By: Laks Ganapathi, Founder and CEO, Unicus Research
The green fever is here to stay.
We are wired to think, factor, and analyze the immediate risks we can conceptualize. As we have been in denial about the slow, consistent, climate-related threats we have caused, it Is encouraging that investors worldwide are forcing corporations to face the hard reality: 1. Accept that we have a crisis, and 2. Take the required steps necessary towards a low carbon future. Climate-related risks are taken seriously by investors, corporations, and consumers. Climate-related risks are systemic risks for the financial system in the long term.
For instance, according to Financial Stability Oversight Council’s (FSOC’s) report on Climate-Related Financial Risk 2021 found that businesses, financial institutions, investors, and households may experience direct financial effects from climate-related risks and observed that costs would likely be broadly felt as they are passed through supply chains and to customers and as they reduce firms’ ability to service debt or produce returns for investors.
The United States Securities and Exchange Commission (SEC) issued a proposal on mandatory ESG disclosures last month. This article intends to clarify the content of the SEC’s proposal and the potential impact on corporations and investors if the proposal were to be accepted.
The SEC’s nearly 350 pages of the proposal on mandatory disclosures have nothing to do with Environmental and Social Governance (ESG). Instead, it has everything to do with climate-related risks and opportunities and how to disclose them in the financial statements efficiently.
The SEC’s proposal understands the investors’ need for clarity on the corporation’s climate-related promises. While traditionally absent from financial reporting, larger companies have published sustainability reports separately. Ninety-two percent of S&P 500 companies have published a sustainability report for 2020, compared with 90 percent in 2019. In 2020, 70% of the Russell 1000 companies were expected to release a sustainability report, up from 65%. In addition, 1000 companies published a sustainability report in 2020, up from 65% in 2019.
The Need for the Disclosure
SEC’s proposal focuses on enhancing and standardizing climate-related disclosures for investors. The proposal to require disclosures about climate-related risks and metrics reflecting those risks as SEC believes that the information can impact public companies’ financial performance. In addition, the disclosure will help investors to make informed information.
The proposed rules would require information about a registrant’s climate-related risks that are reasonably likely to impact the registrant’s business, operations, and financial condition. SEC’s proposal promotes decision-useful information & transparency as well as:
- Clarity and Reliability
While disclosing the registrant’s climate-related events and transition activities.
The March 2022 SEC proposal is not new
In its 2010 Guidance, the SEC observed that many companies voluntarily disclose their climate-related information outside their filings with the SEC. Accordingly, the 2021 guidance also required the registrants to show the climate-related disclosure in the registrant’s Description of Business, Risk Factors, Legal Proceedings, and Management’s Discussion and Analysis of Financial Condition (MD&A).
The need to enhance and standardize climate-related disclosures is due to the lack of consistency among the reporting, “cherry” picking the reporting, and filing a separate sustainability report that is not a part of SEC’s financial statements.
The challenge is a lack of transparency and accountability by the registrants. For example, the registrants provide more climate-related disclosures in sustainability reports, while excluding such materially relevant information from Forms 10-K makes it difficult for investors to analyze and compare how climate-related risks and impacts affect registrants’ businesses and consolidated financial statements.
What Does SEC’s New Enhancement Proposal Demand from Registrants?
On behalf of the investors, SEC demands the following from the registrants (more will be covered in Part II of the article):
- SEC’s mandatory climate risk disclosure requirements align with the Task Force’s recommendations on Climate-Related Disclosures (TCFD).
- Aligning with TCFD echoes SEC’s promotion of consistency, comparability, and reliability of climate-related information.
- SEC does not propose scenario analysis for climate-related risks; however, if a registrant is already performing scenario analysis, the SEC requires the registrant to disclose the scenario analysis.
- SEC bases its proposal on Greenhouse Gas (GHG) and expects the registrants to measure and report the seven GHG covered by the Kyoto Protocol within Scope 1, Scope 2, and Scope 3.
- The oversight and governance of climate-related risks by the registrant’s board and management.
