On March 21, 2022, the US Securities and Exchange Commission (SEC or Commission) proposed new rules that would require domestic and foreign registrants to provide climate-related disclosures in their registration statements and annual reports (the Proposed Rules). The Proposed Rules would require registrants to disclose:
- Disclose detailed information about their handling of climate change issues, including climate-related governance, strategy, risk management and metrics and goals;
- Measure and disclose greenhouse gas (GHG) emissions in accordance with the GHG Protocol methodology, the most widely known and used international standard for calculating GHG emissions;
- Larger registrants would be required to provide data regarding their direct GHG emissions (Scope 1) and indirect GHG emissions from purchased electricity and other forms of energy (Scope 2) attested to by independent “GHG emissions attestation providers”;
- Larger registrants would be required to disclose data regarding their Scope 3 emissions (factoring in the emissions of their suppliers and customers who use the products) if material to them, or if they have set a GHG emissions reduction target or goal that includes its Scope 3 emissions, subject to a safe harbor;
- Add a note to their financial statements that provides disaggregated metrics and related disclosure concerning climate-related impacts included in line items of the financial statements required under existing financial statement requirements.
There is now a public comment period, which will remain open for 30 days after publication in the Federal Register, or until May 20, 2022, whichever period is longer. The SEC will then consider those comments and determine whether to modify any portions of the Proposed Rules before voting to make them effective.
The Proposed Rules are intended to provide climate-related disclosures akin to the Management Discussion and Analysis (MD&A) that companies already provide in their securities filings. According to SEC Chair Gary Gensler, the Proposed Rules will "provide investors with consistent, comparable, and decision-useful information for making … investment decisions, and it would provide consistent and clear reporting obligations for issuers." Nevertheless, if adopted, the Proposed Rules are likely to be challenged in court. This alert provides our perspective on the impact of the Proposed Rules followed by a detailed summary.
Implications and key takeaways
1. Adopt practices to reduce litigation and enforcement risks
Companies should adopt practices to reduce their litigation and enforcement risks, including:
- Review and hone reporting processes to the board. Companies may benefit from separating climate and carbon related reporting to the board into separate, standalone sessions to ensure the board is giving climate-related matters appropriate focus. One observation we have noticed in multiple controls tests and regulatory inquiries is a perceived inadequacy of board focus on climate matters when these matters are included in larger discussions, particularly discussions on financial risks where compliance matters are kept at a high level and placed near the end of the discussion.
- Develop internal controls for climate-related disclosures. Companies should develop internal controls, similar to controls over financial reporting, to ensure that climate-related statements are supported by facts and data. Companies should designate who is authorized to speak on climate-related matters and develop processes to ensure climate-related statements are consistent across the company's reporting to regulators and stakeholders. Companies should ensure internal carbon prices are supported and consistent.
- Specifically tailor disclaimers to climate-related risks. Companies should consider the specific climate-related risks applicable to their particular circumstances and prepare individualized and detailed cautionary statements tailored to those risks. Cautionary language should be reviewed and updated regularly, warn of specific risks and discuss actual developments relevant to those risks.
- Integrate legal review into formerly technical functions. Since the selection of methodologies and mechanisms to assess climate risk and materiality might be subject to legal scrutiny, companies may want to consider including legal review in addition to technical adequacy.
2. Effects on Non-Reporting Companies
Even before the SEC proposed these new climate-related disclosure rules, stakeholders were pressuring companies to disclose their climate-related risks and goals. For example, to attract investment from individuals and organizations concerned with the financial effects of climate-related risks, many companies were already responding to ESG ratings agency questionnaires and making climate-related disclosures under various frameworks—like the Task Force on Climate-Related Disclosures and the Global Reporting Initiative. If adopted, the Proposed Rules may increase investors' expectations about what climate-related information they require to make investment decisions. Thus, non-reporting companies should consider to what extent similar disclosures may make them attractive to investors, and balance that consideration against the associated costs of implementation and risks created by disclosure.
