Everything you need to know about the SEC’s proposed climate disclosure rule

The SEC (the Commission) has proposed its long-awaited rule concerning climate-related information in registration statements and annual reports. The proposal is meant to enhance and standardize certain climate-related disclosures to address investor demands for information consistency and comparability.

The rule would require public companies to provide investors with material information on the climate risks they face, including those driven by the physical impacts of a changing climate as well as those posed by a transition to a low-carbon economy. Ill-prepared companies may lose investor value if they can’t manage the negative impacts of these risks, or face legal liability if their actions don’t match their disclosures. Let’s take a look  at how the rule will affect businesses today.

All publicly traded companies will be subject to the climate disclosure rule.

Proposed Climate Disclosure Rule: The essentials

What would the rule do?

The rule would add a new Subpart 1500 to Regulation S-K, the Commission’s reporting requirements for various filings used by public companies.

The rule also would add a new Article 14 to Regulation S-X, the Commission’s requirements around the form and content of financial statements by public companies.

Who would be subject to the rule?

All publicly traded companies will be subject to the climate disclosure rule. Specific requirements and compliance timelines will vary somewhat based on company size and filing history.

What will companies be required to disclose?

Public companies will be required to disclose risks related to climate change — including both physical and transition risks — that are reasonably likely to materially impact their businesses. Companies also will be required to disclose greenhouse gas (GHG) emissions metrics, to assist investors in assessing those risks. The proposed rule also requires companies to disclose climate-related impacts on strategy, along with the company’s governance and risk management frameworks for managing climate-related risks. Lastly, and perhaps most importantly, the rule would require companies to disclose how their climate-related risks quantitatively impact the line items of their annual consolidated financial statements, as well as the estimates and assumptions used in those financial statements.

Good news: Companies that have already begun to disclose climate-related risks in accordance with various voluntary programs have a big head start. The Commission’s proposed rule incorporates many concepts and much of the vocabulary set out by the Task Force on Climate-Related Financial Disclosures (TCFD) and GHG Protocol.

Risks Related to Climate Change

Firms facing physical risks posed by a changing climate must disclose direct and indirect impacts.

For example, companies that operate farms or heavily rely on agricultural supply chains will need to disclose the numerous threats to crop production posed by climate change. This includes the impact of long-term climatic shifts, such as prolonged drought, increasing pest pressures, and changes in where crops can be grown, which can devalue property and disrupt operations. It also includes the impact of extreme weather events, which pose the potential for catastrophic crop losses due to flooded fields and extreme heat or wind.

Companies whose facilities and operations may not be impacted directly by climate change will still be required to disclose risks relating to a transition to a low-carbon economy. Many forms of transition risk are much more difficult to quantify in a standardized way but may be even more material to a company based on the magnitude of potential impact. Such risks could be reflected in a company’s value, perhaps due to new regulations, shifting consumer preferences, or supply chain disruptions.

Alternatively, some sectors face an upside in that their products will gain new marketability in a transition to a low-carbon economy. For example, the timber industry may experience expanded demand from clients seeking building materials that naturally store carbon. Similarly, agribusinesses can capitalize on the increased need for low-carbon fuel by facilitating methane-capture from manure and other agricultural biowastes.

Quantification of Greenhouse Gas Emissions

To contextualize the risk posed by climate change, particularly the extent of a company’s transitory risk, the proposed rule directs companies to quantify their GHG emissions. The proposal adopts the emissions categorization framework of the GHG Protocol, which defines three categories, or scopes, of emissions. Scope 1 emissions include emissions from sources owned or controlled by the company, while Scope 2 emissions are those from the energy purchased by a company. Scope 3 emissions are the “result of activities from assets not owned or controlled by the reporting organization, but that the organization indirectly impacts in its value chain.” For example, emissions produced by a company’s suppliers and by customers using the company’s products are Scope 3 emissions.

The proposed rule would require companies to report all Scope 1 and 2 emissions, but only material Scope 3 emissions. The proposal does not provide a standard for determining the materiality of Scope 3 emissions. Companies must also report Scope 3 emissions if they have set a GHG emissions reduction target or goal that includes Scope 3 emissions. “Small reporting companies” are exempt from the requirement to report material Scope 3 emissions.

Climate-Related Strategy Development, Governance, and Risk Management

The proposed rule also requires companies to provide additional information about how climate-related risks impact strategy, along with the company’s governance and risk management frameworks for managing climate-related risks.

