Last week, the Securities and Exchange Commission (SEC) released its much-anticipated and ground-breaking proposed rule for the disclosure of climate-related risks. “The Enhancement and Standardization of Climate-Related Disclosures for Investors” (the “Proposed Rule”) would require all publicly traded companies to include in their registration statements and annual reports any information on the company’s climate-related risks that are reasonably likely to have a material impact on its business, operations or financial condition. If adopted, the Proposed Rule, which can be read here, would require companies to make disclosures regarding:

• The material climate-related risks to the company and its business strategy.
• How those climate-related risks impact the company’s business and financial statements.
• The governance and oversight processes in place at the board and management levels to address climate-related-risks.
• The processes adopted and implemented to identify, assess and manage climate-related risks.
• The company’s disaggregated greenhouse gas emissions (including, for larger companies, disclosures about the emissions of supply chain partners).

While the Proposed Rule is viewed by the SEC as a necessary step to protect investors by requiring public companies to provide consistent, comparable and reliable climate-related disclosures, there is no question that its broad and sweeping nature will impose significant time and cost burdens on those companies. Below we have provided answers to basic questions regarding the Proposed Rule, as well as definitions to certain terms and concepts that are discussed and a high-level summary of its principal disclosure requirements. We plan to publish a series of follow-up alerts that will analyze the key requirements in more detail.

Who Does the Proposed Rule Apply to?

All publicly traded companies regardless of their size, industry or operations. If approved, the compliance deadlines will vary depending upon the size of the company and certain requirements do not apply to smaller reporting companies.

What is the Process for Submitting Comments?

The Proposed Rule is open to public comment until May 20, 2022, or until 30 days after publication in the Federal Register, whichever occurs later. The SEC has included within the Proposed Rule a list of more than 200 questions for which it is seeking comment, and companies are free to also comment on any other aspect of the Proposed Rule. Comments may be submitted through the SEC’s online comment form, by email or in hard copy. Instructions for submitting comments can be found within the Proposed Rule.

What is the Anticipated Compliance Timeline?

Although the compliance deadline is presently a moving target, if the Proposed Rule is adopted with an effective date of December 31, 2022 and the filer has a December 31^st fiscal year-end, the following deadlines would apply:

What is a Physical Risk?

Physical risks may include harm to companies and their assets arising from acute climate-related disasters and extreme weather events such as wildfires, hurricanes, tornadoes, floods, and heatwaves. Physical risks can also include chronic risks and more gradual impacts from long-term temperature increases, drought, water scarcity and rising sea levels. A company may be exposed to other types of physical risks from climate change depending on its specific facts and circumstances.

What is Transition Risk?

Transition risks may include increased costs attributable to climate-related changes in law or policy, reduced market demand for carbon-intensive products leading to decreased sales, prices, or profits for such products, the devaluation or abandonment of assets, risk of legal liability and litigation defense costs, competitive pressures associated with the adoption of new technologies, reputational impacts that might trigger changes to market behavior, changes in consumer preferences or behavior, or changes in a company’s behavior. For example, an automobile manufacturer might disclose how changing customer demand and investor preferences for electric vehicles (EVs) will impact its production choices, operational capabilities and future expenditures. A car company that transitions from the production of internal combustion engine vehicles to the production of EVs might disclose that it expects to incur costs in the short term to change its manufacturing processes, but over the longer term it expects to realize increased sales, protect its market share against transition risks, including reputational risk, and potentially avoid regulatory fines or other costs as consumer and regulatory demands change.

How Detailed Does the Disclosure of Climate-Related Risks Have to Be?

In its current form, and keeping in mind that some aspects will likely change following the comment period, the Proposed Rule would require disclosure of very detailed and specific information. For example, a company’s disclosure must identify the location, by ZIP Code (or if the jurisdiction does not use ZIP codes, a similar subnational postal zone or geographic location) of properties, processes, or operations subject to a physical risk that has had or is likely to have a material impact on the company’s business or consolidated financial statements. If flooding presents a material physical risk, for example, the Proposed Rule would require a company to disclose the percentage of buildings, plants or properties, in square meters or acres, that are located in flood hazard areas in addition to their physical location.

What is an Example of a Climate-Related Opportunity?

