The Joe Biden presidential administration has consistently targeted the adoption of policies that significantly integrate environmental, social and governance (ESG) and sustainability considerations across the U.S. economy. For example, we’ve observed how the U.S. Department of Labor’s pendulum has swung back towards ESG integration since he took office.
While ESG remains a particularly divisive area of policy discourse in the U.S., the Biden administration has remained steadfast in the face of vocal dissenters and climate considerations remain one of its central tenets. In signing an Executive Order in May 2021, President Biden directed all federal agencies to assess and mitigate financial risks related to climate change. This order set in process a swathe of industry consultations and fervent political and economic debates about the relative merits and drawbacks of a program of government activity focused on climate change mitigation and management.
For asset managers, all eyes turned to the Securities and Exchange Commission (SEC). The SEC has skirted the edges of ESG rulemaking for many years, but it was expected that under Gary Gensler’s chairmanship, it would finally move to propose ESG rulemaking. That happened on March 21, 2022, when the much anticipated and fervently debated SEC draft proposals for mandatory climate disclosure rules were released.
Let’s take a brief look at the primary proposals contained in the 500+ page proposal before moving onto the main practical takeaways.
The Main Proposals
The primary proposed rule changes relate to incorporation of climate related information in issuer registration statements (Regulation S-K) and periodic reports (Regulation S-X), including audited financial statements. The proposals relate to both U.S. domestic and foreign registrants.
The SEC mandatory climate related disclosure proposals have far-reaching impacts for all public companies who currently report to the SEC and add formal obligations on how they govern, measure, assess and ultimately report their company’s climate risk activities and impacts.
The main deliverables include reporting of information such as:
- Actual or likely material impacts to a company’s business, strategy and future outlook;
- The oversight and governance structure, risk management and controls in place to monitor and address climate risk (inclusive of board obligations);
- Information about climate-related targets and goals, and transition plans (if any);
- Greenhouse Gas Emissions data; and
- Several climate-related financial statement metrics and related disclosures in notes to the financial statements. Most of these metrics and disclosures would be subject to external audit.
Now let’s delve into some of the more interesting areas of focus for asset managers:
1. Proposals Anchored in Global Standards
While there is much to be done to adhere to the SEC’s draft proposals, a crumb of comfort can be found in the fact that the proposed disclosures are anchored in the relatively mature Task Force on Climate-Related Financial Disclosures (TCFD)1 and the Greenhouse Gas (GHG) Protocol Corporate Standard.2
2. Wide Partisan Divide to be Bridged
The SEC commissioners voted 3-1 to approve the proposal with Commissioner Hester Peirce casting the dissenting vote and providing a robust critique of the proposals in terms of SEC overreach and the costs of adherence to corporates.
Several U.S. business advocacy groups and arms of the government stretching from the federal judiciary to Senate Banking Committee and House Financial Services Committee, have each already expressed reservations on the proposals, particularly considering current fast rising energy prices following Russia’s invasion of Ukraine. Some U.S. states are also likely to strongly dissent on the proposals and there is much conjecture that lawsuits will be filed, particularly over elements such as Scope 3 indirect-emissions provisions.
3. Qualitative and Quantitative Demands
Like most climate/ESG related policymaking, the proposal is a mixture of qualitative written narrative and quantitative data and metrics. Learning from the EU ESG experience, the words, promises and future commitments to climate ambitions are the easy part, backing up those claims with hard data and empirical evidence is the harder part. As such, in scope firms will need to carefully craft their qualitative narrative and back it up with timely and accurate scientific data-led evidence. For certain parts of the market, data scarcity is an issue, and it is hoped and expected that the SEC proposal will bridge this gap. Only time will tell.
4. 1, 2, 3 Go! Emissions Metrics
The proposal asks firms to establish a process for measuring GHG emission metrics using standardized measurements. Scope 1 emissions are those directly produced by the issuer itself. Scope 2 emissions are indirect GHG emissions associated with the purchase of electricity, steam, heat, or cooling.
Scope 3 emissions are harder to quantify and relate to the emissions of the issuers’ vendors, companies involved in its supply chain and distributors of the issuers’ products. The proposals only demand Scope 3 disclosures if they are considered “material” or if the issuer has a stated greenhouse gas emission reduction plan in place (such as a “Net Zero” commitment, for example). Any Scope 3 emissions disclosures come with a “safe harbor” provision to limit the liability of such disclosure given the difficulty in assessing large or complex supply chains within a business model.
