On 21 March 2022, the United States Securities and Exchange Commission (SEC) issued a proposed rule (Proposed Rule) to enhance and standardise the climate-related disclosures provided by public companies including both domestic and foreign private issuers. The Proposed Rule seeks to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 (Exchange Act) to require public companies (which includes foreign private issuers) to provide disclosures regarding their annual greenhouse gas (GHG) emissions and the climate-related risks their businesses face.
In introducing the Proposed Rule, SEC Chair, Gary Gensler, stated “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.”
SEC’s consideration of this issue follows the introduction of mandatory climate risk disclosures by corporate regulators in countries including the UK, the EU, Switzerland, Hong Kong, Japan, Singapore and New Zealand. It draws on the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD). Whilst not mandatory in Australia, APRA and ASIC have both cited the TCFD recommendations as being best practice for climate-related financial disclosures. The Investor Group on Climate Change (IGCC) has also called for Australia to make climate-related financial disclosures mandatory.
The Proposed Rule will be open for consultation until the later of 30 days after the proposal’s publication in the Federal Register or 20 May 2022. Whilst a final rule could be adopted later in 2022 and taking effect in financial year 2023, it is expected that there will be highly divergent views on the scope and content of the Proposed Rule, which may draw out the process and could lead to legal challenges.
Australian companies who have securities registered under the Exchange Act will need to be across these disclosure requirements as they may need to include climate-related information in their filings. The Proposed Rules, if adopted, may also inform the scope and content of future disclosure requirements in Australia.
Content of proposed disclosures
The Proposed Rule would require public companies (including foreign private issuers) to provide similar disclosures to those under the TCFD recommendations across the areas of governance, strategy, risk management and metrics and targets, informed by scenario planning.
Assessment of material impact of climate risk
The Proposed Rule would require companies to disclose any climate-related risks reasonably likely to have a material impact on the company’s business or consolidated financial statements which may manifest over the short, medium or long term.
Climate-related risks means the actual or potential negative impacts of climate-related conditions and events on a company’s consolidated financial statements, business operations, or value chains (including both upstream and downstream activities) as a whole, and includes both physical and transition risks.
Physical risk includes both acute and chronic risks to a company’s business operations or the operations of those with whom it does business. The Proposed Rule defines “Acute risks” as event-driven risks related to shorter-term extreme weather events, such as hurricanes, floods, and tornadoes. “Chronic risks” are defined as those risks that the business may face as a result of longer term weather patterns and related effects, such as sustained higher temperatures, sea level rise, drought, and increased wildfires, as well as related effects such as decreased arability of farmland, decreased habitability of land, and decreased availability of fresh water.
Transition risks refer to the actual or potential negative impacts on a company’s consolidated financial statements, business operations, or value chains attributable to regulatory, technological, and market changes to address the mitigation of, or adaptation to, climate-related risks. These can relate to regulatory, technological, market (including changing consumer, business counterparty, and investor preferences), liability, reputational, or other transition-related factors.
Companies will be required to specify whether an identified climate-related risk is a physical or transition risk, and the nature of that risk, so that investors can better understand the nature of the risk and the company’s actions or plan to mitigate or adapt to it.
The SEC notes that a matter is material if there is a substantial likelihood that a reasonable investor would consider it important when determining whether to buy or sell securities or how to vote.
The disclosure of climate-related opportunities is optional to allay any anti-competitive concerns that might arise from a requirement to disclose a particular business opportunity.
The SEC has not proposed a specific range of years to define short, medium and long term time horizons. Instead, companies are required to describe how it defines these time horizons to allow companies to select the time horizons most appropriate to them.
Companies must also discuss their assessment of the materiality of climate-related risks over the short, medium, and long term to ensure companies are considering the dynamic nature of climate-related risks. The Proposed Rule notes that the materiality determination regarding potential future events requires an assessment of both the probability of the event occurring and its potential magnitude or significance to the company. Noting the difficulty in determining future impacts for some businesses, it is proposed that the forward-looking statement safe harbors pursuant to the Private Securities Litigation Reform Act (PSLRA) would apply, assuming the conditions specified in those safe harbor provisions are met.
Disclosure regarding climate-related impacts on strategy, business Model and outlook
Once the company has described the climate-related risks reasonably likely to have a material impact on the business or consolidated financial statements over the short, medium, and long term, it is then required to describe the actual and potential impacts of those risks on its strategy, business model, and outlook, and the time horizons in which those risks may manifest. This would require disclosures regarding:
- business operations, including the types and locations of its operations;
- products or services;
- suppliers and other parties in its value chain;
- activities to mitigate or adapt to climate-related risks, including adoption of new technologies or processes;
- expenditure for research and development; and
- any other significant changes or impacts.
The Proposed Rule would require a company to discuss how it has considered the identified impacts as part of its business strategy, financial planning and capital allocation. This includes providing both current and forward-looking disclosures that facilitate an understanding of whether the implications of the identified climate-related risks have been integrated into the company’s business model or strategy, including how resources are being used to mitigate climate-related risks.
The SEC notes that companies are required to provide a narrative discussion of whether and how any of its identified climate-related risks have affected or are reasonably likely to affect the company’s consolidated financial statements. However, this narrative discussion of the climate-related impacts on its consolidated financial statement should cover more than just short-term impacts.
If a company has used carbon offsets or renewable energy certificates (RECs) as part of its emissions reduction strategy, information about the carbon offsets or RECs is required to be disclosed, including how much of the progress made is attributable to offsets or RECs. The SEC notes that understanding the role that carbon offsets or RECs play in a company’s climate-related business strategy can help investors gain useful information about the company’s strategy, including the potential risks and financial impacts. Companies that purchase offsets or RECs would need to reflect the additional set of short and long term costs and risks, including the risk that the availability or value of offsets or RECs might be reduced by regulation or market changes.
Maintained internal carbon price
An internal carbon price is defined as an estimated cost of carbon emissions used internally within an organisation. If a company uses an internal carbon price, it would be required to disclose:
- the price in units of the company’s reporting currency per metric ton of carbon dioxide equivalent (CO2e);
- the total price, including how the total price is estimated to change over time, if applicable;
- the boundaries for measurement of overall CO2e on which the total price is based; and
- the rationale for selecting the internal carbon price applied.
Companies would also be required to describe how they use their disclosed internal carbon price to evaluate and manage climate-related risks.
The Proposed Rule would not require a company to maintain an internal carbon price or to mandate a particular carbon pricing methodology, but where it does, the proposed disclosures would apply.
Scenario analysis is a process for identifying and assessing a potential range of outcomes of future events under conditions of uncertainty. In the climate change context, this typically involves testing how climate-related risks may impact on a business at different levels of global temperature increases.
If a company uses scenario analysis or other analytical tools to assess the impact of climate-related risks on its business and consolidated financial statements, the Proposed Rule state it must disclose a description of the scenarios, assumptions and projected financial impacts on the company’s strategy under each scenario. However, the SEC is not proposing to mandate scenario-analysis.
The Proposed Rule would require a company to disclose, as applicable, certain information concerning the board’s oversight of climate-related risks, and management’s role in assessing and managing those risks.
At a board level, it is proposed that a company identify board members and committees responsible for oversight of climate-related risks, including:
- their expertise;
- the process and frequency of discussion on this topic; and
- whether and how the board or committee considers climate-related risks as part of business strategy, risk management and financial oversight.
Additionally, disclosure about if and how the board sets climate-related targets or goals and oversees progress against those targets or goals is required.
At a management level, the Proposed Rule would require a company to disclose a number of items about management’s role in assessing and managing any climate-related risks.
Risk management disclosure – risk management processes
The Proposed Rule would require a company to describe its processes for identifying, assessing and managing climate-related risks, and whether any such processes are integrated into the company’s overall risk management system or processes.
In the context of risk identification, companies would be required to disclose the following factors:
- how it determines the relative significance of climate-related risks compared to other risks;
- how it considers existing or likely regulatory requirements or policies, such as GHG emissions limits, when identifying climate-related risks;
- how it considers shifts in customer or counterparty preferences, technological changes, or changes in market prices in assessing potential transition risks; and
- how it determines the materiality of climate-related risks, including how it assesses the potential size and scope of any identified climate-related risk.
In the context of risk assessment, a company would be required to describe its processes in respect of:
- how it decides whether to mitigate, accept, or adapt to a particular risk;
- how it prioritizes addressing climate-related risks; and
- how it determines how to mitigate a high priority risk, including the use of insurance or other financial products.
The integration of these risks into a company’s overall risk management system would also need to be disclosed.
Risk management – transition planning
A “transition plan” is defined to mean a company’s strategy and implementation plan to reduce climate-related risks. These types of plans are typically seeking to align a company’s plan to reduce GHG emissions in line with the Paris Agreement commitments of jurisdictions in which it has significant operations, and may also detail how transition risks are being addressed.
If a company has adopted a transition plan, the Proposed Rule would require it to describe its plan, (including the relevant metrics and targets used to identify and manage physical and transition risks), and to disclose how it plans to mitigate or adapt to identified transition risks and how it plans to achieve identified opportunities (eg through the production of low-carbon products, generation and use of renewable energy, setting conservation goals etc). The company would then need to update its disclosures about the plan on an annual basis.
As with other forward-looking statements, the Proposed Rule anticipates that safe-harbour provisions in the PSLRA may apply for these statements.