3. Disclosure of newly-material risks
Although the Proposed Rules would be new if adopted, the SEC's 2010 Guidance already identified examples of situations in which climate-related risks could be material and subject to disclosure, and the SEC states that the materiality determination for climate-related risks would be similar to that already required for the MD&A section in a registration statement or annual report. Therefore, when disclosing existing risks for the first time, reporting companies should be prepared to justify why the risk was not previously disclosed. The Proposed Rules themselves, other climate-focused legislation and regulation, developments in climate science, changing factors within the reporting company's organization, and the passage of time may all support a company's determination that an existing risk has crossed the materiality threshold, as opposed to suggesting that the company should have identified the risk earlier.
4. Consistency of SEC disclosures and other public statements
Public statements about a company's climate-related performance can also lead to litigation under a variety of state laws if stakeholders perceive those statements as misleading, and SEC disclosures are no exception. In many pending greenwashing cases brought under state laws, the plaintiffs complain of statements made in SEC filings. Companies should prepare for the possibility that potential plaintiffs will compare statements in climate-related disclosures to other public statements, seeking inconsistencies. Reporting accurately, clearly defining terms of art internally, and fostering cross-team collaboration can help reduce the risk that other public statements would appear inconsistent with climate-related SEC disclosures.
5. Limitations of safe harbor for Scope 3 emissions disclosures
While the safe harbor for Scope 3 emissions disclosures would reduce a reporting company's risk of potential liability for misstatements, it does not eliminate that risk. The safe harbor does not apply if it is shown that a statement was made without a reasonable basis or was disclosed other than in good faith, both of which can potentially create fact-based inquiries unlikely to be resolved early in a lawsuit through motion practice. The safe harbor also does not explicitly limit liability for claims under state laws. Nonetheless, defendants are likely to argue that the safe harbor and lack of attestation for Scope 3 emissions disclosures should be considered when assessing the legal elements of claims, like whether a plaintiff's reliance on Scope 3 emissions disclosures was reasonable. These issues will likely be taken up by the courts if plaintiffs seek to impose liability on any reporting companies for alleged misstatements in their Scope 3 emissions disclosures.
Summary of Proposed Rules
1. Who would be subject to the Proposed Rules?
The Proposed Rules would apply to any domestic or foreign issuer that: (1) files a registration statement under the Securities Act (Forms S-1, F-1, S-3, F-3, S-4, F-4, and S-11); (2) files a registration statement under the Exchange Act (Forms 10 and 20-F); or (3) files an annual report on Forms 10-K or 20-F (Reporting Company).
2. What would Reporting Companies be required to disclose?
The Proposed Rules would require Reporting Companies to disclose:
- The impact of any identified climate-related risks on the Reporting Company's business and consolidated financial statements.
Under the Proposed Rules, Reporting Companies would be required to disclose any climate-related risks that have had, or are reasonably likely to have a material impact on the Reporting Company's business or consolidated financial statements over the short, medium, and long term. The Proposed Rules define "climate-related risk" as both physical and transitional risks. Physical risks include acute risks (event-driven risks in the short term, like extreme weather events) and chronic risks (those related to longer term changes in climate, like susceptibility to drought or rising sea levels). Transition risks are those related to transitioning to a lower carbon economy, like compliance costs or changing consumer preferences.
The Proposed Rules would require Reporting Companies to disclose: (1) whether a climate-related risk is physical or transitional; (2) whether a physical risk is acute or chronic; (3) the location (zip code) of the properties, processes, or operations subject to an identified physical risk if the Reporting Company determines the risk has or will likely have a material impact on its business or consolidated financial statements; (4) the nature of transition risks and how those factors impact the Reporting Company; (5) the time horizon of how the identified risks will affect the Reporting Company, particularly with respect to the risk's magnitude and probability; (6) how the Reporting Company defines its short, medium, and long term horizons; (7) how the Reporting Company assesses the materiality of the risks in the short, medium, and long term; and (8) the Reporting Company's plans to address the identified climate-related risks.
