After months of controversy and 24,000 plus comment letters, the SEC passed the climate disclosure rule today by a 3-2 partisan vote. Before discussing the new rule, it might be helpful to understand what an investor might want from corporate disclosure of risks associated with climate change:

-As a reminder, climate risk is broadly broken down into physical risk and transition risk. A White House memo defines physical risks as “risks resulting from climatic events, such as wildfires, storms, and floods.” Transition risks result from “policy action taken to transition the economy off of fossil fuels.”

-As an investor, I want to know whether the firm has thought about and hence disclosed:

o Is physical risk a material concern for your firm?

o If it’s not a concern where common sense tells me otherwise (say a REIT that rents apartments in the large coastal cities of the US such as New York, Los Angeles or Boston), help me understand why? Have you hedged the risk? Do you intend to sell the current portfolio of buildings in the near term?

o Is transition risk a material concern for your firm, especially as consumer preferences change in favor of green or sustainable products?

o If it’s not a concern where common sense tells me otherwise (oil and gas extraction and refining), help me understand why?

o I am not as worried about emissions disclosures in general. Scope 1, 2 and 3 disclosures would be available anyway if the company operates in California or in the EU because of their respective regulatory mandates. Moreover, scope 1 and 2 and to some extent scope 3 emissions (indirect, value chain emissions) are very strongly correlated with the size of the firm and its value-added activities. Hence, investors and data providers can estimate such emissions within a reasonable band of confidence.

o I understand scope 3 disclosures are a stretch in the US as of now, given the machinery we need to put in place to measure these well. My worry is that way too much time and attention has been sucked by the debate about scope 3 emissions at the cost of the more basic questions related to physical and transition risk.

1.0 Did the SEC’s rule give me these data points?

I think it gave me more than I asked for in an election year given the belligerent political backlash that followed the introduction of the proposed rule back in 2022. Of course, the new rule will get litigated as the political push back will likely continue at least till the election. Setting politics aside, let us look at the new rule in detail.

The new rule asks firms to disclose the following information, categorized in seven broad areas: (i) climate risk impact; (ii) mitigation and adaptation; (iii) board oversight and risk management; (iv) climate goals; (v) scope 1 and 2 disclosures; (vi) severe weather events; and (vii) carbon offsets and RECs (renewable energy certificates).

1.1 Climate risk impact

· Climate-related risks that have had or are reasonably likely to have a material impact on the firm’s business, operations and financial condition;

· The actual and potential material impacts of any identified climate-related risks on the firm’s strategy, business model, and outlook;

1.2 Mitigation and adaptation

· A quantitative and qualitative description of material expenditures incurred and material impacts on financial estimates and assumptions that directly result from mitigation or adaptation activities undertaken by the firm;

· Specified disclosures regarding a registrant’s activities, if any, to mitigate or adapt to a material climate-related risk including the use, if any, of transition plans, scenario analysis, or internal carbon prices;

1.3 Board oversight and risk management

· Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the firm’s material climate-related risks;

· Any processes the firm has for identifying, assessing, and managing material climate-related risks and, if the firm is managing those risks, whether and how any such processes are integrated into the its overall risk management system or processes;

1.4 Climate goals

· Information about a firm’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal or actions taken to make progress toward meeting such target or goal;

1.5 Scope 1 and 2 disclosures

· For large accelerated filers (LAFs) and accelerated filers (AFs) that are not otherwise exempted, information about material Scope 1 emissions and/or Scope 2 emissions if the firm considers them to be material (my emphasis);

· For those required to disclose Scope 1 and/or Scope 2 emissions, an assurance report at the limited assurance level, which, for an LAF, following an additional transition period, will be at the reasonable assurance level;

1.6 Severe weather events

· The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;

· If the estimates and assumptions a firm uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements.

1.7 Carbon offsets and RECs

· The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (RECs) if used as a material component of a firm’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements.

2.0 Is this a defeat for the ESG community?

Some prominent media outlets have portrayed the new rule as a setback. I don’t agree. Why? Because other regulators and stakeholders and the ecosystem, as a whole, have acted. Several interested groups, be it boards, customers, employees, and investors, see climate either as an opportunity or a threat and have voluntarily taken steps to either manage associated risks or have made investments in the green tech area. Consider a few examples:

2.1 The EU rules:

The CSRD (Corporate Sustainability Reporting Directive) requires large enterprises that do business in the EU to disclose their emissions. The CSRD was adopted by the European Commission in November 2022, and will apply to EU-based public companies and large EU-based private companies beginning in 2025. Mandatory reporting of Scope 3 emissions is already in place in Europe under the EU Corporate Sustainability Reporting Directive (CSRD).

