By Kay Goldberg, S22 Advanced Environmental Clinic Student, S21 Environmental Clinic Student
The SEC’s recent rule proposal, titled “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” would require publicly traded companies to provide an assessment of climate-related risks, business decisions, and emissions alongside their standard financial disclosures. The SEC has the authority to request climate-related disclosures, as well as other disclosures, at its discretion as it sees “necessary or appropriate in the public interest or for the protection of investors” under 15 U.S.C. §77g and 78l, m, and o. It further claims that investors have requested this information as an important part of their decisions to invest.
What must be disclosed?
The rule would require all registrants to disclose and analyze climate-related risks that they face or might face in the short, medium, and long term. These risks might include climate catastrophes like flooding or wildfires that threaten buildings, facilities, or factories owned by the registrant; they might also include more abstract risks such as transitioning to a lower-carbon economy. The registrant would be required to disclose how these risks might affect its business operations, financials, strategies, and outlook. The risk disclosure would need to include the methods used to identify and assess the risks; for example, is climate risk assessment part of the company’s broader risk management strategy?
Scope 1 and 2 Emissions
All registrants would also be required to disclose their direct and indirect greenhouse gas emissions. These “Scope 1” and “Scope 2” emissions would be disclosed as disaggregated constituent greenhouse gases as well as aggregated total emissions. Scope 1 emissions refer to those which the registrant produces itself and Scope 2 emissions are those associated with purchased electricity or energy.
Scope 3 Emissions
If the registrant’s Scope 3 – upstream and downstream – emissions are material, or if the registrant has set an affirmative goal for Scope 3 emissions, it would have to disclose aggregated Scope 3 emissions. In the context of the SEC’s rule, a given metric is “material” “if there is a substantial likelihood that a reasonable investor would consider [it] important when making an investment or voting decision.” Upstream activity includes sourcing, processing, or supplying materials; downstream activity refers to further processing, packaging, distributing, or employee traveling. Source 3 emissions might also include “financed emissions” from companies that the registrant funds.
Other Disclosures
The SEC has proposed additional disclosures for certain registrants and situations. If a registrant has a transition plan for reducing climate-related risks, it would be required to disclose the broad strokes of the plan, including timeline, self-assessment metrics, and potential impact on financial statements. If a registrant uses scenario analysis to assess its business strategy’s efficacy, it would be required to disclose the scenarios it has modeled and the projected financial impacts. Finally, if the registrant has any public climate goals, it would be required to disclose the specific goal activities, its plan to reach the goal, yearly data describing any progress that has been made towards the goal, and the use of carbon offsets or renewable energy certificates in its plan.
What is the SEC’s rationale for the rule?
The SEC was careful to tie its proposals back to how investors might use the information. Many of the proposed disclosures are related to a company’s preparedness for future climate policy changes, regulations, and market demands. Investors who realize the possibility of these policy changes will want to ensure they put money into companies that will thrive in the future, not just in the present regulatory scheme. For example, the SEC believes that Source 3 emissions make up a large percentage of overall GHG emissions for many companies, which could leave a company vulnerable to future regulation. For this reason, registrants will be required to disclose all emissions – not just Scope 3 – in absolute terms without offsets. The SEC also believes that registrants have influence over Scope 3 emissions and can work with their upstream and downstream partners to reduce them.
Considerations about the Rule
Scope 3 Emission Reporting: Of the proposed disclosures, the Scope 3 emissions have probably generated the most discussion from commenters in various fields.
Some investment and asset management firms opposed to Scope 3 emission disclosure have pre-existing protocols for tracking Scope 1 and Scope 2 emissions, and feel that Scope 3 disclosure is unnecessary or premature. The American Bankers Association claims that Scope 3 emissions are predicated on third-parties’ Scope 1 and 2 emissions, and that it will be difficult to collect and present this information. Cisco is concerned that “it will take considerable time and investment to build out [the] necessary processes” for tracking and reporting Scope 3 emissions. The American Petroleum Institute urges the SEC to simply adopt the EPA’s Scope 1 Greenhouse Gas Reporting Program, which it claims is founded on the “best science available, and extensive public shareholder input.” Finally, the Teachers Insurance and Annuity Association of America lists five industries that should be required to disclose Scope 3 emissions: financials (investment, banking, insurance), energy, transportation, construction (materials and building), and agriculture.
In response to some of these concerns, the SEC has provided a “phase-in” period and a limited safe harbor for Scope 3 emissions reporting.
Permissive Nature of Reporting: Many of the SEC’s proposed rule provisions are permissive. The SEC rule gives companies the freedom to not have a transition plan, to not set an internal carbon price, to not set public climate goals, and to not perform any situational analyses for climate-related events. The only required disclosures are those that any business should monitor already as part of its risk management model, direct emissions produced by the registrant, and indirect emissions in the form of Source 2 and material Source 3 emissions.
Another permissive element of the proposal is the leeway registrants have to determine their organizational boundaries, even allowing different boundaries for different metrics. Organizational boundaries are used in the context of financial statements to define the entities, operations, assets, and other holdings that are owned or controlled by a business organization. The SEC has proposed that registrants should use the same organizational boundaries used for financial statements for their Scope 1, 2, and 3 emissions disclosures. The SEC chose to prioritize consistency between financial statements and emissions disclosures over other GHG calculation methods, such as the Corporate Accounting and Reporting Standard’s GHG Protocol. The GHG Protocol’s two approaches to setting organizational boundaries are by equity share, where a company accounts for emissions based on its equity share in a given entity or enterprise, and by control, where a company accounts for emissions from entities it has either financial or operational (not legal) control over. The SEC’s proposed approaches for calculating Scope 1, 2, and 3 emissions are based on, but not entirely the same as, this Protocol.
However, the proposed SEC rule would permit registrants to draw different organizational boundaries for the purposes of setting internal carbon prices. Carbon pricing is not mandated by the new rule; instead, the SEC has asked registrants that have set a carbon price to disclose it, as well as the method by which it was set. Organizational boundaries for carbon pricing are typically set by a company’s carbon footprint – a map of direct (Scope 1) and indirect (Scope 2 and 3) emissions that the company is responsible for. The SEC’s proposed rule could have required the carbon price boundary to be the same as that for Scope 1, 2, and 3 emissions, to promote greater harmony across financials and climate disclosures. However, carbon pricing is often used to track a company’s progress toward its climate-related goals, not strictly to monitor emissions. If a company’s planning is better-served by eliminating some entities from its carbon price calculation, they have the discretion to do so under the SEC’s proposal.
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