- How any identified climate-related risks have affected or are likely to affect the Reporting Company's strategy, business model, and outlook.
The Proposed Rules would require a description of the actual and potential impacts of identified material climate-related risks on the Reporting Company's strategy, business model, or outlook. This description would include an explanation of the impacts on the Reporting Company's:
- Business operations, such as with respect to 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 and processes;
- Expenditure for research and development; and
- Any other significant changes or impacts.
The Proposed Rules would require Reporting Companies to disclose the time horizon for each impact (short, medium, or long term). The SEC acknowledged that the Proposed Rules are intended to provide climate-related disclosures akin to the MD&A.
Reporting Companies would also have to disclose and explain how the following affect the Reporting Company's strategy, business model, and outlook: (a) carbon offsets or renewable energy credits, if used; (b) any maintained internal carbon prices; and (c) any scenario analyses used. The Proposed Rules recognize that forward-looking climate disclosures are not guarantees, and that certain forward-looking statements would be protected by the Private Securities Litigation Reform Act (PSLRA) safe harbor (presuming all requirements are met).
- Oversight and governance of climate-related risks.
The Proposed Rules would require Reporting Companies to provide detailed insight into the processes and methods by which their boards of directors consider climate-related risks, such as through a separate committee or an existing committee, and biographical information as to the relevant expertise and qualifications of board and committee members. The SEC's goal is to help investors understand whether and how the board considers climate-related risks as part of its overall corporate strategy, risk management, and financial oversight responsibilities. For example, Reporting Companies may discuss how the board or committee considers climate-related risks when reviewing and guiding business strategy, when setting and monitoring risk management policies and performance objectives, when reviewing and approving annual budgets, and/or when overseeing major expenditures, acquisitions, and divestitures. The Proposed Rules would further require disclosures of any climate-related targets or goals set by the board, and mechanisms for overseeing the company's progress against such targets or goals.
Similarly, the Proposed Rules would require Reporting Companies to disclose, as applicable, the management positions and committees responsible for assessing and managing climate-related risks, and detailed relevant expertise of the individuals involved. Reporting Companies would also need to disclose the processes by which such responsible management persons or committees become informed about and then monitor climate-related risks, and how often such persons or committees then report to the board on these risks. Together, the Commission intends for these proposed disclosure requirements to aid investors in evaluating whether management has created and implemented adequate processes to identify, assess, and manage climate-related risks on a comparable basis across Reporting Companies.
- The Reporting Company's processes for identifying, assessing, and managing climate-related risks and whether any such processes are integrated into the Reporting Company's overall risk management system or processes.
The Proposed Rules require disclosures regarding internal processes for identifying, assessing, and managing climate-related risks, including whether and to what degree such processes are integrated into the Reporting Company's overall risk management processes. These disclosures include discussion of how the Reporting Company considers and factors regulatory and market developments related to climate and transition risks, and how the Reporting Company determines the relative significance of such climate-related risks against other risks it faces.
In the Proposed Rules, the Commission emphasizes the importance of a transition plan detailing the Reporting Company's strategy and implementation plan to reduce climate-related risks, factors that Reporting Companies consider when creating and maintaining such plans, and plans for achieving any available climate-related opportunities. The Proposed Rules, however, stop short of requiring Reporting Companies to adopt such transition plans. For Reporting Companies that adopt transition plans, the Proposed Rules would require disclosures of any internal targets or metrics used therein, as well as discussion of any measures taken to address any applicable climate-related physical risks (i.e., rising sea levels or extreme weather events) or transition risks (i.e., regulatory developments such as GHG regulation and carbon prices). The Proposed Rules would require Reporting Companies to update their transition plan disclosures each fiscal year by describing the actions taken during the reporting period to achieve the plan's targets or goals.
- The impact of climate-related events and transition activities on the line items of a Reporting Company's consolidated financial statements and expenditures, and disclosure of financial estimates and assumptions impacted by such climate-related events and transition activities.
