Key Steps for Environment, Social and Governance Disclosure Reporting Readiness in Advance of the Final Rule

This is the second in our series describing topics and activities law firms can discuss with their clients pertaining to the SEC’s anticipated final rule on ESG Disclosures. If you have not already reviewed the first article, "Plan Your Response to the Anticipated U.S. Securities and Exchange Commission Rule".

Following more than a decade of analysis on climate disclosures, amid global debate and discourse, the U.S. Securities and Exchange Commission (SEC) in March 2023 proposed a new rule that will require covered companies to publicly disclose climate-related information to increase transparency on their Environmental, Social, and Governance (ESG) strategies, climate governance, and how they are addressing climate risks. While the rule itself is not yet final, having undergone a public comment period, its finalization is imminent, particularly for large companies who will almost certainly be required to report first in the pending rule’s implementation timeline. And while the SEC’s rule will be subject to continued refinement as a result of judicial action, for law firms, there are immediate opportunities to counsel clients on threshold and readiness topics, ensuring their clients are prepared to comply and accurately disclose information such as climate risks, governance over these risks, greenhouse gas (GHG) emissions, climate targets, and goals and transition plans.

The following are suggested more tactical steps law firms can recommend their clients take in order to prepare for the SEC’s anticipated rule:

Introduce the concept of climate risk in executive governance discussions, particularly with risk committees or in the course of risk discussions — As we noted in our first article in this series, a first step is to encourage a conversation about the rule itself at the executive governance level. Companies will need to disclose both physical and transitional risks over the short, medium, and long terms. Now is a good time to start introducing the concept of physical and transitional risks in executive leadership discussions, if they are not already under consideration. Doing this will require risk managers to identify risks and assess what data or information the company may have or have access to in order to paint their picture of climate risk now and in the future, potentially using the examples and guidance in the SEC’s draft rule as a starting point. Secondly, law firms and risk managers can play a critical role in providing technical assistance to educate corporate leaders on these topics, many of which are new to the traditional boardroom. How well do decision makers understand Scope 1, 2, and 3 emissions? Do executives understand what “scenario analysis” means?  And if a firm aspires to establish “science-based targets,” how should corporate leaders approach the gathering of data to inform that ambition? Those who will be involved in approving the company’s disclosures should understand what these are, how they are measured, and how these choices impact the bottom line. Fundamentally, the individuals who govern the company will need to be educated to make informed decisions on climate risk, at least as far as it relates to the company’s disclosures. Law firms can be good advisors to their clients by advocating for these initial discussions, providing the legal backdrop, and encouraging decision makers to get the foundational vernacular and knowledge they will need in order to make informed decisions about future disclosures and ESG strategy.  Boards will need to identify how they are integrating climate risk expertise. This may well require new board members to be added to the governance process, and law firms can help clients navigate an analysis of board skills and composition through the Nominating and Governance Committee. This can assist in identifying potential options for the board to meet the expertise requirement.

Conduct a Gap Analysis of the SEC Rulemaking against any current public reporting — Many public companies already participate in a variety of mandatory or voluntary disclosure and reporting programs. These can include annual filings to the Carbon Disclosure Project or to the Value Reporting Foundation, publicly announced greenhouse gas emission targets accepted by the Science Based Targets Initiative, or other reporting that aligns to the Sustainability Accounting Standards Board, to name just a few.  Some firms participate in industry groups, such as the Partnership for Carbon Accounting Financials (PCAF).  Many companies also publish voluntary ESG or other Corporate Social Responsibility reports, aimed at meeting investor interest in these topics but which may not themselves adhere to any of the above formal disclosure frameworks. The SEC notes that some public companies already include climate-related information in existing regulatory filings, though such information is not standardized and consistently reported year over year. Overlapping reporting and variances between current disclosures presents an administrative burden and may complicate reporting under the SEC rulemaking. It also creates the situation where conflicting ESG or other climate-related information could be inadvertently released publicly. In the most benign instance, that situation could cause confusion amongst investors; in a worst case, such discrepancies could invite regulatory scrutiny. As such, companies ought to conduct an internal assessment of all current ESG reporting across the enterprise. They should examine the nature of reporting, where underlying data is sourced from, the processes used to consolidate data, the systems used for reporting, and the various stakeholder groups to whom information is published. This will allow companies to assess the quantitative and qualitative processes behind such reporting and develop a Gap Analysis against the requirements of the new SEC climate-disclosure rulemaking.