American multi nationals that have a significant presence in the EU cannot just up their sticks and leave. So, they will comply with CSRD and hence potentially report such information for the American operations as well. A few “conservative” US multinationals will likely not report climate related data for their American operations. This reminds me of an initiative of Malta, the EU’s smallest country, that got Apple, the world’s most valuable company, to adopt the more commonly available USB-C cable instead of its proprietary lightning cable.

2.2 Californian rules:

Any entity that does business in California and has total revenue exceeding $500 million is now required to disclose climate-related financial risks and measures adopted to address the risks. The climate-related financial risks must be disclosed in accordance with either with the Task Force on Climate-Related Financial Disclosures’ (TCFD) framework or the ISSB’s International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards. Covered businesses will be required to disclose Scope 1 and Scope 2 (data starting in 2026 for calendar year 2025. Businesses will be required to disclose Scope 3 data starting in 2027 for calendar year 2026.

Beginning January 1, 2024, the rules also require reporting for entities “operating in” California that make claims within California that include (i) statements regarding the achievement of net zero emissions; (ii) statements that the entity or a product is “carbon neutral;” (iii) statements implying the entity or a product does not add net carbon dioxide (CO2) or GHG emissions to the climate or has made significant reductions to its CO2 or GHG emissions. Independent third-party verification (audits) is encouraged but not required.

A few conservative lawyers and corporate leaders hope to have these rules overturned in the courts.

2.3 US government rules:

Besides the EU and CA, the Biden administration has embedded climate related filters in several aspects of the business conducted by the federal agencies. For instance, the largest suppliers including Federal contractors receiving more than $50 million in annual contracts would be required to publicly disclose Scope 1, Scope 2, and relevant categories of Scope 3 emissions, disclose climate-related financial risks, and set science-based emissions reduction targets. Federal contractors with more than $7.5 million but less than $50 million in annual contracts would be required to report Scope 1 and Scope 2 emissions.

The interest in climate reporting goes beyond regulators in other countries and states. Boards, investors, employees, and customers seem to care.

2.4 Boards:

The Wall Street Journal reported on February 26, 2024 that “three-quarters of business leaders from across the Group of 20 nations said the push to invest in renewable energy is being driven mainly by their own corporate boards, with 77% of U.S. business leaders saying the pressure was extreme or significant, according to a new survey conducted by law firm Ashurst.” Clearly US boards are not all “woke” as most board members are presumably Republican.

2.5 Investors:

Investors will continue asking firms for sustainability reports, emissions information, and data on how firms manage their climate risk. ESG rating agencies are most likely not going away anytime soon. They will continue rating companies even if companies were to stop reporting their exposure to climate risk. On the opportunities side, investment in green technology has taken off, especially after the Inflation Reduction Act (IRA). In fact, the IRA has been so successful that the EU and Canada have considered their own versions of the IRA. Ironically, the jobs and investments in green manufacturing and mining to support such manufacturing are concentrated in Republican states.

2.6 Customers:

Use of “green” or “sustainable” labels represent corporate disclosures to customers. Increasingly, litigation against greenwashing is being brought by states, not the SEC. Last week, the NY Attorney General sued the meatpacker JBS for claims that it was to get to net zero emissions by 2040.

3.0 What, if any, are the downsides to the new rule?

3.1 Cost to the reporting ecosystem

The one major cost to the reporting ecosystem of the SEC’s less restrictive ruling is the patchwork of rules that large companies now must follow in California and the EU. A more prescriptive SEC rule might have leveled at least the national playing field in the reporting arena.

3.2 Leaving materiality assessment of climate risk to the firm:

Some have expressed concerns about leaving materiality assessment of climate risk to firms. This is implicitly an indictment of auditors and board members who are most familiar with the ground reality of a firm. Auditors and boards are supposed to enforce materiality thresholds that management might want relaxed. Can an external regulator really enforce materiality thresholds if the internal governance system does not play ball?

But all in all, this is progress. The climate reporting genie is out of the bottle. The SEC’s initial climate proposal in 2022 may have triggered a chain reaction of regulatory and market driven initiatives to address climate reporting. Ironically, these moves may have rendered the less restrictive SEC rule somewhat less impactful even if it were to get tied up in litigation for the foreseeable future.


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