SEC Climate Change Rule May Reframe Risk Management and Governance

In a widely anticipated rule published March 21, the SEC is proposing to require listed companies to disclose climate-related financial risks and metrics to investors. The SEC believes that the information will help investors make decisions about how climate change may impact their investments because the information “can have an impact on public companies’ financial performance … .”

The SEC’s Enhancement and Standardization of Climate-Related Disclosures for Investors (33-11042) proposed rule notes that existing sustainability reports on company websites are not very good. And the boilerplate discussions in public filings drafted by corporate lawyers are worse, with inconsistent methodologies. Third-party rating agencies are not any help, because they often provide different scores to the same company and fail to use uniform criteria. The SEC says in the proposed rule release that “the current disclosure system is not eliciting consistent, comparable, and reliable information that enables investors to assess accurately the potential impacts of climate-related risks on the nature of a registrant’s business and to gauge how a registrant’s board and management are assessing and addressing those topics.” Comments are due by May 20.

The release notes that the SEC has focused on tackling climate change since the 1970s, focusing on compliance with environmental laws, with the most recent disclosure guidance, which was put out in 2010, noting that climate change disclosures may be material to investors and identifying certain climate-related issues that companies may need to consider, including direct and indirect impacts of climate-related regulations, international agreements, and other business impacts. The new rule wades significantly deeper into this water and away from the “materiality” anchor of the 2010 release.

The SEC’s path is not uncharted. The Task Force on Climate-Related Financial Disclosures (TCFD) and greenhouse gas (GHG) protocol have become the coin of the realm for climate-related reporting. TCFD was created in 2015 and chaired by Michael Bloomberg. TCFD sets forth a reporting framework for climate-related financial risk, and the GHG protocol defines and categorizes different types of emissions activities for reporting purposes:

• Scope 1, or direct GHG emission from company-owned activities, like operating a facility;
• Scope 2, or indirect GHG emissions from company-consumed activities that are generated by someone else like the electric company; and
• Scope 3, or indirect GHG not in Scope 2 but generated by something the company does, such as supply-chain emissions.

The SEC adopted these standards because the agency didn’t want to create a new, unfamiliar framework for public companies. The GHG protocol and TCFD are established frameworks. The SEC ran the same play with this year’s special purpose acquisition company (SPAC) litigation by borrowing some of the ideas for rulemaking from the plaintiff’s pleadings. Both efforts generated controversy. Why read Beowulf when CliffsNotes has already done the work?

The SEC says that it acted because investors demand action. At least, investment funds with over $60 trillion under management do. Presumably, their customers feel the same way (sort of like asking Major League Baseball owners what the fans think). The rule notes that the fund industry has been active in pushing for environmental, social, and corporate governance (ESG) disclosures. In 2019, 630 of these fund investors (managing more than $37 trillion) signed declarations urging governments to require more climate change reporting. Comments for the rule have come from individual investors, funds, law professors, law firms, companies, etc. The SEC said a similar global initiative has over 4,000 signatures, representing more than 120 big fund investors.

See also:

• Companies Worried About Cost of SEC’s Climate Disclosure Rules

The rule seems written to appease these large investors, with their concerns getting the most ink. Comments to the rule have questioned whether those funds were looking out for their investors and wondered whether they needed additional disclosures to make ESG-related investment decisions (pointing to existing ESG-related funds and the performance of companies that focus on climate change—e.g., Tesla)?

The proposed rule requires disclosure in registration statements and annual reports on:

• Board and management oversight and governance of climate-related risks;
• Material impact of climate-related risk management on business (short, medium or long term) and how they may impact financial statements, strategy, business model, or outlook;
• A description of the process for identifying and managing client-related risks and whether they are embedded in the company’s risk management system or process;
• The impact of client-related events on financial statements, expenditures, and disclosure of estimates and assumptions of the impact;
• Scope 1 and 2 GHG emissions;
• Scope 3 GHG emissions (if material and with a safe harbor), or if the company put a target that included Scope 3 (this does not apply to small reporting companies);
• Climate-related targets, goals, and transition plans (if publicly set);
• An independent attestation report for, at a minimum, Scope 1 and 2 emissions, for accelerated filers and large accelerated filers;
• The financial statements will also need a note on climate-related metrics.

