SEC Wants to Know How Directors Oversee Climate Risks

After two years of vigorous debate, the U.S. Securities and Exchange Commission (SEC) on March 6 approved by a 3-2 vote the nation’s first climate disclosure rules—weaker than what was originally proposed in March 2022.

Of note, the SEC dropped a controversial plan to require companies to report Scope 3 greenhouse gas (GHG) emissions. These are emissions generated throughout the company’s supply chain and customers’ use of its products.

The final rules, a hefty 886 pages, require companies to disclose Scope 1 and 2 emissions, those that result from their operations and energy use. These disclosures are required only to the extent that the company believes the information would be financially material to a reasonable investor’s decision-making. Assurance is required for those companies that disclose Scope 1 and/or Scope 2 emissions. In another change from the original proposal, smaller reporting companies are exempt from the emissions reporting requirements.

In addition to emissions disclosures, companies are also required to report:

• Climate-related risks that have had or could have a material impact on their strategy, operations, or financial condition
• Their activities to mitigate or adapt to climate risks
• Information about the board of directors’ oversight of climate-related risks
• Management’s role in managing climate-related risks
• Information on any climate-related targets or goals material to their business, results of operations, or financial condition
• The capitalized costs, expenditures expensed, charges, and losses incurred because of severe weather events and other natural conditions (i.e., hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise)
• The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (RECs) if used as a material component to achieve disclosed climate-related targets or goals

The SEC modeled its climate disclosure requirements on the Taskforce on Climate-related Financial Disclosure (TCFD) framework. The Commission reasoned that using the TCFD framework would “mitigate the compliance burden of the (SEC’s) final rules, particularly for registrants that are already providing climate-related disclosures based on the TCFD framework or soon will be doing so pursuant to other laws or regulations.”

The compliance deadline for these new disclosures is staggered depending on a company’s SEC registrant type, with large, accelerated filers required to begin disclosing parts of the requirements in fiscal year 2025 and the remaining requirements, including emissions, for fiscal year 2026 (i.e., annual reports generally filed in 2027 for companies with December 31 fiscal year ends). Additionally, assurance on emissions disclosure for large companies is expected by fiscal year 2029, giving companies some additional time to gain third-party assurance of their emissions data.

 

Motivating Climate Action

In executive incentives, the use of environmental measures is becoming more common. Environmental measures in incentive plans increased to 58% globally, with significant increases across the various regions, according to 2024 Global Trends in Stakeholder Incentives: What’s Next? published by Farient in conjunction with the Global Governance and Executive Compensation (GECN) Group. For example, in the U.S., 52% of large-cap companies now use environmental incentive measures, up significantly from 34% in 2021 and 8% in 2020, the research shows.

GHG emissions are by far the most common environmental measure in executive incentives, according to the research, increasing by 33 percentage points from 2023 reporting. This considerable jump coincides with increases in companies setting emission reduction targets and disclosing them publicly (63% of S&P 500 and STOXX Europe 600 companies have publicly disclosed Scope 1 and 2 emissions reduction goals for 2030).

 

Disclosures in E.U., California

Standardization of reporting was one key objective of the new rules. Despite the volume of voluntary reporting, disclosures vary by company and can be difficult for investors to understand. Asaf Bernstein, associate professor of finance at the University of Colorado at Boulder, who consulted with the SEC on the rules, told The Wall Street Journal: “Voluntary reporting is all over the map. Standardization is something you can use as a decision tool as an investor.”

The new rules immediately attracted a legal challenge and others are expected. West Virginia Attorney General Patrick Morrisey said he was joining a coalition of 10 states, including Georgia and South Carolina, to challenge the rule in the U.S. Court of Appeals for the 11th circuit in Atlanta.

Even so, companies face rules that require Scope 3 reporting elsewhere. California’s climate risk reporting laws require companies doing business in the state with more than $500 million in annual revenue to prepare reports on climate-related financial risks using a framework recommended by the TCFD; and companies with more than $1 billion in revenue must report their Scope 1, 2, and 3 emissions with third-party assurance.

The European Union’s Corporate Sustainability Reporting Directive, which went into effect January 5, 2023, also requires such disclosures affecting thousands of U.S. companies with operations in the region. The first companies will have to apply the new rules for the first time in the 2024 financial year, for reports published in 2025. And in the U.K., the Streamlined Energy and Carbon Reporting (SECR) framework, passed in 2018 with reporting that began in 2020, requires companies to disclose Scope 1 and 2 emissions, with Scope 3 emissions voluntary, as well as actions taken by the company to improve energy efficiency.

 

Farient Recommendations

Timing is of the essence. The board should discuss the new rules with their advisors—how they will be phased in for different sized companies and whether the company is exempt from providing GHG emission disclosures and related attestation because they are smaller companies, emerging growth companies, or nonaccelerated filers.

Other considerations:

• Does the board’s current structures support oversight of climate-related risk and how? The SEC’s new rules require the board to provide details on its oversight
• How is the board’s responsibility for climate-risk mitigation and oversight documented?
• Does the full board oversee climate risk, is it divided among committees, or handled by a specific or specially created committee?
• Does the company currently have or publish emissions or other climate targets? And are executive incentives aligned with climate goals?
• What sustainability reporting framework does the company use and are there gaps between that and the SEC requirements?
• How and when are the material costs of severe weather events reported to the board?

 

Prevalence of Environmental Measures by Type
Among Large Companies Globally Using Environmental Measures

Source: Farient Advisors, a GECN Group partner

 

By Brian Bueno – Farient ESG Leader