics. The EU’s Corporate Sustainability Reporting Directive is an attempt to set a more robust, standardized global framework for ESG disclosure across corporations. It takes effect at the end of 2023 and is expected to impact more than 49,000 firms.
This diversity of approaches reflects a dynamic discussion around what firms should be required to disclose.
The current proposed rulemaking has now entered a 60-day comment period. After this comment period, the SEC is expected to issue its final rules and its final enforcement date. Although the timeline for a final rulemaking remains uncertain, the SEC’s disclosure timelines assume a December 2022 date for the final rule to take effect.
The rules are also likely to have important impacts on entities beyond registrants. Private firms are likely to see increased pressure to provide similar information as these requests become normalized in the capital markets. Additionally, increased data may generate increased interest in the investment product space.
4 As the SEC noted in the proposed rule, in the US, for these purposes, “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” (p. 69).
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