While much of the Proposed Rule is focused on the disclosure of climate-related risks, companies are encouraged, but not required, to make disclosures about climate-related opportunities. Climate-related opportunities include cost savings associated with the increased use of renewable energy, increased resource efficiency, the development of new products, services, and methods, access to new markets caused by the transition to a lower carbon economy, and increased resilience along a company’s supply or distribution network. Disclosure of climate-related opportunities is voluntary in order to avoid requiring companies to divulge competitive business information.

What are Scope 1, Scope 2 and Scope 3 Emissions?

Scope 1 emissions are direct greenhouse gas (GHG) emissions that occur from sources owned or controlled by the company, such as from company-owned or controlled machinery or vehicles, or methane emissions from petroleum operations.

Scope 2 emissions are those emissions primarily resulting from the generation of electricity purchased and consumed by the company.

Scope 3 emissions are all other indirect emissions not accounted for in Scope 2 emissions. These might include emissions associated with the production and transportation of goods the company purchases from third parties, and the processing or use of a company’s products by third parties. Because Scope 3 emissions fall outside a company’s direct management and ownership, these emissions can be exceptionally difficult to quantify and control.

What is a Value Chain?

A company’s value chain includes the upstream and downstream activities related to a company’s operations and products. Both climate-related risks and climate-related opportunities would extend to a company’s value-chain.

Summary of the Proposed Rule

I. The Proposed Rule Framework

The Proposed Rule is modeled in part on the Task Force on Climate-Related Financial Disclosures (TCFD) framework and also draws upon the Greenhouse Gas Protocol (GHG Protocol). The Proposed Rule incorporates the TCFD definitions of “climate-related risks” (the actual or potential negative impacts of climate-related conditions and events on a company’s consolidated financial statements, business operations, or value chains, as a whole) and “climate related opportunities” (the actual or potential positive impacts of climate-related conditions and events on a company’s consolidated financial statements, business operations, or value chains, as a whole). The Proposed Rule would require a company to disclose any climate-related risks reasonably likely to have a material impact on the company’s business or consolidated financial statements. A matter is considered material if there is a substantial likelihood that a reasonable investor would consider it important when determining whether to buy or sell securities or how to vote. The Proposed Rule would require disclosure in a separately captioned “Climate-Related Disclosure” section of registration statements and annual reports and disclosure of climate-related financial statement metrics in the notes to the company’s consolidated financial statements.

With regard to timing, the Proposed Rule would require a company to disclose whether any climate-related risk is likely to manifest over the short, medium or long-term, and to describe how it defines short-, medium-, and long-term horizons. Companies would also be required to include in the narrative discussion of their consolidated financial statement whether climate-related impacts are anticipated to manifest over the short, medium or long-term. For example, an automobile manufacturing company that transitions from the production of internal combustion engine vehicles to the production of EVs might disclose that it expects to incur costs in the short term to change its manufacturing processes, but over the longer term, it expects to realize increased sales, protect its market share against transition risks, including reputational risk, and potentially avoid regulatory fines or other costs as consumer and regulatory demands change.

The Proposed Rule would not mandate that companies conduct studies on the impact to the company of climate-related risks under plausible (but hypothetical) future scenarios, such as the impact of global temperature increases of 1.5° C, 2° C, and 3° C, known as scenario analysis. Instead, under the Proposed Rule, if a company elects to use scenario analysis or any other analytical tools to assess the impact of climate-related risks on its business and consolidated financial statements, then the company would be required to disclose information about its scenario analysis and the assumptions, considerations and metrics relied upon.

II. Proposed Governance Disclosures

The Proposed Rule would require robust disclosures related to a company’s governance of climate-related risks and opportunities at the board and management levels. With respect to board oversight, companies would be required to identify the board members and/or board committees tasked with the oversight of climate-related risks. If any board member has particular expertise with climate-related risks, then the company would be required to describe the nature of that expertise. The Proposed Rule does not define or provide any guidance as to what would constitute the level of expertise sufficient to trigger the additional disclosures.

Companies would be required to provide investors with a description of the process and frequency by which the board (or applicable board committee) discusses climate-related risks, including how the board is informed about climate-related risks and how frequently the board considers those risks.

In order to help investors assess both (i) the extent to which a company’s board has integrated climate-related risks into the company’s overall strategic business and financial planning and (ii) the board’s efforts to maintain shareholder value, the Proposed Rule would require companies to disclose whether and how the board considers climate risks as part of its business strategy, risk management and financial oversight. In that regard, the Proposed Rule would require companies to disclose whether and how the board sets climate-related targets and goals, and what processes the company has put in place to enable the board to oversee the company’s progress toward meeting its targets.

