SEC Proposes Climate Risk Disclosure Rule

The Securities and Exchange Commission today unveiled its long-awaited proposal for disclosure of risks related to climate change, including disclosure of greenhouse gas emissions stemming from a company’s supply chain as well as audit and attestation requirements for larger companies’ disclosures. 

The SEC adopted the proposed rule on a 3-1 vote, with lone Republican commissioner Hester Peirce opposed. The proposal will now be open for public comment for 60 days, followed by the SEC presumably adopting some revised, final version of the rule sometime after that. 

One point right away: this proposal addresses climate change risks only. Once upon a time the SEC had larger ambitions to require more disclosure of ESG risks generally, climate change included. This is not that. Today’s proposal addresses climate change alone. 

The disclosures that companies would need to make include:

• Greenhouse gas (GHG) emissions. All companies would need to disclose GHG emissions that are Scope 1 (GHG generated by your own operations) and Scope 2 (GHG generated by your purchase of electricity. Larger companies would also need to report Scope 3 emissions (GHG generated by your supply chain) and those disclosures would be subject to outside review. 
• The impact of climate-related events (severe weather events and other natural conditions) and transition activities on line items in the financial statements.
• How the company governs climate-related risks and the relevant risk management processes.
• If the company has set a goal to transition to net-zero emissions, the company needs to disclose that goal, as well as how management intends to meet those targets and any supporting data to show the company’s progress toward the goal. 

That’s only the broadest summary of the proposed disclosures, by the way. The SEC released a more detailed fact sheet that we can explore in due course, and the full rule proposal runs a whopping 510 pages. 

Assuming no delays in adopting a final rule, the compliance clock would start ticking on Jan. 1, 2023, with the first disclosures appearing in annual reports that arrive in spring 2024. Large accelerated filers would go first, with accelerated filers, non-accelerated filers, and smaller reporting companies all following suit over the subsequent two years. Figure 1, below, shows the deadlines.

The Driver Here: Consistency in Disclosure

The three SEC commissioners in favor of more climate change disclosure all stressed that the goal here is to give investors more consistency and comparability from one company to the next. SEC staff estimate that by 2020 more than one-third of all public companies were already disclosing at least some type of climate change risks, but current SEC rules on climate change disclosure are principles-based— meaning, each company has considerable discretion in deciding what to report and how to calculate those disclosures.

“Companies and investors alike would benefit from the clear rules of the road proposed in this release,” chairman Gary Gensler said in a statement. “I believe the SEC has a role to play when there’s this level of demand for consistent and comparable information that may affect financial performance. Today’s proposal thus is driven by the needs of investors and issuers.”

To that end, the proposed rule is modeled after a framework known as the Task Force on Climate-Related Financial Disclosure (TCFD). That framework would guide companies to make disclosures about, say, how extreme weather events might harm their financial performance or how the company plans to transition to net-zero operations sometime in the future. Along similar lines, the proposed rule also cites the Greenhouse Gas Protocol as a framework companies could use to calculate their Scope 1, 2, and 3 emissions.  

The SEC’s approach here is broadly similar to how the agency enacted rules for Sarbanes-Oxley Act compliance 20 years ago. That is, SOX compliance rules don’t specifically say, “Thou shall use the COSO framework to assess internal controls over financial reporting” — but those rules do specifically say that the COSO framework is a great example of what the SEC wants to see. 

Likewise, here the SEC name-drops the TCFD and GHG Protocol frameworks, clearly telegraphing the message that, yes, you should base your climate risk disclosures on these two standards if you want to stay in the good graces of the SEC Division of Corporation Finance.

Climate Risk Questions

We could probably ponder hundreds of questions about this climate risk proposal, including the very real question of whether federal courts will strike down any final rule as beyond the SEC’s purview. For now, let’s focus on several issues within the proposal itself, and whether they’re likely to change when the SEC does adopt a final rule later this year. 

First, should greenhouse gas emission disclosures be subject to internal control?  

Commissioner Allison Herren Lee raised this question. She compared GHG emissions to financial statement disclosures, “involving, as they do, significant estimates and assumptions and providing critically important insight into a company’s operations.” In that case, she asked, shouldn’t GHG emissions be governed by some set of internal controls, in the same way financial disclosures are governed by internal control over financial reporting? 

Right now those GHG disclosures would not be subject to internal control. The proposed rule includes them as part of Regulation S-K, which is all about qualitative disclosures not subject to internal control. Lee wondered whether investors would be better served putting GHG emissions under Regulation S-X, which is all about quantitative disclosures that are subject to internal control, or perhaps adding some “new requirement to establish ICFR-like internal controls for GHG wherever they reside.” 

Second, how will attestations over GHG emissions work? 

Large accelerated filers and accelerated filers will need to obtain an attestation to the accuracy of their GHG disclosures from an independent outside assurance provider. The attestation would need to cover at least the Scope 1 and 2 disclosures, although a company could include Scope 3 as well. Non-accelerated filers and smaller reporting companies would be exempt from the attestation.

As proposed, large companies would first be allowed one year of limited assurance (“The reviewer is unaware of any material issues”) before upgrading to reasonable assurance (“The reviewer believes the disclosures are correct in all material aspects”) for all future years. 

Compliance, audit, and risk managers should consider several issues here. Will the SEC change that plan for phased-in reasonable assurance, either adopting the reasonable standard right away or keeping limited assurance forever? What about the attestation firms themselves — who will they be? How can a company (or investors) be confident of that firm’s expertise? 

The proposed rule says any independent, experienced assurance firm could review GHG data, not just CPA firms. That said, audit firms have already been building their climate change audit skills and see this as a lucrative new revenue stream. As commissioner Peirce noted, “Audit firms are likely to be the biggest winners, as they already have established assurance infrastructures and are familiar with SEC reporting and the proposed independence framework.”

Third, how will these disclosures square with what companies say in corporate sustainability reports? 

One big area of disclosure will be companies’ plans to transition to a carbon-neutral future, and how companies will actually deliver on those goals. To be clear, the proposed rule does not require that companies make any such transition. It only says that if moving to net zero operations is part of your plan, you need to explain how you’ll achieve that goal and what the likely costs will be. 

Well, that sounds to me suspiciously like the gauzy promises that companies make in corporate sustainability reports — and we’ve already seen SEC staff ask companies to explain how they reconcile statements made in the sustainability report with information disclosed (or, more often, not disclosed) in the quarterly filings. So could this SEC proposal end up forcing companies either to take gauzy promises in the sustainability report more seriously, or to retreat away from such statements because those promises can’t be backed up in the 10-Q or the 10-K? 

Anyway, that’s enough for today. We’ll have lots more discussion of this proposal in weeks to come, I’m sure.