The Securities and Exchange Commission in March gave initial approval to the Enhancement and Standardization of Climate-Related Disclosures for Investors. These disclosures include three different categories:
- Scope 1 – Emissions that come directly from company-owned sources.
- Scope 2 – Indirect emissions from energy purchased, and consumed by a company.
- Scope 3 – All other indirect emissions that occur during the course of a company’s business.
One of the major proposed changes essentially eliminates the “materiality standard” for companies’ Scope 1 and 2 emissions disclosures. The Section D disclosures require a public company to provide “a description of the processes and frequency by which the board or board committee discusses climate-related risks,” including “how the board is informed about climate-related risks; how frequently the board considers such risks,” and “whether and how the board or board committee considers climate-related risks as part of its business strategy, risk management, and financial oversight.”
The SEC believes these Scope 1 and Scope 2 disclosures to be essential because they provide investors with material information regarding a public company’s “transition risk.” That category of risk includes the increased operating and investment costs resulting from stricter climate-related regulations, reduced demand for carbon-intensive products, and the potential for stranded assets such as oil and gas reserves that will result from the world moving towards net-zero carbon emissions.
According to the SEC, the move to net-zero emissions will cause companies with high Scope 1 and 2 emissions to suffer declining cash flows, “either from greater costs of emissions or the need to scale back on high-emitting activities” relative to other firms with lower emissions. Hence, such disclosures will be material information for investors.
Scope 3 emissions disclosures will be, in practice, essentially required for all public companies. Scope 3 emissions will be deemed material if they amount to 40 percent of a company’s total carbon emissions. But even if a company does not reach this mark, Scope 3 emissions may “still be material where Scope 3 represents a significant risk (e.g., transition risk), when a significant SEC investigation indicates that additional Scope 3 emissions will ultimately be required, or ‘if there is a substantial likelihood that a reasonable [investor] would consider it important.’” The latter requirement goes well beyond a definition of materiality focused on firm-specific financial risk.
The proposed rule guides public companies to take the following approach to Scope 3 disclosures that further upends the materiality standard: “Even if a materiality analysis requires a determination of future impacts, [e.g., a transition risk yet to be realized], then both the probability of an event occurring and its magnitude should be considered. Even if the probability of an adverse consequence is relatively low, if the magnitude of loss or liability is high, then the information in question may still be material.” Finally, if a company “determines that its Scope 3 emissions are not material, and therefore not subject to disclosure, it may be useful to investors to understand the basis for that determination.”
The SEC has not yet finalized these rules. Many organizations have chimed in with both positive and negative feedback during what has been a lengthy comment period. But if the current proposed rules are finalized in anything close to their current form, every public company will need to take a hard look at its emissions disclosures to ensure compliance.