Assess existing governance structures — The SEC rulemaking will require companies to provide detailed information related to topics such as Scope 1, 2, and 3 GHG emissions and how a firm is quantifying climate-related risks, inclusive of physical, acute, chronic, and transitions risks. But it is not enough merely to capture risks; the rulemaking requires disclosure of the specific role that a firm's management or board plays in monitoring, addressing, and mitigating those risks and opportunities (where identified). Companies ought to consider whether existing policies and procedures, governance authorities, committee structures, or other governance articles provide an effective forum whereby management can effectively demonstrate their commitment to and role in evaluating climate-related risks. This is especially important since a key precept of the SEC rulemaking is an assessment of "materiality" — that is, management needs visibility into risk factors to assess which ones pose the greatest potential risk or impact to a firm's financial performance. In short, management will need to make an informed judgment on what climate-related risks are material — and why — and management needs to be in a position to justify their judgement. Public disclosure in a regulatory filing will be the opportunity to illustrate how management determines which are material risks to the firm's financial performance.

Stakeholder engagement to assess the current state of data — The SEC rulemaking will require disclosures which themselves demand the gathering of data across the enterprise. This could include data related to facilities, procurement activities, and energy consumption, as well as both upstream and downstream activities. Information may need to be sourced from international operations, thereby subject to local data protection and privacy laws (such as the European Union’s General Data Protection Regulation). And while the data needed to assess Scope 1 and 2 emissions may come from internal sources, the data necessary to assess Scope 3 emissions will require close coordination with external suppliers of goods and services to the firm. This is because one firm's Scope 1 and 2 emissions become another firm's Scope 3 emissions. A firm should undertake planning for how they intend to gather information from their vendor community. This could also include engaging with the firm's procurement teams and legal counsel, to ensure that requesting such information is permissible under existing contracts, or whether contracts will need to be amended. And it is an important point to note that the SEC offers a "safe harbor" provision with regard to Scope 3 emissions, where a firm must rely on the quality of data provided by downstream suppliers. But ultimately, the quality of the data depends on the downstream entity providing the information. To that end, this “safe harbor” provision provides protections to firms in their disclosure of Scope 3 emissions provided those disclosures are made in good faith. Nevertheless, companies should begin dialoguing with their supplier and vendor community to ensure the data is as accurate as needed to meet the “good faith” spirit of the disclosure.

Assess existing climate literacy & capabilities — The nature of assessing climate-related risks requires an understanding of a new taxonomy. Terms such as "carbon accounting," "greenhouse gas emissions," "scenario analysis," and "science-based targets" may be new concepts with which most of a corporation's workforce are unfamiliar. Moreover, the SEC rulemaking provides guidance that firms ought to begin studying various calculation methods and accounting standards such as the Greenhouse Gas Protocol (for creating a carbon accounting of emissions across Scopes 1, 2, and 3) or the PCAF, a consortium working on frameworks related to the quantification and reporting of financed emissions related to banking activities. The SEC rulemaking also aligns with many of the recommendations of an external entity called the Task Force on Climate-Related Financial Disclosures, or TCFD. Firms should dedicate internal resources to begin studying these various frameworks, and to begin to familiarize themselves with approaches to gather information, conduct analysis, generate a carbon accounting, and assess scenarios whereby material climate-related risks could impact a firm's operations or enterprise value.

Thinking about the annual assurance process — The SEC rulemaking also has an additional requirement for large accelerated filers, accelerated filers, and non-accelerated filers to provide additional assurance for their disclosures, beginning with limited assurance and moving toward reasonable assurance over time. Firms should therefore begin a dialogue with their independent auditors on these topics. Many firms may want to engage the services of external parties who specialize in attestations around carbon accounting for Scope 1, 2, and 3 emissions, or who have expertise in running scenario analysis or setting science-based targets. As demand grows in the climate-risk industry for such expertise, it may create constraints on the availability of resources to provide such attestations. Therefore, firms ought to begin working with any external firms as soon as possible to establish relationships to ensure their external auditors are able to move quickly once disclosure timelines come into focus.

As noted above, the SEC climate disclosure rule is not yet in its final form; robust public debate continues. However, firms should use this time wisely to begin the foundational work to put themselves on a path toward disclosure-readiness. At the same time, law firms ought to be engaging with clients to make the best use of this time as well. Because once the SEC climate rulemaking is finalized — as expected sometime in the fall of 2023 — there will be a rush of firms crowding into the sustainability industry, seeking the specialist expertise needed to tackle these requirements. Making optimal use of this current calm period truly is of the essence.