On March 21, 2022, the US Securities and Exchange Commission (SEC) released proposed Climate Disclosure Rules that would require companies to provide information about climate-related risks that could have a material impact on their business, finances, or operations. These rules would affect all public companies, including Smaller Reporting Companies (SRC) (though SRCs would be exempt from Scope 3 reporting requirements), and represent a major step toward recognizing the impacts that climate change can have on the continued health of a business. The most recent SEC rulemaking process began in earnest in March 2021 with its initial call for public comment, which yielded over three hundred responses within the 90-day official response period. Over 80% of respondents from large investors and other organizations, including pensions, endowments, sovereign wealth funds, ratings agencies, underwriters, reinsurers, REITs and large corporations, were in support of new climate change disclosure rules. As one respondent representing over $2.7 trillion in investments noted, “Climate risk disclosure would bring significant benefits to investors and companies. They need access to consistent, comparable, and reliable information at scale to fully assess their risk exposure and to navigate the path to a net-zero future. The current state of climate change disclosure does not meet our needs.”

Climate-related disclosure requirements are not new. There have been efforts underway since the 1970’s, with the most recent guidance released in 2010. The SEC has long held that climate and environmental risk factors can cross the threshold for materiality because of their possible impacts on the long-term viability of capital assets, continuity of operations, and even the viability of a business as a whole. The SEC’s view of materiality is broad, and it generally covers anything that an investor would consider important to the “total mix of information” used to evaluate a position in a company or other investment vehicle. However, since current securities laws do not mandate much in the way of climate and ESG disclosures, much of the information that investors might find important is not actually currently required to be disclosed unless it’s related to an existing requirement for disclosure.  One important caveat relates to discretionary statements made by management. 17 CFR § 240.12b-20 states that “in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.” More simply, when a company makes a net-zero or other ESG-related pledge, they have established a duty to disclose their current status, plans, and progress so that investors can accurately and completely evaluate the company.

Over the last several years, increasing numbers of corporations have made ESG pledges, and the resulting improvements in ESG scores have led to a lower cost of capital due to a perception of reduced risk. One study by MSCI shows that the cost of capital, equity, and debt all see substantial reductions as a company improves its ESG score. Ultimately, cost of capital is a measure of risk, and a company that has taken climate-risk factors into account should be less likely to be affected by climate risks than one that isn’t considering them. This is reflected in the significant oversubscription of green bonds compared to their vanilla equivalents and the meteoric rise of investment into ESG and sustainability linked funds.

Source: Climate Bonds Initiative, Green Bond Pricing in the Primary Market

The ESG commitments and pledges of many companies are driven not only by direct financial metrics like cost of capital, but also by consumer pressure. The SEC is especially concerned with protecting retail investors, and as consumers who have increasingly been drawn to Exchange-Traded Funds (ETFs) over the past decade have now turned their attention to ESG ETFs, disclosure becomes even more top of mind for regulators.

Source: ESG ETF Liquidity Continues to Warm Alongside Demand, ETF Trends, March 2021

The recent Russian invasion of Ukraine has exposed the improper compositions of a variety of ESG funds, highlighted the gap between marketing and reality, and increased the sense of urgency around disclosure. Changes have been swift; Morningstar has removed the ESG label from over 1,200 funds, and investors are becoming increasingly demanding before accepting that a company or fund truly deserves the label. The importance of the SEC’s efforts then becomes clear: a company can no longer simply claim to be sustainable or to have ESG goals and targets, and take advantage of the benefits that these labels bring. The onus will be on the company to prove to the investment community that it’s truly deserving of the label. Regardless of the specifics of the final rule, the SEC is going to have to chart a course to protect investors rushing into new sustainability linked assets.

The proposed rules would require companies to disclose information in several categories. While it was widely expected that the SEC rules would focus on carbon accounting, the rule would also require companies with public climate targets and goals to detail how they plan to achieve them. This is critical to protect and incentivize long-term investors who are taking into account ESG pledges when making their investment decisions. These pledges are typically years or even decades out, which means that investors who consider these pledges in their decision-making process are much more interested in gaining confidence in a company’s ability to hit its stated climate goals than in a precise accounting of a company’s current environmental impact. This highlights an important distinction between carbon accounting and transition planning. Accounting is a point-in-time measurement about the state of a company’s impact today, based on its current assets and operations. It is helpful for understanding a company’s baseline impacts, and for verifying if progress has been made. However, accounting by itself provides no indication of a company’s ability to hit its future climate targets, as even companies that have adopted robust accounting standards and processes have failed to meet their targets.

On the other hand, plans are about the future. They detail the specific investments that a company is planning to make, the timing of these investments, any anticipated changes to the business model, product offerings, or markets, contemplated divestments, and more. They provide investors with an indication about the level of thought, planning, and organizational commitment that has gone into securing the future of the company and to minimizing long term risks, and help investors decide if a company is a worthwhile investment over their time horizon. Because transition plans would be considered forward-looking and covered by safe harbor protections, investors are increasingly confident in demanding to see these plans.

To successfully complete an ESG Transformation, companies must:

• Assemble cross-functional and cross-domain expertise outside of their core business expertise

• Manage stakeholder expectations with clear, actionable and understandable plans

• Track progress and keep plans up to date as new technologies become available, financial conditions change and regulations evolve

• Deploy tools which enable the above to happen in a seamless and coordinated manner.

It’s now become table stakes for companies to make pledges, even in the absence of mandates, in order to maintain access to capital. It’s clear, then, that even if the reporting requirements for scenario planning and transition plans are reduced in scope or removed from the final rule, companies looking to differentiate themselves and further reduce their cost of capital will begin to disclose the specifics of their climate plans and precipitate a “race to the top” as investors become increasingly discerning. Ultimately, the effect of the proposed SEC rules are to accelerate the inevitable and provide a standardized framework that will improve an investor’s experience. The companies that successfully and proactively navigate this change will dramatically enhance their future value and emerge stronger than before.

Illustration by Stefan Gustafsson of Stefangus Design.