In particular, the proposal requires companies to describe how popular tools for tracking and reducing emissions are used to meet internal climate-related goals. For example, if companies maintain an internal carbon price, registrants must disclose the price, how it is estimated to change over time, and the rationale for selecting the price. Companies must also disclose how carbon offsets or renewable energy credits are used in the firm’s climate-related business strategy.

Additionally, for any company whose climate-risk management strategy includes a commitment such as a corporate net-zero pledge, the company also must explain its plans to meet such goals, and with enough clarity that investors will be able to track and predict corporate progress.

Financial Statements

Finally, the rule would require certain climate-related financial statement metrics—i.e., disaggregated climate-related impacts on existing financial statement line items—and related disclosure to be included in a note to a registrant’s audited financial statements. For example, financial impacts of severe weather events and other natural conditions, financial impacts related to transition activities, and climate risk mitigation expenditures must be disclosed.

The Fine Print: Diving deeper into the details

Will there be an audit or assurance process or requirement for the climate disclosures?

Accelerated filers must file an attestation report covering disclosure of Scope 1 and Scope 2 emissions, at the limited assurance level for the first two years of compliance during the transition period and at the reasonable assurance level for the fourth year and beyond. Corporate financial reporting requires filings be evaluated and assured by third parties, but auditing practices for climate disclosures are not yet comparably standardized. The proposed phase-in period provides time for companies to develop internal record-keeping processes that will support third-party verification.

How does the proposal address liability?

The Commission is proposing to treat the rule’s climate-related disclosures as “filed” with the SEC, except for disclosures furnished on Form 6-K. This distinction means that companies face heightened liability for material misstatements or omissions. The disclosures would also be subject to potential liability if they were included in or incorporated by reference into the company’s registration statement.

That being said, the proposal does include forward-looking statement safe harbors pursuant to the Private Securities Litigation Reform Act, to the extent that proposed disclosures include forward-looking statements. In an acknowledgment of the “unique” difficulties associated with reliably quantifying Scope 3 emissions, the proposal also includes a safe harbor for liability for these disclosures. Specifically, the proposed safe harbor would provide that disclosure of Scope 3 emissions by or on behalf of the company would not be considered 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.

What is the timeline for compliance?

The proposed rule phases in compliance for different categories of companies, based on an assumption the rule is finalized this year and takes effect in December 2022.

Under this timeline, large accelerated filers must make all required disclosures—except their quantification of Scope 3 emissions—in fiscal year 2023 filings. Accelerated filers and non-accelerated filers must take this first set of steps starting for fiscal year 2024, and small reporting companies must first take these steps for fiscal year 2025. As for Scope 3 emissions, large accelerated filers will make them starting for fiscal year 2024, and accelerated and non-accelerated filers will start making them for fiscal year 2025. Small filers are exempt from the Scope 3 requirements.

The rule’s assurance requirements are also phased. Starting for fiscal year 2024, large accelerated filers must provide limited assurance of their Scope 1 and Scope 2 GHG disclosures that such companies began making for fiscal year 2023. By fiscal year 2026, large accelerated filers must provide reasonable assurance of these disclosures. For accelerated filers, those respective assurance deadlines are delayed by another year. Non-accelerated filers and small reporting companies are not subject to the attestation requirements.

What’s next

The Proposed Disclosure Rule remains subject to change based on public input. Interested stakeholders — including businesses — should consider submitting written comments to the SEC, and are encouraged to seek help from legal or technical experts in preparing comments for submission. 

Once a final version is drafted, the rule must be voted on again by the SEC commissioners. The rule will most likely face immediate legal challenges on several fronts by various parties.

Even with compliance months (or years) away, companies can take steps now to get (or stay) ahead of the curve. They can take stock of existing disclosures and identify processes or other gaps that will need lead time to fill. They can also consider early engagement with consultants and legal counsel to assess the company’s climate risk profile and advise on the eventual climate-related disclosures and attestation requirements. 

Mandatory climate disclosures are already forthcoming in the United Kingdom and Japan,and have been proposed in the European Union. The SEC itself is also taking related actions, including by establishing a Climate and ESG Task Force in the Division of Enforcement to address ESG-related misconduct. Any changes to the final rule—or even a court striking down the entire rule—shouldn’t reduce the increasing salience of climate disclosures.

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