The Proposed Rules require Reporting Companies to include certain climate-related financial statement metrics and related disclosures in a note to their audited financial statements. These disclosures would include the financial impacts of climate-related events and risks, as well as transition activities, on the consolidated financial statements. Reporting Companies would be required to disclose when the aggregated impact of climate-related events, risks, or transition activities exceeds 1% of the total line item for the relevant fiscal year.
- Scopes 1 and 2 GHG emissions.
All Reporting Companies would be required to disclose their Scope 1 and Scope 2 GHG emissions, separately, after calculating them from all sources that are included in the Reporting Company's organizational and operational boundaries. Scopes 1 and 2 GHG emissions are those that result directly or indirectly from facilities owned or activities controlled by the Reporting Company. The Proposed Rules would further require Reporting Companies to disclose their Scopes 1 and 2 GHG emissions in the aggregate, as well as disaggregated by each GHG.
Under the Proposed Rules, Reporting Companies would be required to disclose the sum of Scopes 1 and 2 GHG emissions in terms of GHG intensity — a ratio that expresses the impact of GHG emissions per unit of economic value or production. Moreover, the Proposed Rules would require Reporting Companies to describe the methodology, significant inputs, and significant assumptions used to calculate GHG emission metrics. The Proposed Rules would allow (1) reasonable estimates, so long as the Reporting Company describes the assumptions and reasons for using estimates; and (2) reasonable estimates for fourth quarter GHG emissions, so long as the Reporting Company subsequently discloses any material difference from actual emissions in a timely manner. Reporting Companies would also be required to disclose (1) the use of any third-party data, including the source and the process used to obtain and asses the data; (2) any material changes to the Reporting Company's reporting methodology or assumptions underlying disclosures in previous fiscal years; and (3) any gaps in data required to calculate GHG emissions.
The Proposed Rules would require Reporting Companies to disclose Scope 3 GHG emissions only if those emissions are material, or if the Reporting Company has set a GHG emissions reduction target or goal that includes its Scope 3 emissions. If a Reporting Company is required to disclose Scope 3 emissions, the Reporting Company must make the same disclosures for Scope 3 as for Scopes 1 and 2. The Proposed Rules would require several additional disclosures related to Scope 3 emissions. First, when determining whether Scope 3 emissions are material and when disclosing them, in addition to emissions from activities in the Reporting Company's value chain, Reporting Companies would be required to include GHG from any outsourced activities previously conducted as part of its own operations, as reflected in its consolidated financial statements. Second, the Proposed Rules would require Reporting Companies to describe any overlap in categories of activities that produce Scope 3 emissions. The Proposed Rules would allow Reporting Companies to estimate Scope 3 emissions as a range, so long as the Reporting Company discloses its reasons for using the range and the underlying assumptions.
3. How and when would Reporting Companies disclose?
The Proposed Rules would require Reporting Companies to make the required disclosures through the searchable, online EDGAR system. Disclosures (unless on Form 6-K) would be deemed filed with, not furnished to, the Commission, thereby subjecting climate-related disclosures to Section 18 liability, which extends to any person who makes or causes to be made any false or misleading statement of material fact required to be filed under the Exchange Act. Reporting Companies would be required to electronically tag climate-related disclosures in the Inline eXtensible Business Reporting Language (Inline XBRL) format.
The Proposed Rules would add a new subpart to Regulation S-K (Subpart 1500) that would require Reporting Companies to provide the required climate disclosures in a separately captioned "Climate-Related Disclosure" section in their registration statements and annual reports.
The Proposed Rules would add a new article to Regulation S-X (Article 14) that would require Reporting Companies to include the climate-related financial statement metrics and related disclosures in the Reporting Company's audited financial statements.
