Today’s investors are eager to understand the climate-related risks of their business investments, not just because they are becoming more climate-conscious but also because climate-related risk can bring financial risk. A newly proposed rule in the US aims to bring more transparency to those risks.
In March, the US Securities and Exchange Commission (SEC) published a landmark proposal to enhance and standardize climate-related risk disclosures. The proposed rule—approved by a 3-to-1 vote—would require public companies to report their climate-related impacts to shareholders and the federal government.
If adopted, this would be a dramatic regulatory change in the governance of climate-related financial disclosure in the United States. Furthermore, the proposed rule could bolster the Biden Administration’s energy and climate agenda. It is likely, however, that the rule will face numerous legal challenges.
Details of the proposed rule
The proposed rule aims to give investors consistent, comparable and decision-useful information about the risks companies face from climate change. Climate-related risks, including flooding, droughts, extreme temperatures, wildfires, and sea-level rise are on the rise.
Accurate and timely disclosure of these risks is essential for financial markets to correctly price them to support informed and efficient capital-allocation decisions.
Over a longer horizon, unplanned economic transitions could result in stranded assets – equipment or resources that no longer provide value – thereby posing significant implications for the firm’s business strategies.
Since climate change is an all-encompassing challenge, investors may be concerned about businesses with high greenhouse gas emissions in their portfolios, which could lead to stranded asset risks.
Assets become stranded primarily due to sudden changes in policies or laws (regulation stranding), changes that make it difficult to extract a resource due to an increase in distance or other climate-related factors (physical stranding). A change in relative costs and prices of an asset or resource (economic stranding) could also be a factor.
Investors can recognize the impairment of these stranded assets on the balance sheet as a loss of profit because of these disclosures.
What should domestic and foreign public companies do to meet the proposed regulatory requirements? There are eight key provisions of the proposed disclosures:
Scope 1, 2 and 3 greenhouse gas emissions metrics
The proposed rule would require registrants to disclose greenhouse gas emissions in SEC filings. Scope 1 emissions result from operations owned or controlled by a registrant. Emissions allotted to Scope 2 refer to electricity acquired and other sources of energy consumed by operations owned or controlled by registrants. Emissions assigned to Scope 3 pertain to upstream and downstream activities of registrants.
Scope 1 and 2 emissions affect valuation through earnings, cost of capital, and investor demand regardless of whether they are considered material. Companies should disclose Scope 3 emissions if they are material or if the company has a set greenhouse gas emissions reduction target related to Scope 3 emissions.
Climate-related financial metrics
Public companies would disclose information related to the impact of climate-related events. The registrant must disclose severe weather events, other natural conditions, and physical risks on consolidated financial and business statements if the disclosure threshold is met.
Categories of the impacts could include information about the impacts of climate change on financial performance, financial expenditure and any financial assumptions used.
Risk management disclosure
Registrants would be required to describe risk management processes that identify, assess and manage climate-related risks. Materiality of the risks, current and likely future impacts of regulatory actions and how climate-related factors are integrated into the registrants' risk management systems or processes.
TCFD-based disclosure framework
To mitigate the compliance burden for issuers and any burdens faced by investors in analyzing and comparing the disclosure requirements, the proposed rule draws heavily from the disclosure framework from Task Force on Climate-Related Financial Disclosures (TCFD). Many investors and issuers are already familiar with the TCFD framework due to its global use.
As a result, aligning SEC rules with the TCFD ensures consistency and comparability of climate disclosures. Greater consistency in emissions disclosures in jurisdictions around the world would promote transparency, a better understanding of the overall risk of portfolios and higher levels of compliance globally.
Climate-related risks on strategy, business model and outlook
This means requiring registrants to disclose the impacts, or likely impacts of the identified climate-related risks (and climate-related opportunities if the registrant elects to do so). This includes transition risks, material impacts, carbon offsets or renewable energy credits (RECs), maintained internal carbon price, or scenario analysis of the company's strategy, business model and outlook.
For example, requiring registrants to disclose the impacts of climate-related risks on business operations, products or services, supply chain or value chain, activities to mitigate or adapt to climate-related risks and expenditures for research and development.
This means requiring registrants to disclose information concerning the board's oversight of climate-related risks and management's role in assessing and managing those risks. This includes, for instance, disclosure of whether any member of its board of directors has expertise in climate-related matters.
Climate-related targets or goals
Registrants must demonstrate how the targets or goals will be achieved that are climate-related. These climate-related targets or goals might include the reduction of greenhouse gas emissions, water and energy usage, energy efficiency measures or ecosystem restoration.
The SEC filing disclosure information would include descriptions such as the scope of activities and emissions included in the target, the unit of measurement, the defined time horizon for realizing the set target, the baseline emissions for measuring progress, information on interim targets and how the registrant intends to meet these targets or goals.
Information about the progress toward achieving these targets, including information about how the progress has been made, as well as carbon offsets or renewable energy certificates that were applied to help reach the targets would be included.
Registrant's transition plan
Registrants must provide information regarding their transition plans, including their strategy and implementation plan for mitigating climate-related risks. Investors often rely on these transition plans to assess if the firm's strategy is effective in realizing its climate-related targets or goals in the short, medium and long term.
Transitioning to a lower-carbon economy entails extensive technological, economic, political, policy or legal, spatial, social, and environmental changes.
Registrants who have adopted a transition plan must describe this plan in detail, including the relevant metrics and targets they used to assess and manage physical risks.
Given the available low- and zero-carbon sources of electricity in the energy sector, for instance, including renewable energy, green hydrogen and nuclear power, we can expect varying levels of financial and reputational risks to public companies depending on the nature, speed and spread of these transition factors.
Analytics will be a growing market for assessing climate risk
Going forward, we’ll see greater scrutiny on how companies handle disclosure of climate-related risks while managing business operations and financial conditions.
In more capital-intensive sectors, such as energy, transportation, facilities, infrastructure, agriculture and manufacturing where climate-related asset stranding risk is a growing concern -- the market for advanced solutions, models and tools for assessing and pricing these risks and opportunities is vast.