Many board members were taken aback by the range and sweep of the landmark SEC proposal regarding disclosure of climate-related information, formally called “The Enhancement and Standardization of Climate-Related Disclosures for Investors.” Others were downright insulted. As longtime energy executive Bill Dozier, a member of the board at oil and gas company Evolution Petroleum, put it, “It comes across like an ‘awakening,’ as if nobody has been doing anything over the years to reduce their greenhouse gas emissions. The progress attained to date appears to have been dismissed in a concerted effort by the current administration to appease investors.”
Published on March 21, the rule-making package is long and dense, intermittently difficult to interpret and jam-packed with daunting oversight and governance responsibilities. “I found all of it to be extremely complicated from a compliance and implementation standpoint,” says Sheila Hooda, who serves on multiple public company boards. Among these complications were the proposal’s “oversight and governance requirements, the metrics defining greenhouse gas emissions and the need to assess materiality and establish targets and goals and how you will reach them,” she says.
In statements announcing the proposal, SEC Chairman Gary Gensler has said the agency is helping investors make more informed judgments about climate-related information in their investment decision-making, standardizing the climate-related disclosures voluntarily provided by many public companies, thereby, the SEC’s thinking goes, offering greater consistency in assessing companies on more of a carbon-to-carbon basis. “We are concerned that the existing disclosures of climate-related risks do not adequately protect investors,” the SEC said in announcing the proposal publicly.
Significant criticisms of the proposal were leveled from the minute it became public, including attacks on the length of the phase-in period for compliance, the granularity of greenhouse gas (GHG) emission disclosures, the timing for filing the disclosures, the prescriptive nature of the disclosures relating to strategy and business models, and the disclosures around board oversight and qualifications, among others. “My sense is that the SEC went too far on purpose, knowing it would need to pull back,” says Michael Littenberg, partner and global head of ESG and human rights practice at law firm Ropes & Gray. “I have no doubt that there will be legal challenges, given the dissent made by SEC Commissioner Hester M. Peirce.”
Peirce’s dissenting statement, a detailed and sharply worded rebuttal, consumed more than 6,300 words and included 74 footnotes. She maintains that the SEC lacks the authority to propose climate-related rules and asserts that the proposal will not lead to comparable, consistent and reliable disclosures, ultimately hurting investors, the economy and the SEC itself.
Nonetheless, expect an amended SEC proposal to be adopted and implemented, says David M. Silk, a partner at securities law firm Wachtell, Lipton, Rosen & Katz. “It is never too early for board members to prepare how they will respond to the rules. There is significant work to be done.”
What’s actually In there?
The proposal—nearly 500 pages of it—was the subject of a public comment period through June 17, at which point the SEC will take these comments into consideration before adopting a final rulemaking, likely to be implemented in 2023 or 2024.
In its present form, it would require registrants to disclose information about their GHG emissions, indirect emissions from purchased electricity or other forms of energy and indirect GHG emissions from upstream and downstream activities in their value chain, if they present material risk. The three disclosure requirements are referred to as Scope 1, Scope 2 and Scope 3.
The proposed rules stiffen board member oversight responsibilities, adding a new Subpart 1500 to Regulation S-K that includes Item 1501, which addresses board governance. Item 1501(a) would require board oversight of climate-related risks. Additionally, the names of board members and specific board committees responsible for this oversight must be disclosed, and boards must identify members with expertise in climate-related risks and describe the nature of their expertise.
Other board-related items include disclosure of the processes and frequency by which members or committees discuss climate-related risks and how they consider these exposures in relation to the registrant’s business strategy, risk management and financial oversight. Disclosure about whether and how the board sets climate-related targets or goals and how members oversee progress toward achieving these aims also would be required.
The changes are substantial—and sobering. “If adopted as proposed, the SEC would require detailed and extensive disclosures by registrants,” says Littenberg. “That said, the final rules are likely to differ from the current proposal, perhaps substantially.”
Shock and Awe
EY had long been informing directors of what to expect, but the disclosures “were broader than what we’d anticipated, a bit overwhelming and vast,” says Kris Pederson, leader of the EY Americas Center for Board Matters. “The SEC is calling out specifically for the board to be engaged on this subject more than I’ve ever seen before with any other subject,” she says. “They’re holding board members responsible for the oversight and governance of climate-related risks and related financial impact. It’s a rather daunting prospect.”
Carolyn Frantz, senior counsel and co-head of the public companies and ESG practice at law firm Orrick, Herrington & Sutcliffe, says what she found interesting in the proposal is the SEC’s “prescriptive approach to the disclosures, which depart somewhat from materiality principles.”
Commissioner Peirce has a similar objection, stating that some of the proposed disclosures “apply to all companies without a materiality qualifier, and others are governed by an expansive recasting of the materiality standard.” Both approaches “depart from the generally applicable, time-tested materiality constraint on required disclosures.”
Frantz is concerned the proposal will result in a form-over-substance exercise for management and the board, “where everybody feels they need to hit some minimum expectation, such as the number of minutes devoted by directors to discussing climate change,” she says. “A board that is doing a good job overseeing climate issues at present may feel compelled by the proposal to change its processes and procedures for the worse.”
She provided the example of a board of a company in a particular industry sector with a thoughtfully assembled standing committee of members who bring in relevant climate experts to discuss climate change as it specifically affects that company and industry. “Reading the SEC proposal, they may change their existing governance methods to meet what they expect other companies’ disclosures will look like, maybe adding a director or making climate a less in-depth topic at a larger number of meetings, or even elevating the issue to the full board, which may result in inferior governance of climate issues,” she says.
Investors are generally bullish about the SEC’s proposal, according to proxy advisory firms Glass Lewis and ISS. “I’m still trying to read the room, but at recent annual meetings, the vast majority of investors are pretty happy about [the proposal],” says Courteney Keatinge, director of ESG at Glass Lewis. “It brings us to par with countries in Europe and elsewhere that have far more consistency around the disclosures.”
Nevertheless, Keatinge and Marija Kramer, head of ISS Corporate Solutions, have concerns over the proposal’s Scope 3 disclosures. For many companies, the bulk of their GHG emissions emanate from upstream activities. According to CDP Worldwide, supply chain emissions are more than five times greater than operational emissions, on average.
“It’s hard enough to set science-based targets for your own operations, much less disclose the emissions produced across the value chain,” says Keatinge. “Every company I talk with has challenges with respect to this issue, and I can understand why—it’s incredibly complex, with a lot of factors to consider. No one has come up with a reliable way to manage and mitigate these emissions.”
“It’s definitely the headline issue for boards,” says Kramer. “Our data indicates that 16 percent of the S&P 500 are not reporting on any emissions whatsoever, and more than 60 percent are not reporting in depth.”
Understanding these challenges, the SEC has provided a limited safe harbor from liability for Scope 3 disclosures, assuming they are not fraudulent, and an additional phase-in period for compliance. “The proposal gives some leeway on the timing for Scope 3 reporting, but you can’t kick the can down the road indefinitely,” Kramer says. “Boards need to speak with management about their plans and strategies to comply with all three scopes, with particular focus on Scope 3.”
In these discussions, Pederson advises that board members focus on materiality—whether a supplier’s climate-related risk is reasonably likely to have a material impact on the company’s business or consolidated financial statements over the short-, medium- and long-term. “What will be at risk for the business if there is a terrible situation in the supply chain and products are unavailable, creating serious revenue and cash flow problems?” she says. “That’s a good start to get at materiality.”
Companies also need to heed the impact of so-called transition risks—what the business is doing to manage the risks caused by a world transitioning to a greener economy. For example, regulations curbing GHG emissions can result in significant financial ramifications and operational challenges for companies operating in highly emitting industries. “Depending on the industry or sector, the transition risks can cause adverse changes in asset values or a higher cost of doing business,” says Keatinge.
To hit the ground running, Littenberg advises management and the board to integrate the Task Force on Climate Financial Disclosure (TCFD) framework and the GHG Protocol standards into their climate-related oversight, management, processes and reporting. TCFD has developed a set of voluntary climate-related financial risk disclosures. The GHG Protocol comprises a set of standardized global frameworks to measure GHG emissions from company operations and value chains, the latter an important step toward addressing the proposed Scope 3 disclosures.
Silk agrees the TCFD framework is a good start toward compliance with the SEC’s proposal (he also touts the value of the SASB reporting framework). In late-March, the SASB unveiled two proposed standards, one pertaining to general sustainability disclosures and the other involving climate-specific sustainability disclosures.
Kramer agrees as well. “Boards interested in learning about climate-related disclosures in their specific industry sector should review the SASB framework, which provides industry-specific overlays for disclosing financially material climate sustainability information to investors,” she says, adding that markets appear to be coalescing around TCFD, SASB and International Sustainability Standards Board (ISSB), another set of standards involving sustainability disclosures to investors.