One of the most fervent industry debates about the implementation of climate disclosures is the principle of “materiality”. Materiality is a legal and accounting concept which dictates how much information must be disclosed to investors. It remains purposefully vague under securities law and there is no detailed definition or guidance given within the SEC proposal other than material information is said to be that “which there is a substantial likelihood that a reasonable investor would attach importance”.
The issue of whether an activity or certain metrics are material will be hugely consequential as industry looks to address the SEC proposals. Materiality can draw issuers into Scope 3 emissions reporting which in practice are far more onerous than Scope 1 & 2 – so how materiality is defined in subjective and objective terms will significantly dictate the impact of the SEC proposals on an issuer.
6. Greenflation Concerns
One of the primary concerns on the SEC proposals is the fact that adhering to their requirements will cost money and absorb a lot of human capital resources from in scope firms. Even though there is a carve out for smaller firms, the proposals cover a large proportion of corporate America and will undoubtedly layer costs into business models. The fear is that the transition to a lower-carbon economy could trigger an increase in general inflation for the consumer who ultimately may bear these costs. The SEC has weighed these additional business costs against the benefits to investors.
7. It Could Have Been a Lot Worse
In framing the proposals, the SEC have threaded the needle of imposing a meaningful disclosure regime with the fact that they expected substantial pushback from certain industry segments. Some States are also likely to push back hard against such ESG proposals.
However, as alluded to earlier, the disclosure regime draws on standards that are currently in play for many multinational issuers and stops far short, for example, of European Union standards as expressed in the triangulation of ESG regulation that many EU issuers and asset managers are working through including: the Sustainable Finance Disclosure Regulation (SFDR), EU Taxonomy, and the Corporate Sustainability Reporting Directive (CSRD).
Further, many U.S. issuers are already engaged on reporting and disclosure initiatives such as International Sustainability Standards Board (ISSB) climate related disclosures prototype3 which is a global accounting initiative. It seeks to reduce ESG report fragmentation by setting global climate accounting reporting standards. These disclosures were broadly welcomed upon release due to the proliferation of standards which was challenging firms’ resources. Many U.S. issuers would fall under the proposed ISSB disclosure requirements, which go beyond the SEC proposals in terms of detail to include capital expenditure (Capex), internal carbon pricing, remuneration linked to climate risks and other more onerous elements. On a relative basis, the SEC disclosure standards could have been more challenging.
8. Audit and Assurance
A challenge for regulators across the globe is that while they have much experience in analyzing financial balance sheets, profit and loss statements and traditional financial and compliance reports, they are now being tasked with branching out to reviewing climate science metrics and non-financial measures of success. This is a new competency and is complex.
The same issue resides at the traditional audit and assurance firms where new skill sets and assessment of the new metrics requiring validation are being put on a mandatory legal footing. The subjective nature of “materiality” for example is an accounting principle which will draw a large level of scrutiny in the comment period and beyond.
This is not the only SEC ESG related policy, we are likely to see. In fact, this is likely to begin a cycle of assessing the various elements of sustainability disclosure. But starting with issuer disclosure is the correct starting point. One of the criticisms of the EU ESG agenda is that the various parts of the overall policymaking program were rolled out in an order that in itself was challenging. It started with a disclosure regime (SFDR), then a classification regime (EU Taxonomy) and ended with issuer disclosure (CSRD). By – sensibly – starting with issuers, the asset managers in the U.S. will have an opportunity to assess aggregated and firm-specific metrics with a view to then taking an investment view in order to comply with their own obligations. The SEC proposal looks to bridge the biggest drawback of ESG disclosure and that is data scarcity.
10. The End of the Beginning
The proposal commentary period will last for at least 60 days from the date of publication. Given the disparate volume of industry input expected on the ruleset, this is by no means the end of the SEC ESG journey. The proposals will undoubtedly be subject to impact assessments and revisions. Time will tell how much they will change or be formally affected, but what is certain is that they have a long way to go before they will be enforced. This is undoubtedly the single most significant step in the U.S. markets towards the integration of climate related rulemaking. Believe me when I say, as I did in my recent LinkedIn video: ESG IS EVERYWHERE!
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