This article expands on a related one in Trends’ July/August 2022 issue.
The March 21, 2022, U.S. Securities and Exchange Commission (SEC) proposed rule sets greenhouse gas (GHG) emissions disclosure requirements for registered companies. This agency action reflects a paradigm shift in the investment world; increasingly, banks and pension funds are concerned about the impacts of climate change on a company’s bottom line. The proposed rule responds to this demand for comparable, accurate, and reliable information about registrant’s climate risks by enhancing and standardizing climate-related disclosures.
The proposed rule would require a registrant to make disclosures about its scope 1, 2, and 3 GHG emissions. Scope 1 emissions are a company’s direct GHG emissions. Scope 2 emissions are indirect emissions from purchased electricity or other forms of energy. Scope 3 emissions encompass upstream and downstream activities in a company’s value chain.
Scope 1 and 2 emissions are fairly straightforward. A company has ready access to data regarding its direct and indirect emissions. But estimating scope 3 emissions poses more difficulties. Few registrants have a detailed understanding of emissions in their supply chains, making it difficult to report on scope 3 emissions accurately or at all.
Nonetheless, scope 3 emissions are necessary to paint a complete picture of a registrant’s GHG emissions. According to Deloitte, for many businesses, scope 3 emissions account for more than 70 percent of their carbon footprint. Without disclosing its scope 3 emissions, a registrant could appear stable despite a changing climate, when in fact the firm is facing serious climate risks with negative financial consequences.
The proposed rule attempts to make emissions reporting more feasible. First, the reporting requirements would not be enforced for several years down the line, to provide reporting companies time to consider their approach to compliance.
Second, the SEC does not mandate conformance with the GHG Protocol, comprehensive global standardized frameworks to measure and manage GHG emissions. Instead, the proposed rule allows a company to choose the reporting methodology that makes the most sense for its portfolio and financing activities. But while this is beneficial to reporting companies, it is not ideal for investors. By not mandating a specific protocol, the lack of uniformity in reporting will make it difficult for investors to make accurate determinations and comparisons of companies’ GHG emission data as part of their investment decisions.
The delay in effective date and the flexibility in methodology are examples of the SEC trying to make reporting more feasible. There is an additional layer of feasibility by way of industry guidance. The SEC’s reporting requirements are not novel ideas. Industry professionals have spent years developing climate frameworks and guidance that are readily useable, which helps companies immensely.
The GHG reporting requirements vary depending on the type of registered company. Scope 1 and 2 disclosure requirements would be applicable to registered companies with the SEC. Companies that exceed revenue and public float limits set by law would have to secure assurances from third parties that their reporting is accurate.
The proposed rule exempts “smaller reporting companies” (SRCs) from scope 3 emissions disclosures, to lessen their reporting burden. SRCs must meet specific investor and revenue requirements to qualify.
Private companies are exempt from the proposed rule altogether. This exemption may encourage some larger companies to forego going public to avoid the reporting requirements of scope 3 emissions. It could also encourage reporting companies and firms to hide their emissions in private markets. That said, GHG emissions data of some private companies would be revealed when public companies have private companies in their supply chain. Further, businesses and firms might change suppliers or disengage from certain clients due to the effect that they have on the firm’s Scope 3 emissions. This could create indirect pressure on private firms to control their emissions.
The proposed rule would require disclosure of scope 3 emissions for qualifying registrants in two scenarios. The first scenario is if reporting scope 3 GHG emissions is material. A disclosure is considered material if it would assist a reasonable investor in making an investment decision. Considering that investors have been requesting accurate, reliable, and comparable climate risks disclosures for some time, scope 3 emissions are considered material across most industries. At the same time, the materiality requirement gives the reporting requirements flexibility to adapt should scope 3 emissions no longer be material to a company in the future.
The second scenario is if the registrant has set GHG emissions targets or goals that include scope 3 emissions. This scenario has the potential to prevent companies from setting targets altogether so as to avoid reporting requirements.
The proposed rules would provide a safe harbor for liability from scope 3 emissions disclosure if companies’ estimates are wrong. This limitation on liability deems a scope 3 disclosure fraudulent only if it was made without a reasonable basis or disclosed other than in good faith.
Reporting companies are permitted to use industry averages and other data to estimate supplier emissions, rather than obtain real data from each supplier. This allowance is beneficial to reporting companies because it makes an already extensive reporting regime somewhat less intensive. By relying on industry averages, registrants can avoid the difficult task of gathering the emissions data throughout the supply chain. On the other hand, this safe harbor also significantly reduces the motivation to seek precise data, which will leave investors wondering if the information is accurate.
The SEC’s proposed rule attempts to protect investors by ensuring they have access to a registrant’s climate-related risks that are reasonably likely to have a material impact on its business, results of operations, or financial condition. The GHG emission reporting requirements balances the competing interests of the reporting companies and investors—that being the burden of reporting and the need for information. There has been robust public comment on the proposed rule from many stakeholders. The final rule will yield legal and practical challenges. However, industry professionals, investors, registered companies, and other stakeholders have been carving out the practice of climate-related disclosures for years, which will cushion the transition.
