On March 6, the SEC adopted final rules “to enhance and standardize climate-related disclosures by public companies and in public offerings.” Even though, in the final rules, the SEC scaled back significantly on the proposal—including putting the kibosh on the controversial mandate for Scope 3 GHG emissions reporting and requiring disclosure of Scope 1 and/or Scope 2 GHG emissions on a phased-in basis only by accelerated and large accelerated filers and only when those emissions are material—all kinds of litigation immediately ensued. In one of those cases, a petition for review of the final rule was filed on March 6 in the Fifth Circuit by Liberty Energy Inc. and Nomad Proppant Services LLC, followed on March 8 by a motion asking the Court to issue an administrative stay and a stay pending review of the rule. As discussed in this PubCo post, on March 15, in a one-sentence order, the Fifth Circuit granted Petitioners’ motion for an administrative stay. How long this pause will continue is anyone’s guess; its longevity may well be determined by another court designated by the Judicial Panel on Multidistrict Litigation to hear the multiple pending challenges to the rules, to which SEC alludes in its response. But, given that the stay is temporary, below is Part III of a revision and update of my earlier post on the climate disclosure rules. Part III addresses “Financial Statement Effects.”
The final climate disclosure rules require disclosure to be included in registration statements and annual reports and draws, in part, on disclosures provided for under the Task Force on Climate-Related Financial Disclosures and the Greenhouse Gas Protocol. The new rules require public companies to disclose information about material climate-related risks, companies’ governance, risk management, any material climate-related targets or goals and certain GHG emissions information, as well as disclosure of the financial statement effects, such as costs and losses, of severe weather events and other natural conditions. As noted above, in the final rules, the SEC pared down the proposal in response to public comments, such as the elimination of the mandate for Scope 3 GHG emissions reporting. One of the areas that was scaled back was the proposed financial statement disclosure, including elimination of the requirement to disclose the impact of severe weather events and transition activities on each line item of the financial statements and, instead of requiring disclosure of material expenditures directly related to climate-related activities under Reg S-X, requiring that disclosure under strategy, transition plans and targets under Reg S-K. As noted above, my earlier post on the climate disclosure rules described the background of these rules, various changes from the proposal in the final rules that were identified in the adopting release, and the statements by the Commissioners at the open meeting at which the rules were adopted. Part I covered various aspects of the proposal other than the sections on GHG emissions disclosure and attestation and financial statement information; Part II addressed GHG emissions disclosure and attestation.
Here are the final rules—a daunting 886 pages!—the fact sheet and the press release.
Financial Statement Effects (Article 14)
Overall. As proposed, a company that was required to file climate-related disclosure in a filing with audited financial statements would have been required to disclose in a note to its financials disaggregated climate-related financial statement metrics, mainly derived from existing financial statement line items, including financial impact metrics, expenditure metrics, financial estimates and assumptions. Disclosure was tied to a one percent threshold.
Comments were mixed, with some arguing that the proposal would promote consistency across reporting and would satisfy investor demand for reliable information about the financial impacts of climate-related risks, while others contended that the proposal would be costly, difficult to implement (requiring “burdensome adjustments to their controls, procedures, and accounting records”), and would result in the disclosure of a potentially overwhelming volume of immaterial information.
The final rules still require certain financial statement effects to be disclosed in a note to the financial statements, but narrow the scope of the required disclosure. Specifically, the SEC did not adopt the proposed financial impact metrics and modified the scope of the proposed expenditure metrics and financial estimates and assumptions. In addition, the final rules do not require disclosure of any impacts on the statement of cash flows. Importantly, the final rules focus on “disclosure of capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, and capitalized costs, expenditures expensed, and losses related to carbon offsets and RECs [renewable energy credits or certificates], subject to disclosure thresholds. These capitalized costs, expenditures expensed, charges, and losses represent quantitative information that is derived from transactions and amounts recorded in a registrant’s books and records underlying the financial statements.”