With respect to management oversight of climate-related risks, the Proposed Rule would require companies to make many of the same disclosures applicable to the board at the management level. Companies would be required to disclose the management positions or committees tasked with assessing and managing the company’s climate-related risks. Unlike the board disclosures, however, companies would be required to disclose the climate-risk expertise of the members of management who are involved in managing the company’s climate-related risks.

The required disclosures would include a description of how the company’s managers (or management committees) are advised about any climate-related risks facing the company, and how those managers monitor and manage against such risks. The required disclosures would also require companies to disclose whether members of management report to the board with respect to climate-related risks and, if so, how frequently those discussions take place. Although the Proposed Rule does not require companies to disclose whether executive compensation is tied to a company’s progress toward meeting its climate-related targets and goals, the Proposed Rule observes that such disclosures may well be required under the existing framework for disclosures related to executive compensation.

III. Proposed Risk Management Disclosures

The Proposed Rule would also mandate disclosures that require companies to describe the processes in place to identify, assess and manage climate-related risks and how the company plans to mitigate or address those risks. With regard to the processes in place for identifying, assessing and managing climate-related risks, companies would be required to disclose:

• How the company determines the significance of climate-related risks and how the company measures its climate risk against other risks to the company.
• How the company determines the materiality of climate-related risks, including the size, scope and potential impact of such risks.
• How the company prioritizes addressing climate-related risks.
• How the company determines how it will mitigate its climate-related risks.
• The extent to which the company considers evolving legal and regulatory requirements, as well as shifting demands in the marketplace and changes in technology, when identifying and assessing its climate-related risks.

For companies that rely upon insurance to help manage and mitigate their exposure to climate-related risks, the company would be required to disclose its reliance on insurance products if, for example, the loss of that insurance would have a material impact on the company.

If a company has adopted or implemented a plan aimed at reducing its climate-related risks, described in the Proposed Rule as a “transition plan,” then the Proposed Rule would require the company to describe that plan, including the metrics and targets used by the company to identify, manage and mitigate physical climate-related risks and transition climate-related risks. Specifically, companies would be required to disclose how they plan to address or mitigate physical risks to the company including, but not limited to, exposure to extreme weather events, rising sea levels, wildfires, draught, severe heat and water scarcity. By way of example only, the Proposed Rule suggests that companies with operations in areas that may be vulnerable to extreme weather events may have adopted a plan to relocate those operations or to construct appropriate barriers or reinforcements that can withstand such events. The Proposed Rule would require those plans to be disclosed.

The Proposed Rule also would require companies that have adopted a transition plan to include a discussion of how they will address or mitigate specific transition risks including, but not limited to:

• Laws or regulations that restrict GHG emissions or products with significant GHG footprints or impose land or natural resource conservation.
• The imposition of a carbon price.
• Shifting and changing demands among the companies relevant stakeholders (such as customers, investors, employees and business partners).

The Proposed Rule makes clear that, even though companies will face different physical and transition risks, as applicable, the required disclosures must be relevant, specific and meaningful, as opposed to generic, so that investors can better understand and evaluate how the company will address, mitigate or adapt to the climate-related risks it has identified. Companies that have adopted a transition plan would be required to update its disclosures on an annual basis and describe the actions taken by the company in the prior year to achieve the company’s targets and goals.

IV. Proposed GHG Emissions Disclosures

The Proposed Rule would require the disclosure of GHG emissions for the company’s most recently completed fiscal year. GHG encompasses carbon dioxide, methane, nitrous oxide, nitrogen trifluoride, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. These gases are expressed in terms of metric tons of carbon dioxide equivalent (“CO2e”). The justification for using GHG emissions to measure progress in meeting net-zero commitments is well-documented.

The Proposed Rule establishes requirements for the measurement and reporting of GHG emissions to promote comparability across companies. GHG emissions are defined as either direct (resulting from sources owned or controlled by the company) (Scope 1) or indirect (resulting from activities of the company but that occur at sources the company does not own or control) (Scope 2 and Scope 3). Emissions are further categorized into one of three different classes or “scopes” consistent with the GHG Protocol as follows: