Climate-Related Disclosure
The Enhancement and Standardization of Climate-Related Disclosures Final Rules are a continuation of the SEC’s efforts to respond to investor demands for more consistent and reliable information regarding the financial effects of climate-related risks. The new rule added a new subpart 1500 to Regulation S-K and a new Article 14 to Regulation S-X utilizing the U.S. Supreme Court’s definition of materiality. Subpart 1500 and Article 14 would require companies, inter alia, to disclose information about any climate-related risks, identified by the company, that have had or are reasonably likely to have a material impact on the business results of operations, or financial condition in the short and long term. Additionally, if the registrant has undertaken measures to mitigate or adapt to material climate-related risk, the registrant must also inform the quantitative and qualitative description of material expenditures incurred and material impacts on financial estimates and assumptions that, in management’s assessment, directly result from such activities. Similarly, if the issuer has adopted a climate-related target or goal that materially affected or is reasonably likely to materially affect the issuer’s business, results of operations, or financial condition, certain disclosures about these pledge objectives are required, including financial estimates and assumptions as a direct result of actions taken to meet these objectives. Another pertinent requirement related to a company's business operations is the disclosure of capitalized costs, expensed expenditures, charges, and losses incurred due to severe weather events and other natural conditions, such as hurricanes, tornadoes, extreme temperatures, and sea level rise. With this general overview of the new regulation, it's important to analyze how it specifically addresses value chain climate-related financial risk disclosure, as well as how they differ from those outlined in the proposed rules.
Subpart 229.1500, Climate-related Disclosures of Regulation S-K defines climate-related risks as the “actual or potential negative impacts of climate-related conditions and events on a registrant’s business, results of operations, or financial condition[.]” These include physical risks, such as acute risks from severe weather events like hurricanes and wildfires, as well as chronic risks from long-term weather patterns like rising temperatures and sea levels. In addition, transition risk is also included, which encompasses negative impacts on business, operations, or financial conditions due to regulatory, technological, and market changes addressing climate-related risks.
The final rule excluded the term "value chain" from its definition of climate-related risks. Nevertheless, it still requires companies to describe the actual and potential material impacts of any climate-related risk that have materially impacted or are reasonably likely to have a material impact on the registrant supplier, purchasers, or counterparties to material contracts, to the extent known or reasonably available. Therefore, climate-related risk disclosure requirements continue to apply to the value chain, but exclusively to direct parties involved, such as suppliers and purchasers, limiting the potential for companies to engage in unreasonable searches for information within their value chain.
Scope 3 Emissions
The SEC based its definition of scope 3 emissions in the proposed rules on the Greenhouse Gas (GHG) Protocols concept of scopes. The Environmental Protection Agency (EPA) refers to the GHG Protocol’s definition of Scope 3 emissions; in order to meet the GHG Protocol Standards, organizations need to report from all relevant scope 3 categories. According to the EPA, Scope 3 emissions result from activities and assets not owned or controlled by the reporting organization, but nevertheless are affected by the organization’s value chain. Scope 3 emissions tend to represent the most of an organization’s total GHG emissions. Scope 3 emissions include emissions from upstream and downstream activities. According to the GHG Protocol’s Corporate Value Chain (Scope 3) Accounting and Reporting Standard, upstream and downstream activities are defined as follows: upstream activities are those such as purchased goods and services, capital goods, fuel and energy-related activities, transportation and distribution, business travel, leased assets, and more; while downstream activities include the processing of sold products, transportation and distribution, the use of sold products, the end-of-life treatment of sold products, investments, franchises, and more. Investors largely supported including Scope 3 reporting in the proposed rule even though Scope 3 emissions were completely eliminated from the final rule largely due to comments opposing the disclosures. Nevertheless, even though companies are not obligated to report Scope 3 emissions, they can still be required to consider and inform these factors if there is a substantial likelihood a reasonable investor would attach importance to these factors and if contemplated as a climate-related material impact.
Analysis of the New Rules’ Impact on Value Chain Climate-Related Disclosure
The SEC has recognized that the new rule imposes additional costs on companies, investors, and other parties, particularly for registrants that have not yet begun collecting climate-related information for disclosure. Moreover, regarding challenges related to value chain climate-related disclosure, there are concerns about the feasibility of these disclosures given the complexity of some companies' value chains and the available financial and human resources. Companies with more complex and global value chains may be particularly impacted by climate-related risks, as well as by considerations such as the cost, time, and certainty of supply chain production and upstream distribution. Furthermore, another challenge relates to the difficulty in quantifying climate change effects, or misunderstanding or underestimating its impacts on the company’s operation, which if proved inaccurate, could subject the company an increased antitrust risk, fines, or other types of litigations.
Nonetheless, climate change is already affecting business supply chain operations worldwide. For example, more frequent natural disasters can disrupt business operations, damage assets, and increase costs, contributing to impacts along a company’s supply chain. In 2022, disruptions from rain and snow in Europe caused the banks of one of the most important commercial waterways to burst, triggering shipping halts for several days. Only a few months later the same river faced a drought forcing cargo ships to limit their load so they would not run into the ground. Also in 2022, heatwaves caused fires in British Columbia, idling rail car transportation in Fraser Canyon. Thus, supply chain disruptions are not limited geographically nor caused by a single weather event. Therefore, investors should be mindful of these climate-related risks, which can affect business operations and financial conditions, enabling them to make informed decisions regarding their investments.
Against this background, the SEC’s final rule is presented as a happy medium to value chain climate-related disclosure because it does not require the disclosure of the whole value chain, but only the suppliers and purchases, and as long as the risk has materially impacted or is reasonably likely to materially impact their business, results of operation, or financial condition, and to the extent known or reasonably available. Accordingly, companies with complex and global value chains are not expected to be overburdened to comply with this new regulation, nor is it likely to excessively strain their financial and human resources beyond what is necessary to provide investors with proper climate-related risk information. Nevertheless, considering the increasing impact of climate change on business and the growing concern and demand of investors for climate-related disclosures, companies should keep up with their efforts to track the impacts of climate change in their whole value chain.
Given the need for more consistent and reliable information regarding the financial effects of climate-related risks, the SEC has intensified its efforts and regulations on a registrant's business through the issue of its final rules, The Enhancement and Standardization of Climate-Related Disclosures. Under this framework, even though financial costs are expected to increase due to this new regulation, the limited value chain climate-related risk regulation can be considered a middle ground between the challenges and concerns of companies with complex value chains and lack of financial or human resources necessary to comply with a full value chain climate-related disclosure and the demand of investors for transparency and proper climate-related risk information that will influence in making informed investment and proxy voting decisions to investors. Moreover, it is to be noted that climate-related information regarding Scope 3 emissions may be required if contemplated as material.