Although the final rules retain the one percent disclosure threshold, the threshold will not be applied on a line-item basis to determine whether disclosure is required. Instead, the final rules apply the one percent disclosure threshold only to “(1) expenditures expensed as incurred and losses and (2) capitalized costs and charges, in both cases incurred as a result of severe weather events and other natural conditions.” The SEC believes that severe weather events and other physical risks “can significantly affect public companies’ financial performance or position.” The final rules also use different denominators for the disclosure thresholds and include de minimis thresholds.
The financial statement disclosures will be required in any filing that is required to include climate-related disclosure under subpart 1500 (see Part I of this Update) and that also requires inclusion of audited financial statements. The SEC confirms that “this means that a registrant is required to comply with the requirements in Article 14 even if it does not have information to disclose pursuant to subpart 1500, as long as the applicable Commission filing requires the registrant to comply with subpart 1500.”
SRCs and EGCs will have a longer phase-in period. (See this PubCo post.) In addition, the final rules will not apply to a private company that is a party to a business combination transaction under Rule 165(f) involving a securities offering registered on Form S-4 or F-4.
Financial Impact Metrics. Under the proposal, a company would have been required to disclose financial impact metrics, that is, the negative and positive financial impacts from severe weather events, such as flooding, drought, wildfires, extreme temperatures, sea level rise, and other natural conditions and transition activities on any relevant line item in the consolidated financial statements during the fiscal years presented. While some commenters supported this proposed rule, many did not, contending that the disclosure was really not feasible primarily because “companies currently do not track climate-related impacts by financial statement line item and companies do not have processes in place to do so under current accounting systems,” nor was it clear that the disclosure would actually benefit investors. Many commenters did not support the proposed one percent disclosure threshold, contending that it would result in excessive and immaterial detail, that the threshold was “significantly below the five percent ‘rule of thumb’ for materiality used by many registrants and auditors” and that it may be difficult to audit. Other commenters highlighted that the term “severe weather events and other natural conditions” is not the same term used in the proposal regarding Reg S-K, which uses “extreme weather events.” They also asserted that additional clarification or guidance was needed, such as a baseline to distinguish historical patterns or events in different regions of the country. Some questioned whether companies “would need to determine that a severe weather event or other natural condition was, in fact, caused by climate change.” Some asked for clarification on the definition and scope of “transition activities” (relative to ordinary attempts at efficiency) and the meaning of “other natural conditions.” Other commenters raised concerns about how companies will be able to “isolate or attribute the effects of severe weather events and other natural conditions and transition activities on the financial statements.” Others raised questions about allocation and attribution, for example, allocation of expenses for core business purposes that may also be characterized as helping to mitigate climate-related risk. There was a lot more—filling almost 30 pages of the release. You get the drift.
After reading all this and more, the SEC decided to jettison the proposed financial impact metrics requirement altogether. Instead, the SEC adopted a “significantly narrower set of requirements that are focused on requiring the disclosure of a discrete set of actual expenses that registrants incur and can attribute to severe weather events and other natural conditions.” The SEC notes that GAAP currently requires companies to consider material impacts on the financial statements, whether driven by climate or not, and therefore, companies should consider whether they currently have an obligation to disclose information that would have been covered by the proposed financial impact metrics. In addition, the SEC observes that, in crafting the remainder of the final rules, it took into account many of the comments raised regarding financial impact metrics that were equally applicable to other provisions in the final rules, such as the use in “expenditure metrics” or the term “severe weather events and other natural conditions.”
Expenditure Effects. Under the proposal, the company would have been required to disclose separately the aggregate amount of expenditures expensed and the aggregate amount of capitalized costs incurred during the fiscal years presented to mitigate the risks from severe weather events and other natural conditions, other identified climate-related risks and transition activities, subject to the same 1% threshold. In each category, a company would have been required to disclose separately the amount incurred during the fiscal years presented toward positive and negative impacts associated with the climate-related events and toward transition activities.
