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The SEC’s mandatory climate disclosure rules are coming soon. Are companies ready?
13 January 2023

The SEC’s mandatory climate disclosure rules are coming soon. Are companies ready?

4 minute read
Climate risks & opportunities
Henry Frankis-Pyle Consultant - Climate Risks & Opportunities - South Pole
Andrew Textoris Associate Consultant, Sustainable Finance - South Pole

Climate regulation is coming – whether companies are ready for it or not.

In March 2022, the US Securities and Exchange Commission (SEC) proposed mandatory rules on disclosing climate-related information. The rules apply to all US public companies and disclosures are required to be integrated into regular financial filings.

The SEC rules are built on the well-established recommendations from the Taskforce for Climate-related Financial Disclosures(TCFD), but, in many areas, go much further. At the moment, it is not yet clear what their final form will be, and their publication date is still uncertain. However, regardless of when the SEC rules are published, all public companies in the US will need to use them as a reference to understand what are the most important issues relating to climate risk disclosure that they should focus their efforts on in the short to medium term.

Recent conversations with companies interested in understanding the potential implications of the SEC rules on their businesses, have made us want to shed some light on three big issues that have come up in these discussions.

1. What do I have to calculate?

The SEC proposal would require organizations to disclose specific climate-related metrics in notes to their audited financial statements. This is where the SEC brings the biggest step up for climate reporting.

To be compliant, companies must disclose the impacts of identified physical and transition risks on financial statements, including revenue, reserves, insurance, interests, impairment charges, operation costs and cash flows. These risks must then be aggregated to an absolute value of the positive and negative financial impacts on a line-by-line basis.

The new SEC requirements are far more prescriptive than the TCFD recommendations. Under the TCFD recommendations, organizations should disclose the financial impact of climate-related risks and opportunities, but are allowed the flexibility to describe such impacts in qualitative and/or quantitative terms.

Such detailed disclosure of financial impacts will need advanced methodologies beyond what we see used in today's climate reporting. While expanding the scope and detail of corporate climate disclosure might seem daunting, starting with a comprehensive risk assessment, having continued strong engagement, and utilizing company specific data will quickly allow the process to be baked into companies' everyday risk management, decision-making and financial planning.

2. What should companies consider as material?

Following the US Supreme Court's 1976 decision (TSC Industries, Inc. v. Northway, Inc.), materiality occurs if there is a “substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote". This decision continues to define the standard definition of materiality in the US.

Under the new SEC rules, however, organizations are required to follow a much more prescriptive definition of materiality. Respondents must disclose financial impacts of any risks that make up more than one percent of the total line item for the relevant fiscal year.

Not only does this one percent threshold give a much more prescriptive definition of materiality, it is likely to be smaller than organizations might typically use in their financial reporting. The theory is that climate impacts are long term and near certain to become more material over the timeframes considered. It is therefore necessary to ensure these risks are considered and accurately understood, even if they have a small financial impact in the current day.

The concept of materiality has always been elusive within ESG (usually non-financial) disclosures. If immaterial information is required for non-financial reasons, organizations are equipped to make that judgment call. This is the approach taken by the TCFD.

Yet, relying on differing in-house definitions of materiality means there is a disconnect between what companies do or do not disclose. This leads to inconsistent information that is hard for investors to compare. The new rules from the SEC aim to bridge this information gap. In doing so, it brings climate risks firmly into the realm of mainstream financial disclosures.

3. Where does scenario analysis belong?

A notable departure from the TCFD recommendations is that the SEC rulings do not require companies to conduct climate scenario analysis. However, if a registrant has conducted a scenario analysis, most likely through voluntary TCFD alignment, it would be required to disclose the results.

Does this take scenario analysis off the table, in effect creating a chilling effect on the use of scenario analysis? We argue that it does not.

The reasoning lies in the difference between the intended function of SEC disclosures and scenario analysis. SEC disclosure aims to provide consistent and complete information to enable better informed investor decision making in the here and now. Climate scenario analysis serves as an internal analytical tool, focused primarily on exploring strategic responses to distinct plausible futures. The value brought by both can be, though aren't necessarily, mutually exclusive.

What next?

The final drafting of the SEC rulings are still to be confirmed. They have, however, fundamentally shifted conversations from whether or not to disclose climate-related information, to when and how to disclose such details. This may be difficult to navigate alongside commitments to other established (mandatory or voluntary) disclosures. In particular the recommendations from the TCFD.

The objective of the SEC climate ruling is to help ensure standardized flow of information to investors. The objective of the TCFD is to help effectively disclose climate-related risks and opportunities through existing reporting processes.

There will be much talk and detailed assessment of the finalized rules once published in early 2023. However, understanding the distinct objective of the SEC climate disclosures will help companies prioritize efforts, and use each disclosure to ensure a complete and accurate flow of information to all stakeholders.

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