If ESG were merely a slogan on the proverbial gym wall, companies are about to be held accountable for their public promises of climate change and sustainability focused ambitions. Last month the Securities and Exchange Commission (SEC) proposed significant rule changes to the U.S. Securities Act of 1933 and SEC Act of 1934. If enacted, the proposed amendment, formally known as The Enhancement and Standardization of Climate-Related Disclosures for Investors, will require the full disclosure of climate change risks, by domestic and foreign registrants alike, in their annual SEC reports and SEC registration filings.
For the first time, SEC registrants will be obligated to not only formally disclose information on risks that climate change poses to business operations but also reveal specific environmental goals and detailed plans to achieve them. Where ESG tasked registrants to promote sustainability and green policies, the SEC’s proposed amendment will expose a company’s true commitment to its touted ESG initiatives by revealing/exposing its energy usage, greenhouse gas emissions, and other environmental metrics. The prerogative of the SEC’s proposal is to uphold its mission to provide investors with full and transparent disclosure, together with decision-useful reporting information about climate-related business metrics, in order to support informed investment decisions. However, the overall concern in response to the SEC’s rule changes is that mandated disclosure of these climate change metrics may prove material to a company’s business and financial integrity.
Specifically, the proposed rule will now obligate SEC registrants to disclose:
- Specific processes for identifying, assessing, and managing climate-related risks;
- How any identified climate-related risks have had or are likely to affect the registrant’s business model, analytical choices, and projected financial outlook, and/or have a material impact on business and financial statements (i.e. severe weather events);
- Direct GHG emissions (Scope 1) and indirect GHG emissions from purchased electricity and other forms of energy (Scope 2); and
- Indirect emissions from upstream/downstream activities in a registrant’s value chain (Scope 3), whether material or if the registrant has a set GHG emissions target that includes Scope 3 emissions.
What exactly are Scope 1, 2, 3 Emissions?
To differentiate between direct and indirect emission sources and improve transparency, three “scopes” are defined for GHG accounting and reporting purposes. Scope 1 accounts for direct GHG emissions from sources that are owned or controlled by the company. For example, Scope 1 includes emissions from the combustion of company owned or controlled boilers, furnaces, and vehicles, or likewise, emissions from chemical production in company owned or controlled process equipment. Alternatively, Scope 2 accounts for indirect electricity GHG emissions from the generation of purchased electricity, steam, heating and. Scope 3 emissions includes all other indirect emissions from sources not owned or controlled by the institution but that occur in a company’s value chain, or more specifically, because of a company’s operations (i.e. purchased goods/services, fuel/energy related activities, transportation, waste generated in operations, business travel, and employee commuting).
The logic behind requiring registrants to disclose Scope 1, 2, and 3 GHG emissions is that they relay useful stats for registrants and investors alike, such as: where the emission hotspots are within an organization, resource and energy risks in the supply chain, and cost reduction opportunities in the supply chains.
Why now?
So why impose these climate-risk disclosures now, when the global economy is, shall we say, stressed? The SEC reminds registrants that they were duly warned, citing the SEC’s 2010 guidance foreshowing these very climate-related disclosures. The SEC maintains that the proposed rule changes are due to compelling projections that businesses, financial institutions, investors, and households could experience direct financial effects from climate-related risks and that such risks could in turn migrate through supply chains and ultimately onto customers. At the end of the day, the SEC insists that more aggressive disclosure rules are essential to protect investors. The SEC cites the following climate-related risks that could materially impact (and with the proposed amendment, obscure) a company’s financial performance:
- Severe and frequent natural disasters that damage assets, disrupt operations, and increase overall operational costs;
- Internal transitions to lower carbon products and practices triggered by changes in regulations, consumer preferences, technology and other marketing forces impacting the registrant’s business model; and
- Global commitments to transition to a carbon neutral economy to meet GHG goals could materially impact registrants
How may the SEC Rule Changes Expose Registrants to Litigation?
Certainly, the aftermath of future SEC filings invites the foreseeable opportunity for litigation. Registrants whose climate-related SEC metrics fall short may be subject to an unexpected but lethal plaintiff, the shareholder. Formalizing climate-related disclosures may trigger derivative commodities/securities lawsuits wherein shareholders allege that a company, for instance, overstated its sustainability claims resulting in market capitalization losses. Perhaps, the SEC’s amendment will prophylactically mitigate such lawsuits. Regardless, increased transparency means spotlighting potential deficits, which translates to inevitable exposure.
Timeline?
While the SEC’s proposed rule changes are open for public comment for 30 days, even if the amendment takes effect, there is a phase-in period for all registrants, with the compliance deadline dependent on the registrant’s filer status and an additional phase-in period for Scope 3 emissions disclosure. Nonetheless – as if the SEC issued a bona fide tornado warning- registrants are scrambling to sharpen Scope 1,2, and 3 metrics and refine climate-related analytics in anticipation of the looming SEC rule changes.