While comments were mixed, many commenters did not support the proposed amendments to Reg S-X because of the time and cost burden, as well as the feasibility and other reasons described above. In response to comments, the final rules mandate disclosure of capitalized costs, expenditures expensed, charges and losses incurred as a result of severe weather events and other natural conditions.
Scope (Rules 14-02(c) and (d)). Paragraph (c) of the final rules requires companies to disclose the “aggregate amount of expenditures expensed as incurred and losses, excluding recoveries, incurred during the fiscal year as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise.” The rule identifies as examples “the amount of expense or loss, as applicable, to restore operations, relocate assets or operations affected by the event or other natural condition, retire affected assets, repair affected assets, recognize impairment loss on affected assets, or otherwise respond to the effect that severe weather events and other natural conditions had on business operations.” The disclosure “must separately identify where the expenditures expensed as incurred and losses are presented in the income statement.” However, the SEC expects that, because significantly fewer line items are impacted by the final rules, the final rules will be less burdensome than as proposed.
Paragraph (d) of the final rules mandates disclosure of the “aggregate amount of capitalized costs and charges, excluding recoveries, incurred during the fiscal year as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise.” The rule identifies as examples “the amount of capitalized costs or charges, as applicable, to restore operations, retire affected assets, replace or repair affected assets, recognize an impairment charge for affected assets, or otherwise respond to the effect that severe weather events and other natural conditions had on business operations.” Again, the disclosure “must separately identify where the capitalized costs and charges are presented in the balance sheet.”
Disclosure of costs and expenditures for mitigation activities is not required; rather, the final rules require disclosure of amounts incurred “as a result of” severe weather events and other natural conditions. In addition, the final rules do not include any of the proposed requirements related to voluntary disclosure of opportunities, although the SEC notes that, in some instances, the discussion of “impacts” required under some of the final rules may involve opportunities. In addition, the final rules do not require, as proposed, disclosure of costs and expenditures related to general transition activities in the financial statements at this time. The SEC notes that some information regarding material expenditures related to transition risks will be disclosed under the Reg S-K requirements related to transition plans and targets and goals (see Part I of this Update). The SEC also reminds us that “current accounting standards may require the disclosure of material expenditures within the financial statements, which may include material expenditures incurred in furtherance of a registrant’s transition activities.” Further, the SEC notes, additional disaggregation and disclosure of material expenditures may be needed to meet FASB financial reporting objectives.
The SEC expects there to be significant overlap between the severe weather events and other natural conditions a company identifies for purposes of disclosure under Rule 14-02 and the climate-related physical risks it identifies for the Reg S-K disclosure (See Part I of this Update.) In response to comments, the SEC has clarified that companies are “not required to make a determination that a severe weather event or other natural condition was, in fact, caused by climate change in order to trigger the disclosure required by Rule 14-02 related to such event or condition.” In effect, the Rule 14-02 requirements may elicit disclosure about events not related to climate, such as earthquakes. The list of climate events identified above is non-exclusive and was not intended to create a presumption. Companies will need to determine whether an event is a “severe weather event or other natural condition” based on the “particular risks faced by the registrant, taking into consideration the registrant’s geographic location, historical experience, and the financial impact of the event on the registrant, among other factors.”
In terms of presentation, the SEC advises that companies
“must separately aggregate the (1) capitalized costs and charges on the balance sheet, and (2) expenditures expensed as incurred and losses in the income statement to determine whether the applicable disclosure threshold is triggered and for purposes of disclosure. The capitalized costs, expenditures expensed, charges, and losses must be segregated between the balance sheet and the income statement depending on which financial statement they are recorded within upon recognition in accordance with applicable GAAP. For each of the balance sheet and income statement disclosures, if the applicable disclosure threshold is met, a registrant is required to disclose the aggregate amount of expenditures expensed and losses and the aggregate amount of capitalized costs and charges incurred during the fiscal year and separately identify where on the income statement and balance sheet these amounts are presented.”