4. Attestation for Scope 1 and Scope 2 emissions disclosure
The Proposed Rules would require a Reporting Company—if it is an accelerated filer or large accelerated filer—to include in the relevant filing an attestation report covering the disclosure of its Scope 1 and Scope 2 emissions and to provide certain related disclosures about the attestation service provider. The attestation requirement would go into effect in the second fiscal year following the Reporting Company's Scope 1 and Scope 2 emissions disclosure compliance date. For fiscal years two and three, the attestation assurance would be limited assurance; for fiscal years four and beyond, the attestation assurance would be reasonable assurance. The Proposed Rules state that limited assurance "is equivalent to the level of assurance (commonly referred to as a 'review') provided over a registrant's interim financial statements included in a Form 10-Q." On the other hand, reasonable assurance "is equivalent to the level of assurance provided in an audit of a registrant's consolidated financial statements included in a Form 10-K."
The Proposed Rules set forth certain requirements for the attestation provider, including that the provider be independent from the Reporting Company and any of its affiliates. The attestation report would be required to be provided pursuant to public standards set by organizations like the Public Company Accounting Oversight Board (PCAOB), American Institute of Certified Public Accountants (AICPA), or International Auditing and Assurance Standards Board (IAASB). The Proposed Rules set forth minimum components for GHG emissions attestation reports, which the SEC derived from AICPA's attestation standards.
Finally, aside from accelerated and large accelerated filers, the Proposed Rules would require any other Reporting Company that obtains third-party attestation or verification of its GHG emissions to disclose that information as well.
5. Phase-in periods and accommodations for proposed disclosures
The Proposed Rules would require a Reporting Company to make the required climate-related disclosures, including Scope 1 and Scope 2 GHG emissions metrics, for the first full fiscal year following the Proposed Rules becoming effective. As an example, were the Proposed Rules to be adopted and become effective in December 2022, a Reporting Company with a December 31st fiscal year-end would be required to make the required disclosures for fiscal year 2023.
In an effort to reduce the compliance burden on Reporting Companies, the Proposed Rules provide an additional phase-in period for Reporting Companies required to disclose Scope 3 GHG emissions and provide certain other accommodations:
- Additional one-year phase-in period for Reporting Companies required to disclose Scope 3 GHG emissions.
The Proposed Rules provide Reporting Companies an additional year to comply initially with the Scope 3 disclosure requirement beyond the compliance date for the other proposed rules.
- Safe harbor for Scope 3 GHG emissions disclosures.
The Proposed Rules would provide a safe harbor for Scope 3 GHG emission disclosures to alleviate concerns that Reporting Companies have regarding liability derived largely from third parties in the value chain. The safe harbor would provide that disclosure of Scope 3 emissions by or on behalf of a Reporting Company would not be deemed a fraudulent statement unless it is shown that such statement was made or reaffirmed without a reasonable basis or was disclosed other than in good faith. The safe harbor would extend to any statement regarding Scope 3 emissions disclosed pursuant to the Proposed Rules and made in a SEC filing. It is not clear from the Proposed Rules what constitutes a reasonable basis or good faith. In a dissenting statement, Commissioner Hester Peirce criticized the Proposed Rule on this point, asking "[h]ow is a company to determine which particular climate model or set of estimates constitutes a 'reasonable basis' when different models and estimations lead to substantially different results?"
- Exemption from Scope 3 GHG emissions disclosure requirements for smaller reporting companies.
The Proposed Rules would exempt smaller reporting companies from the proposed Scope 3 emissions disclosure requirements.
- PSLRA safe harbor would continue to apply to eligible forward-looking statements.
The PSLRA safe harbor would continue to apply to eligible forward-looking statements, so long as all requirements are met. Notably, the PSLRA safe harbor would not apply to all climate-related disclosures because the Proposed Rules would require some disclosures in registration statements and consolidated financial statements, to which the PSLRA safe harbor does not apply.
The Proposed Rules constitute a massive new effort by the SEC to mandate standardized climate change disclosures. We will continue to monitor the Proposed Rules as they progress through the public comment and approval process for important updates.
A special thanks to law clerks Kelly Lin, Stephanie Metherall, and Mikkaela Salamatin for their assistance provided in preparing this update.