Financial statement metrics
The Proposed Rule would require a company to disclose certain disaggregated climate-related financial statement metrics that are mainly derived from existing financial statement line items in a note to its financial statements. This would include the impact of the climate-related events and transition activities on the company’s consolidated financial statements. Such statements would cover financial impact metrics, expenditure metrics and financial estimates and assumptions.
“Climate-related risks” would be defined, in part, as the actual or potential negative impacts of climate-related conditions and events on a company’s consolidated financial statements and would include physical risks, such as extreme weather events, as well as transition risks.
The proposed threshold for disclosure is set at a very low level. Disclosure would be required unless the aggregated impact of the severe weather events, other natural conditions, transition activities and identified climate-related risks is less than one % of the total line item for the relevant financial year.
By way of example, the Proposed Rule notes the following circumstances in which financial impacts may arise:
- changes to revenue or costs from disruptions to business operations or supply chains;
- impairment charges and changes to the carrying amount of assets due to assets being exposed to physical climate risks;
- changes to loss contingencies or reserves (such as environmental reserves or loan loss allowances) due to impact from severe weather events;
- changes to total expected insured losses due to flooding or wildfire patterns;
- changes to revenue or cost due to new emissions pricing or regulations resulting in the loss of a sales contract;
- changes to operating, investing, or financing cash flow from changes in upstream costs, such as transportation of raw materials;
- changes to the carrying amount of assets due to a reduction of the asset’s useful life or salvage value; and
- changes to interest expense driven by financing instruments such as climate-linked bonds issued where the interest rate increases if certain climate-related targets are not met.
The proposed expenditure metrics would be subject to the same disclosure threshold as the financial impact metrics. For the purposes of calculating the disclosure threshold for the expenditure metrics, a company would be permitted to separately determine the amount of expenditure expensed and the amount of expenditure capitalised. However, a company would be required to aggregate expenditure related to climate-related events and transition activities within the categories of expenditure (ie amount capitalised and amount expensed).
Estimates and assumptions
The Proposed Rule would require a company to disclose whether the estimates and assumptions used to produce the consolidated financial statements were impacted by exposures to risks and uncertainties associated with, or known impacts from, climate-related events. If so, the company would be required to provide a qualitative description of how those events have impacted the development of the estimates and assumptions used by the registrant in the preparation of its financial statements.
GHG emissions metrics disclosure
Applying definitions and concepts aligned with the GHG Protocol and other internationally recognised standards, the Proposed Rule would require a company to disclose its GHG emissions for its most recently completed financial year.
The Proposed Rule would require a company to disclose its total Scope 1 emissions separately from its total Scope 2 emissions after calculating them from all sources that are included in the company’s organisational and operational boundaries.
A company would also be required to disclose separately its total Scope 3 emissions for the financial year if those emissions are material, or if it has set a GHG emissions reduction target or goal that includes its Scope 3 emissions.
For each of its Scopes 1, 2, and 3 emissions (if applicable), the Proposed Rule would require a company to disclose the emissions both disaggregated by each constituent GHG and in the aggregate. The company would also be required to disclose emissions in gross terms and in terms of GHG intensity (or carbon intensity) and to specify the methodology used to calculate emissions, as well as the way in which organisational and operational boundaries had been determined.
To balance concerns about reporting Scope 3 emissions with the need for decision-useful emissions disclosure, the Proposed Rule set out the following accommodations for Scope 3 emissions disclosure:
- a safe harbor for Scope 3 emissions disclosure from certain forms of liability under the Federal securities laws, so that disclosure of Scope 3 emissions by or on behalf of the company would be deemed not to be a fraudulent statement, unless it is shown that the statement was made or reaffirmed without a reasonable basis or was disclosed other than in good faith;
- an exemption for smaller reporting companies (SRCs) from the Scope 3 emissions disclosure provision; and
- a delayed compliance date for Scope 3 emissions disclosure.
Attestation of Scope 1 and Scope 2 emissions disclosure
A company that is an accelerated filer or large accelerated filer would be required to include in the relevant filing an attestation report covering the disclosure of its Scope 1 and Scope 2 emissions. The attestation would start at the level of “limited assurance”, but move to “reasonable assurance” at the beginning of the fourth financial year. Information about the independent third-party attestation provider would also need to be disclosed.
Targets and goals
If a company has set any climate-related targets or goals, then the Proposed Rule would require the company to provide certain information about those targets or goals. This includes information about:
- the scope of activities and emissions included in the target;
- the unit of measurement, including whether the target is absolute or intensity based;
- the defined time horizon by which the target is intended to be achieved, and whether the time horizon is consistent with one or more goals established by a climate-related treaty, law, regulation, policy, or organisation;
- the defined baseline time period and baseline emissions against which progress will be tracked with a consistent base year set for multiple targets;
- any interim targets set by the registrant; and
- how the registrant intends to meet its climate-related targets or goals (including with respect to the use of offsets and RECs).