The adopting release includes an illustration that provides greater detail, beginning on p. 492.
Disclosure Threshold (Rule 14-02(b)). As noted above, commenters were critical of the one percent threshold as burdensome and likely to elicit immaterial information. Nevertheless, the SEC elected to retain that threshold but to modify the scope of the proposed disclosures and the denominators used in calculating the disclosure threshold, and to include de minimis exceptions “to focus the final requirements on eliciting material information for investors.” The SEC believes that “the proposed quantitative disclosure threshold provides registrants with greater clarity in implementing the rules, reduces the risk of underreporting, and increases consistency and comparability.” The SEC also observes that, the final rules notwithstanding, companies have a responsibility to consider material impacts, whether climate-related or not, when preparing their financial statements and related disclosures, including “determining whether costs and expenditures that do not trigger the disclosure threshold may be material to the registrant, taking into consideration all relevant quantitative and qualitative factors.”
Under the final rules, disclosure is required if the aggregate amount of “expenditures expensed as incurred and losses equals or exceeds one percent of the absolute value of income or loss before income tax expense or benefit for the relevant fiscal year,” unless the aggregate amount of expenditures and losses is less than $100,000 for the relevant fiscal year. A similar one percent threshold applies to capitalized costs and charges: disclosure is required if “the aggregate amount of the absolute value of capitalized costs and charges equals or exceeds one percent of the absolute value of stockholders’ equity or deficit at the end of the relevant fiscal year,” unless the aggregate amount of the absolute value of capitalized costs and charges is less than $500,000 for the relevant fiscal year.
In a change from the proposal, the final rules use different denominators for the disclosure thresholds: “(1) income or loss before income tax expense or benefit, and (2) stockholders’ equity or deficit,” both of which are typical line items. The SEC expects that many companies “will have insight into the magnitude of these denominators prior to the end of the fiscal year.” To avoid any confusion that could arise from using a negative number, the final rules require the calculation of disclosure thresholds based on the absolute value of the relevant denominator. The final rules also require the use of the absolute value of capitalized costs and charges recognized for the numerator.
According to the SEC, the practical effect of the de minimis exceptions means that, if one percent of a company’s absolute value of income or loss before income tax expense or benefit is less than $100,000 (in 2022, approximately 17% of registrants), the company will not have to provide disclosure until the aggregate amount of expenditures expensed and losses incurred as a result of severe weather events and other natural conditions equals or exceeds $100,000. Similarly, if one percent of the absolute value of a company’s stockholders’ equity or deficit is less than $500,000 (in 2022, approximately 24% of registrants) the company will not have to provide disclosure until the absolute value of the aggregate amount of capitalized costs and charges incurred as a result of severe weather events and other natural conditions equals or exceeds $500,000.
Attribution (Rule 14-02(g)). Because several commenters raised concerns about companies’ ability “to isolate, attribute, and quantify expenditures related to severe weather events and other natural conditions,” the final rules include an “attribution principle” that must be used to determine whether a capitalized cost, expenditure expensed, charge, or loss is “as a result of” a severe weather event or other natural condition and to determine the amount to be disclosed. Under the principle, a capitalized cost, expenditure expensed, charge, loss, or recovery results from a severe weather event or other natural condition “when the event or condition is a significant contributing factor in incurring the capitalized cost, expenditure expensed, charge, loss, or recovery.” If it is a significant contributing factor, then the entire amount of the cost, expenditure, charge, loss, or recovery must be included in the disclosure.
Recoveries (Rule 14-02(f)). Under the final rules, companies will be required to separately disclose whether they have recognized any recoveries, such as insurance proceeds, during the fiscal year, as a result of the severe weather events and natural conditions for which capitalized costs, expenditures expensed, charges, or losses have been disclosed (paragraphs (c) or (d)). This information should be provided as part of the contextual information required under the final rules, as discussed below. The disclosure must also separately identify where the recoveries are presented in the income statement and the balance sheet.