Board Composition and Skills
Since the SEC’s proposed rules would require registrants to disclose board governance items like the specific board members and committees responsible for climate-related oversight, members need to turn the spotlight inward. The proposal suggests an existing standing committee like the audit or risk committee might fill this role; a separate committee focused exclusively on climate-related disclosures could do the same.
“Companies have been asking us what they should do—form an ESG committee or put oversight in existing committees,” says Frantz. “We point out that it’s common to see issues like human-capital management fall to the board’s compensation committee, or cyber and privacy risks fall to the audit committee. Existing committees can oversee climate risks, but if you consider climate risk important enough that it justifies the creation of a separate committee, then go for it.”
About 13 percent of boards have created a separate ESG sustainability committee, according to Deloitte LLP’s Center for Board Effectiveness. “Right now, the board governance structure for climate risk oversight is evolving,” says Maureen Bujno, a managing director at the center. “The research indicates that 53 percent of board nom/gov committees are entrusted with overall ESG oversight, although many boards have given parts of the oversight to different committees and the full board.”
Bujno’s colleague Jon Raphael, the audit and advisory firm’s national managing partner of ESG transformation and assurance, says the audit committee is expected to play an increasingly important role in climate risk oversight, given its traditional oversight of financial statements and reporting. “Company commitments to a net zero emissions path have an impact on key assumptions like future cash flow and asset depreciation in the financial statement reported in the 10-K,” he explains.
The SEC’s statements regarding the disclosure of members’ expertise to effectively oversee climate risks “in sufficient detail” suggests that the board’s aggregate skillsets may need to be augmented. Pamela Yee, who leads Bain & Company’s performance improvement practice, says such skills might include “experience with managing direct or indirect emissions, previous oversight of a climate-related strategy, or identifying and quantifying risks on an enterprise basis.”
Kramer from ISS says a board’s needed skill level is dependent on the industry the company plays in. “ExxonMobil has an atmospheric scientist [Dr. Susan K. Avery] on its board; it makes sense for ExxonMobil to have this technical expertise, but not perhaps a company in a different sector,” she explains.
In thinking about composition, she advises boards to acquire a baseline understanding of the company’s exposure to climate risk. “If members feel comfortable in how the company compiles its emissions inventory, what the emissions look like and the climate change actions being taken to reduce them, then current composition might be fine,” says Kramer. “You can always bring in experts who are fluent on different topics to augment the board’s understanding.”
The proposal also would require disclosure of how board members oversee the tracking of progress toward reaching stated climate-related targets or goals, such as the achievement of net zero emissions by 2050 or a reduction in the carbon intensity of products by a certain percentage as of 2030.
To stay on top of the agenda, Bill Marchionni, senior director of finance, at the Hackett Group, says board members need to closely align with internal corporate climate-risk leaders. “We expect many large companies will entrust overall guidance of climate-related disclosures to their CFO, with assistance from peers in operations, legal, audit, IT and the sustainability office, given that disclosures fall naturally into the CFO’s wheelhouse,” Marchionni says. Regarding smaller public companies, several interviewees commented that compliance with the SEC’s disclosure proposals will require assistance from external audit, advisory and legal firms. “Registrants and their boards will need to ensure that management systems are correctly oriented to track transitions, and their internal controls and enterprise risk management functions are caught up with this rapidly evolving world of ESG,” says Frantz. “Some smaller companies will absolutely need to outsource the reporting obligations. There’s just so much to do.”
The Real Scope of Scope 3
Longtime public company board members were not exactly shell-shocked when the SEC’s climate-related proposal was released in March, with many already knee-deep in discussions with management about their sustainability strategies, ESG frameworks, disclosure metrics and materiality assessments. Still, the sheer length of the comprehensive, nearly 500-page proposal was a tough read for many board members, especially the theoretical language regarding complex Scope 3 greenhouse gas emissions.
Unlike Scope 1 emissions that a company produces directly and Scope 2 emissions involving the emissions related to the energy it chooses to purchase, Scope 3 emissions have nothing to do with assets owned or controlled by the organization. Rather, the emissions are produced by external entities up and down the company’s value chain.
As board member Anna Catalano put it, “Scope 1 and Scope 2 emissions are pretty much in a company’s control, but there’s a lot about Scope 3 emissions in terms of materiality that we just don’t get yet.”
The SEC proposal identifies upstream activities to include purchased goods and services, capital goods, waste generated from operations and employee business travel and commuting. Downstream activities include transportation and distribution of products, a third party’s use of those products and the company’s investments. Registrants must disclose the greenhouse gas emissions emanating from these varied activities both individually and in the aggregate. “Registrants should consider whether Scope 3 emissions make up a relatively significant portion of their overall greenhouse gas emissions,” the proposal states.
