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The SEC’s proposed climate-related disclosure rules: What fund managers and companies need to know

The US Securities and Exchange Commission has announced that, along with existing financial performance and risk disclosures, public companies will soon be required to disclose information on the risks they face from climate change and how they plan to manage them, as well as how their activities will affect climate change.

These proposed disclosure rules are part of a trend of increased requirements for environmental, social and governance (ESG) disclosures worldwide.

While many businesses have been reporting on one or another aspect of climate risk, there has been little consistency, making it difficult for investors to understand the full picture of climate risks for any given investment and to make comparisons. There has been no specific guidance from the US on what information should be reported, though many institutional investors have been pushing for more consistent reporting on climate risk.

There are many non-mandatory frameworks for reporting on climate-change impact, the most prominent from the Task Force on Climate-related Financial Disclosures (TCFD), the Greenhouse Gas (GHG) Protocol, and the UN’s Principles for Responsible Investment (UNPRI).

The proposed rules and their impact

The biggest ESG developments have resulted from investor pressure rather than regulatory pressure. The key demand from investors is for consistency to support sensible decision making, as well as to minimise the chances of receiving unexpected bad news down the line.

The SEC’s proposed climate-change disclosure rules tend to address these demands.

Climate-related business risks to be disclosed under the proposal come in two main categories. One is physical risk to company facilities and operations from climate-change-caused increases in extreme weather events such as hurricanes or wildfires. The second is transition risk — that is, the risk of changing strategies, financing, and policies, which can vary by industry.

The proposed rules also require disclosure of the company’s own climate impact in terms of greenhouse gas emissions, in three categories. Scope 1 covers a company’s own GHG emissions, and Scope 2 covers emissions from a company’s energy consumption and vehicle use. Scope 3 emissions add those generated by a company’s customers and suppliers.

There will be more flexibility around the significantly more challenging Scope 3 disclosure, depending on materiality or significance, particularly for smaller companies. There will also be a safe harbour provision from liability if estimates were provided in good faith.

The proposed disclosure rules also cover governance of climate-related risks and the processes for managing those risks.

Initial compliance dates will depend on filer size, and will be calculated from the effective date of the rules. If the rules are adopted in December 2022: large accelerated filers (over $700 million in market value) would have their first compliance period in fiscal 2023; accelerated (under $700 million in market value) and nonaccelerated filers (under $75 million in market value) in 2024; and smaller reporting companies in 2025. Scope 3 requirements will phase in later. If adoption is delayed, the compliance periods will be extended.

Likely support and opposition

The comment period on the new rules has been extended to June 17, 2022. There are likely to be significant comments, and lawsuits are also expected. If so, the planned implementation of December 2022 will probably be delayed.

The proposed rules are well-structured and well thought through. They are consistent with existing frameworks globally, being based, in part, on the TCFD and GCP.

Popular sentiment has been turning more in favour of such measures than is generally realised. As mentioned, some form of climate-change reporting has become common, particularly among larger companies, as a result of investor demand. Fund managers have also been demanding more data, and more consistent data, to make the process of comparing companies more straightforward.

Opposition to the proposed disclosure requirements is going to be strong as well, particularly in the business community.

One concern is that companies that have already reduced emissions will find themselves having to do relatively more to achieve smaller improvements, which will lead to disparate effects.

Compliance costs are also a major concern. The SEC itself estimates that the increased compliance costs will average $420,000 a year for a publicly listed small company and $530,000 for a larger company.

Trade groups, including the US Chamber of Commerce, are opposing Scope 3 reporting, citing its complexity and uncertainty.

How to prepare

For companies and fund managers alike, the biggest compliance concern related to the proposed rules is: How can we obtain all the data needed for reporting? No one has needed this much data at this level of granularity before.

There are countless reporting scenarios, and each can present its own complexities. Owners of a modern smart green building, for example, will be able to obtain detailed energy usage data, but they may not be able to obtain similar data from older buildings. Furthermore, corporations often have multiple buildings in various jurisdictions, owned or leased under a variety of contracts. Sometimes their energy usage is concealed within overall contract fees and is not reported separately.

Companies and fund managers should not underestimate the amount of effort required to ensure that reporting data is consistently available at the necessary level of detail. There will be audit trail requirements, and reporting will be intensely scrutinised.

Most businesses are undergoing what might be called a data quality transition, from poor and inconsistently acquired data to high-quality data generated through defined processes. Once acquired and standardized, this data can be useful for other purposes, and become a business asset. For example, the difficulties of Scope 3 will decrease over time as customers and suppliers also begin disclosing their emissions and energy usage.

Beyond the data, companies and fund managers will need to review internal policies and processes and perform gap analyses. For example, Scope 3 will require a reconsideration of procurement policies and processes related to all suppliers. How are the suppliers chosen? What ESG criteria are considered and how are they verified?

Companies, fund administrators and investors generally share a desire for global uniformity in ESG reporting requirements. As with efforts to implement a global minimum corporate tax, it’s unlikely that we’ll have consistent ESG reporting requirements across jurisdictions any time soon. Until we do reach a consensus, companies and fund administrators must keep abreast of and understand proposals such as the SEC’s, implement policies, procedures and systems that will allow them to obtain the requisite data, and remain nimble in the face of inevitable change.

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