- Consistent disclosures on climate-related risks the registrant faces in the short-medium-long term.
- How any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook in the short-medium-long term.
- The SEC’s proposal doesn’t define what encompasses short-medium-long term.
- The registrant’s processes for identifying, assessing, and managing climate-related risks and whether the processes are integrated into the registrant’s overall risk management system.
- The impact of climate-related events (physical risks and transition risks) on the line items of a registrant’s consolidated financial statements and related expenditures. And disclosure of financial estimates and assumptions impacted by the physical and transition risks of the climate-related activities.
- Disclosure of Scope 1, 2, and 3 are reasonably likely to have material impacts on the registrant’s business or consolidated financial statements and GHG emissions metrics.
SEC’s “phase-in” periods for its proposed disclosures for GHG Emissions
According to the SEC’s proposal, investors have demanded more detailed information about climate-related targets and companies’ plans to achieve them to assess the credibility of those commitments and compare the companies based on those commitments. For instance, in the proposed rules for GHG emissions, scope 1 and scope 2, SEC has proposed time to transition to minimum attestation requirements.
The Convergence of Words and Actions
SEC’s proposed climate-related disclosures demand transparency and require the registrant to disclose in a note to its financial statements certain disaggregated climate-related financial statement metrics mainly derived from existing financial statement line items. The proposed rule would require disclosure falling under the three categories of information:
- Financial impact metrics
- Expenditure metrics
- Financial estimates and assumptions
The registrants are forced (by this proposal) by the SEC to face the climate-related risks head-on. The proposal requires a registrant to include the climate-related disclosure in the SEC’s annual reports in a separately captioned “Climate-Related Disclosure.”
The proposed rule will include the following disclosure examples in the financial impact metrics/expenditure metrics/financial estimates and assumptions. It will impact the consolidated income statement, balance sheet, or cash flow statement.
- Changes to revenue or costs from disruption to the business operations or supply chains
- Impairment charges and changes to the carrying amount of assets (such as inventory, intangibles, PPE, etc.) due to the assets being exposed to severe physical and transition climate-related risks).
- Changes to loss contingencies or reserves (such as loan loss allowances) due to weather-related events.
- Changes to revenue or costs due to emission pricing or regulations resulting in the loss of sale contract
- Changes to operating, investing or financing cash flow from changes in the upstream costs, such as transportation of raw materials.
- Changes to interest expense are driven by financing instruments such as climate-linked bonds issued where the interest rate increases if specific climate-related targets are not met.
A bold move by the SEC, if passed, will require the corporations to take a hard look at their business model, supply chain, and, most importantly, the bottom line – as the climate-related proposal might create opportunities as well as transition expenses in the short-medium-long term as the corporation moves towards a low carbon economy. But unfortunately, at this point, SEC’s proposal doesn’t address the linking of executive pay to climate-related goals.
The Depth of the SEC’s Disclosure on Climate-Related Risks and Opportunities
The devil is in the details; it is especially true as we read through the hundreds of pages of SEC’s proposal. In my next article, I will drill down into the nuances of the SEC’s disclosure and its impact on the corporations’ bottom line and the asset managers’ portfolio allocation and return on investment.
About the author:
Laks Ganapathi is a researcher in clean energy – focusing on climate change, sustainability, EVs, and ESG. Laks is also the Founder and CEO of Unicus Research. Unicus is a long/short investment research firm dedicated to asset managers, wealth managers, and investors. A key differentiator for Unicus is that they strive to be the voice of reason to the investment community in the ocean of disinformation. They are here to gain their investors’ trust.
 FSOC Report, Chapter (1) From Climate-Related Physical Risks to Financial Risks.
 Page 21 from SEC’s proposal on the enhancement and standardization of climate related disclosures for investors.
 P. 20 through P.100
 Page 27 from SEC’s proposal on the enhancement and standardization of climate related disclosures for investors.
 P 45. Phase-Ins from SEC’s proposal on the enhancement and standardization of climate related disclosures for investors.
 P.124 from SEC’s proposal on the enhancement and standardization of climate related disclosures for investors.