How Real Is Any of This?
How to do just that is the challenge, and in assessing the materiality of Scope 3 emissions, the SEC does not offer much in the way of practical advice. “We are not proposing a quantitative threshold for determining materiality [but] we note that some companies rely on… a quantitative threshold such as 40 percent when assessing the materiality of Scope 3 emissions,” the proposal states.
This may suggest that the SEC may consider a 40 percent threshold to be in order. Or not: “Scope 3 emissions may make up a relatively small portion of … emissions but still be material… ‘if there is a substantial likelihood that a reasonable (investor) would consider it important,’” the proposal states.
Parsing these comments, a 40 percent threshold may or may not be a good yardstick, resting the decision on a discernment of what an investor might consider material. As SEC Commissioner Hester M. Peirce writes in her dissent, the proposal “tells corporate managers how regulators, doing the bidding of an array of non-investor stakeholders, expect them to run their companies.”
Following the end of the public comment period on June 17, the SEC will make what the agency considers needed revisions before adoption and implementation. Hopefully, the smoke will have cleared to make better sense of how to perform a Scope 3 materiality assessment. Until then, board members should put it on the back burner.
“Frankly, having read the SEC proposal’s section on Scope 3 emissions, it comes across as if even they’re not all that sure what to ask for or measure,” says Ana Dutra, who serves on five public company boards, including financial derivatives exchange CME Group and energy transportation provider Pembina Pipeline in Canada. “I’d use this time while the proposal is out for comment and nothing has been adopted to inventory and catalog what’s needed to comply with Scope 1 and 2, as that’s likely to remain very close to what’s in the proposal.”
The Legal Challenge
One month after the SEC issued its landmark proposal on climate risk disclosures, a group of 22 professors of law and finance made their legal and regulatory objections known in a 20-page letter respectfully urging the government agency to withdraw it.
Among the signatories to the April 25 letter were legal scholars from Harvard, Stanford, Yale, UCLA and other top law schools. They cite a long list of objections, chiefly that the proposal to impose mandatory climate-related disclosure rules on public companies exceeds the SEC’s granted authority, which is a function of federal statutes and other federal laws. Another key assertion is that environmental activists and institutional investors have overly influenced the proposal, to the detriment of ordinary investors.
The signatories fully understand and support the critical need to protect the earth’s sustainability, “the most compelling issue of our time,” they state in the first paragraph. But, like another critic of the proposal, SEC Commissioner Hester M. Peirce, they maintain that the SEC is not the appropriate venue to regulate environmental sustainability. As Peirce puts it in her dissenting statement to the proposal, the SEC is not an acronym for the “Securities and Environmental Commission.”
On What Authority?
Professor Lawrence Cunningham from the George Washington University Law School, who wrote the draft letter, iterated and circulated it, concurs with Peirce’s criticism. In an interview, Cunningham says, “The SEC is not empowered by statutes to do what the proposal seeks for the agency to do. The proper forum should be Congress, which is why, assuming the proposal is adopted in close to its current form and a legal challenge is mounted, (the SEC) will lose in federal court.”
Congress made clear since the passage of the Clean Air Act of 1974 that climate disclosure regulation, particularly greenhouse gas reporting, is delegated to the Environmental Protection Agency, which measures and reports on these emissions in the U.S. from all sources, Cunningham says. “The (Clean Air Act) preempts any statutory authority the SEC might claim,” making the proposal a “radical departure from current law,” he contends.
Meanwhile, Cunningham says the SEC proposal would require U.S.-listed companies to disclose extensive climate risks that have little to do with their current financial outlook. As the letter details, these disclosures “start with emissions and extend to a company’s governance, strategy, business model and outlook, risk management targets and goals, and climate-related financial metrics,” all of which are “far afield” from the information traditional investors need to make investment decisions.
Who would the disclosures benefit, then? Environmental advocacy groups looking to influence the behaviors of companies in which they have “little to no economic stake,” Cunningham says. “The proposal never mentions individual ordinary investors, except in passing. There’s this assumption that the Big Three asset management firms [BlackRock, State Street and Vanguard] strongly advocating for the proposal speak for all shareholders, when that is not the case.”
“Their business model is to leverage a market return based on an index, as opposed to competing to offer superior investment returns,” Cunningham says. “At a minimum, the SEC needs to poll individual investors. What’s their appetite [for public companies to provide climate data]?”