The requirements will be phased in depending on the size of the company, and there is a safe harbor for Scope 3 emissions disclosures. Small reporting companies are exempt from Scope 3. Assuming that the SEC adopts these rules (and that the adoption is lawful), companies will have to expand existing efforts to measure and report ESG-related data.

Here are some practical tips:

Governance.  Some of the comments have focused on board oversight of ESG and suggested that ESG be given the same profile as financial-related material matters. The SEC adopted the TCFD framework, requiring companies to provide insight into board and leadership oversight of ESG issues (noting that only a small number of issuers do this today). In addition to the requirement that the company identify board members with experience on ESG issues (and disclosures sufficient to describe the experience), the rule requires disclosures on how the board is informed of ESG issues, how often the board (or a committee) discusses ESG issues, and how ESG fits into board action more broadly (including goals). The rules have similar requirements for company management, requiring management to have ESG experience and a process for managing ESG risk.

Companies typically have ongoing opportunities to educate board members and leadership on areas of importance to the business. The proposed rule makes clear that enterprise risk management (ERM) and ESG should be central to those education efforts. In addition to education, companies should make an effort to document their ERM and other processes relevant to board members, evaluating ESG-related issues and benchmarking to understand gaps and potential opportunities to enhance corporate governance.

Risk Management.  Public companies have long-standing ERM processes for assessing and forecasting risks to the company. Today, mature ERM processes incorporate data to support risk trends and improving their forecasting ability with ERM 2.0. This involves identifying risk in a systematic way, incorporating process enhancements that leverage data and forecasting ability to provide a better overall picture of ERM risk, and providing enhanced ERM reports to leadership and better visibility to the board.

The SEC’s proposed rule contemplates building ESG into the ERM process (or disclosing otherwise). The rule lists specific issues that the ERM process should identify vis-à-vis ESG that are normally part of an ERM process—impact of regulations, evaluation of risk, impact of business changes, and risk management and ranking. The proposed rule requires registrants to describe any analytical tools, such as scenario analysis, that are used to assess the impact of climate-related risks on the business or financial statements.

The proposed rule requires disclosure of both quantitative and qualitative information. This means ensuring that the ERM process incorporates data and identifies ESG-related risks and trends, including defining ESG-related metrics relevant to Scope 1, 2, and 3 activities and building these metrics and data sources into an ERM dashboard for the board and company leadership. Forward-looking risk information should be deemed forward-looking statements exempt from liability under the Private Securities Litigation Reform Act (PSLRA). (The SEC is considering a separate safe harbor for internal carbon price disclosures and further broadening of the PSLRA).

The proposed SEC rule highlights that reporting companies should continually be improving their ERM processes and how they manage risk. The more mature the ERM process, the easier it will be for companies to incorporate ESG and other material risk issues as the risk environment continues to evolve.

If adopted, the rules will be phased in based on the type of issuer. Until then, we’re stuck with the 2010 disclosure requirements and the materiality framework that have formed the foundation of disclosures and investor protection for the last 100 years. One point that’s beyond contention: ESG-related disclosures will get better with greater mandatory disclosures coupled with potential enforcement actions and private securities litigation. This will keep companies honest about what they are doing in the ESG space and avoid green-washing their public filings with lofty aspirational statements.

Some commentators fear that the tremendous costs generated by disclosures may have some companies rethinking entering the public markets—but with the flood of companies that have gone public since the start of the pandemic, maybe that is a good thing. Commenters also wonder whether investors are really clamoring for ESG information, or is it just institutional investors who are supposed to look out for their interests? And can’t institutional investors with trillions under management figure out which companies are green-washing and which ones aren’t (to the extent their shareholders care)? The comment period has raised all these questions, which the final rule may or may not satisfactorily address.

However, irrespective of whether an individual is in favor of, or opposed to, the SEC wading into climate change disclosures, the SEC’s path foreshadows better ERM processes for public companies.

Ryan McConnell, Meagan Baker Thompson and Matthew Boyden are lawyers at R. McConnell Group—a boutique law firm focusing on governance and litigation (including criminal defense) located in Houston and Austin, Texas. Send article suggestions or comments to ryan@rmcconnellgroup.com.

From: Corporate Counsel