The SEC has made it clear that disclosure of its climate-related targets or goals should not be construed to be promises or guarantees. Similar to other forward-looking statements, it is proposed that the PSLRA safe harbors would apply to those statements, assuming all other statutory requirements for those safe harbors are satisfied.
Where and when will disclosures be made?
The Proposed Rule would require a company to:
- provide the climate-related disclosure in its registration statements and Exchange Act annual reports;
- provide the Regulation S-K mandated climate-related disclosure (being matters related to governance, impacts on strategy, business model and outlook, risk management, GHG emission metrics, and targets and goals) in a separate, appropriately captioned section of its registration statement or annual report, or alternatively, to incorporate that information in the separate, appropriately captioned section by reference from another section, such as Risk Factors, Description of Business, or Management’s Discussion and Analysis;
- provide the Regulation S-X mandated climate-related financial statement metrics and related disclosure in a note to the company’s audited financial statements;
- electronically tag both narrative and quantitative climate-related disclosures in Inline XBRL; and
- file, rather than furnish, the climate-related disclosure.
It is proposed that there be a phase-in for all companies, with the compliance date dependent on the company’s filer status. An additional phase-in period for Scope 3 emissions disclosure is proposed, along with the previouslymentioned safe harbor provisions for Scope 3 emissions disclosure. SRCs would also be subject to an exemption from the Scope 3 emissions disclosure requirement.
Implications for Australian companies and banks
The significance of the proposed adoption of mandatory reporting standards aligned with the TCFD framework in what is still the deepest and most important capital market in the world, cannot be overstated. One way or another, these requirements will likely “filter down” into any jurisdiction, including Australia, that enjoys meaningful capital flows with the US.
If adopted, the Proposed Rule would apply to Australian companies that issue debt or have securities listed in the US as it will apply to foreign private issuers, as well as US domestic companies. It’s also likely that over time, the Proposed Rule will, by practice and market expectation if not by law, gradually become part of disclosure practices for other cross border offerings, such as the Rule 144A market. Australian companies that do business with US companies may be required, as a condition of doing so, to provide disclosures to their foreign counterparts to allow them to comply with the required disclosures, including for Scope 3 GHG emissions.
Further, as investors become used to seeing this level of disclosure in jurisdictions where it has become mandatory, they are likely to pressure companies operating under voluntary regimes to ensure they provide similar levels of disclosure as apply under mandatory regimes. Similarly, proxy advisers and activists are likely to single out companies that choose not to voluntarily disclose or provide disclosure which is not commensurate with the mandatory rules that apply in the US and elsewhere.
The Proposed Rule is also likely to guide the future evolution of the regulatory framework for climate-related disclosure in Australia. While there are already comprehensive requirements for the reporting of GHG emissions, energy consumption and energy production data under the National Greenhouse and Energy Reporting Scheme (NGERS), the scheme only applies to corporate groups and facilities that exceed specified thresholds. Many ASX listed companies and APRA-regulated entities would not be covered by these reporting requirements due to their emissions profiles. In addition, NGERS only covers Scope 1 and Scope 2 emissions and public information about these is provided in an aggregated form. Reporting on the use of offsets under the corporate emission reporting transparency initiative is about to commence, but this is voluntary and has only had limited uptake from companies.
There have been calls by a number of Australian stakeholders, including the IGCC to introduce mandatory climate-related risk disclosure. Noting the growing number of countries moving in this direction, the SEC Proposed Rule, if adopted, would give further weight to arguments in favour of consistent, comparable and reliable information for investors – using the TCFD recommendations.
In Australia, ASIC and APRA have already both publicly stated their positions that climate risk may have material impacts on entities and their financial positions and performance. Accordingly, these regulators have tied climate-related disclosures to existing mandatory financial disclosure requirements. They have each released guidance on the contents of climate-related disclosures for annual reports, product disclosure statements, prospectuses and other disclosure statements. However, being guidance materials, they are less prescriptive than the Proposed Rule and the covered areas of disclosure are not as broad. For example, neither ASIC nor APRA has recommended a company disclose the role of carbon offsets. ASIC has also stated that it aims to provide targeted guidance on climate-related disclosure to certain listed companies which could be informed by the content of the Proposed Rule.
The ASX Corporate Governance Principles and Recommendations also include a recommendation that a listed entity should disclose whether it has any material exposure to environmental or social risks and, if it does, how it manages or intends to manage those risks. Where those risks include climate-related risks, consideration of the TCFD recommendations is encouraged.
Finally, the ACCC has acknowledged that companies are financially incentivised to make “green claims” in marketing generally and has indicated that greenwashing will be one of its regulatory priorities for 2022.
With this focus across Australian regulators, it is likely that the scope and content of the Proposed Rule will be carefully scrutinised and could inform future steps towards mandatory disclosures in Australia.