Carbon offsets and RECs (Rule 14-02(e)). Although the final rules do not require disclosure of costs and expenditures related to transition activities, if companies have used carbon offsets or RECs as material components of their plans to achieve disclosed climate-related targets or goals, companies will be required to disclose information related to the purchase and use of carbon offsets and RECs. Specifically, the final rules mandate disclosure of the “aggregate amount of carbon offsets and RECs expensed, the aggregate amount of capitalized carbon offsets and RECs recognized, and the aggregate amount of losses incurred on the capitalized carbon offsets and RECs, during the fiscal year.” Companies will also need to disclose the beginning and ending balances of the capitalized carbon offsets and RECs for the fiscal year. This disclosure requirement is not subject to the one percent threshold. As above, companies will be required to separately identify where the expenditures expensed, capitalized costs, and losses are presented in the income statement and the balance sheet. This information is intended to “provide investors with needed transparency about the financial statement effects of a registrant’s purchase and use of carbon offsets and RECs as part of its climate-related business strategy.” The adopting release includes an illustration of a hypothetical presentation, which provides greater detail (beginning p. 492.)
Financial Estimates and Assumptions (Rule 14-02(h)). As proposed, companies would have been required to provide qualitative disclosure of “whether the estimates and assumptions used to produce their consolidated financial statements were impacted by exposures to risks and uncertainties associated with, or known impacts from, severe weather events and other natural conditions or any climate-related risks identified under Item 1502(a) of Reg S-K. (See Part I of this Update.) Separate disclosure focused on transition activities, including identified transition risks, would have been required.
Commenters were mixed, with some recommending the inclusion of materiality qualifiers and some opposed, contending that the requirement was redundant of current accounting requirements, such as critical accounting estimates. The SEC, however, believes that disclosure about estimates and assumptions will “allow investors to assess the reasonableness of the registrant’s estimates and assumptions.”
The final rules modify the proposal by narrowing some of the proposed disclosure requirements. For example, the final rules narrow the scope of transition activities covered by this paragraph to only those transition plans disclosed by the company. The final rules also add a materiality qualifier. Under the final rules, companies will be required to disclose whether the estimates and assumptions used to produce the financial statements were “materially impacted by exposures to risks and uncertainties associated with, or known impacts from, severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, or any climate-related targets or transition plans disclosed by the registrant.” If so, the company would be required to provide “a qualitative description of how the development of such estimates and assumptions were impacted by such events, conditions, targets, or transition plans.”
An example of how severe weather events, natural conditions, disclosed targets or transition plans could affect financial estimates and assumptions may be “if a registrant disclosed a commitment that would require decommissioning an asset by a target year, then the registrant’s useful life and salvage value estimates used to compute depreciation expense as well as its measurement of asset retirement obligation should reflect alignment with that commitment.” Similarly, a disclosed commitment to achieve net-zero emissions by 2040 could affect certain accounting estimates and assumptions. Other examples of estimates and assumptions that may require disclosure include those related to the “estimated salvage value of certain assets, estimated useful life of certain assets, projected financial information used in impairment calculations, estimated loss contingencies, estimated reserves (such as environmental reserves, asset retirement obligations, or loan loss allowances), estimated credit risks, fair value measurement of certain assets, and commodity price assumptions.”
Financial Statement Disclosure Requirements
Contextual Information (Rule 14-02(a)). The SEC had proposed to require companies to disclose contextual information to enable readers “to understand how it derived the financial statement metrics, including a description of significant inputs and assumptions used, and if applicable, policy decisions made by the registrant to calculate the metrics.” Although some opposed the proposal, most commenters favored the requirement for contextual information.
The final rules include some clarifying modifications, adding some new types of mandatory contextual information: significant judgments and other information important for understanding the effect on the financials. As described above, one example of the type of important information that is expressly required is information regarding recoveries, discussed above under Rule 14-02(f)). Under the final rules, companies will be required to provide contextual information, “describing how each specified financial statement effect disclosed under [Rule] 14-02(b) through (h) was derived, including a description of significant inputs and assumptions used, significant judgments made, other information that is important to understand the financial statement effect and, if applicable, policy decisions made by the registrant to calculate the specified disclosures.” If disclosure regarding carbon offsets and RECs is required, the company must also state its accounting policy for carbon offsets and RECs as part of this contextual information.
The contextual information may include “disclosure such as the specific severe weather events, natural conditions, and transactions that were aggregated for purposes of determining the effects on the balance sheet and income statement amounts and, if applicable, policy decisions made by a registrant, such as any significant judgments made to determine the amount of capitalized costs, expenditures expensed, charges, and losses.” (See the illustration in the adopting release at pp. 494-5.)
Basis of Calculation (Rule 1401(c)). The SEC proposed as “basis-of-calculation” requirements that a company must apply the same set of accounting principles that it is required to apply in the preparation of the rest of its consolidated financial statements included in the filing, whenever applicable. Most commenters supported the proposal, although some “raised concerns that certain of the proposed financial statement metrics would not necessarily comport with GAAP, including amounts for lost revenues, cost savings, or cost reductions.”
The SEC decided to adopt the requirement for companies to “calculate the financial statement effects using financial information that is consistent with the scope of the rest of the registrant’s consolidated financial statements and to apply the same set of accounting principles that a registrant is required to apply in preparation of the rest of its consolidated financial statements, consistent with the proposal.” The financial statement metrics are not required to be calculated at a reportable segment level or to be presented by geographic areas.
Historical Periods (Rule 14-01(d)). The SEC had proposed to require disclosure for the company’s most recently completed fiscal year and for the historical fiscal years included in the consolidated financial statements in the applicable filing, when reasonably available without unreasonable effort or expense. Most commenters did not support requiring disclosure for historical periods prior to the compliance date of the rules, contending that compliance would be too challenging and burdensome.
In the final rules, companies will be required to provide disclosure for historical fiscal years included in consolidated financial statements on a prospective basis only. Disclosure must be provided for the company’s most recently completed fiscal year, and to the extent previously disclosed or required to be disclosed, for the historical fiscal years for which audited consolidated financial statements are included in the filing.
Inclusion of disclosures in the financial statements (Rule 14-01(a)). The proposal required the financial statement metrics to be included in a note in the financial statements, with the result that the metrics would be “(i) included in the scope of any required audit of the financial statements in the relevant disclosure filing, (ii) subject to audit by an independent registered public accounting firm, and (iii) within the scope of the registrant’s ICFR.”
A number of commenters thought that making the information subject to audit would make it more reliable and decision-useful, while others thought it would be costly and more appropriate to include the information in MD&A or a supplement or alternative report. Some recommended exempting the metrics from the audit or treating metrics under a separate assurance engagement. Some suggested that additional guidance and auditing standards may be necessary. Some commenters pointed out that the PSLRA safe harbor does not apply to “forecasting information in the financial statements and urged the Commission to include a safe harbor for any forward-looking financial disclosures included in the financial statements and footnotes.”
The SEC believes that it is appropriate to require that the financial statement effects disclosure be presented in a note to the financial statements and that subjecting the required disclosures to audit and to ICFR will enhance the reliability of that information. PCAOB standards will apply to the disclosures. The SEC also clarifies that the financial statement disclosure requirements “must be included in the scope of the audit when a registrant files financial statements in accordance with IFRS as issued by the IASB.” Finally, the SEC did “not think it would be necessary or appropriate to adopt a safe harbor for the financial statement disclosures.”
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