New Developments Could Raise the Temperature of Climate Change Disclosure

Current SEC Requirements to Disclose Climate-Related Risks

Under SEC rules and regulations, there is an overarching requirement to disclose information that would be material to investors. The SEC’s materiality standard generally provides that information is material if a substantial likelihood exists that a reasonable investor would consider it important in making investment decisions—in other words, "that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available."[2]

With regards to disclosure of climate-related risks, the SEC issued a guidance document in 2010 that provided examples of material information.[3] The guidance included examples of transition risks and physical risks that the SEC considered material. Some of the identified transition risks included the costs required to comply with regulatory limits on greenhouse gas ("GHG") emissions, a new "cap and trade" system’s effect on costs or profits, changes in demand for products based on carbon footprint, the impact of international treaties relating to climate change, and the impact of public information on a business’s reputation. Examples of physical risks included severe weather, sea level rise, the availability of farmland and water, and supply and distribution chain delays.

SEC rules that were updated last year, during the prior Administration, do not explicitly address climate-related risks; they employ a principles-based approach, rather than prescribing bright-line rules. But disclosure of such risks, nonetheless, may fall within a company’s obligation to report material risks under Regulation S-K, within sections 101, 103, 105, and 303. Section 101 requires a company to include in the description of business costs the cost of complying with environmental laws. Section 103 requires disclosure of environmental litigation that "is material, involves damages in excess of 10% of the company’s assets, or involves a government entity."[4] Section 105 requires disclosure of material risk factors that make investment in a company speculative or risky. Significantly, these risks can include pending regulations and legislation. Additionally, section 303 requires disclosure of whether the current financial success of a company may dissipate in the future due to a "material event" or "uncertainty."[5]

Due to the materiality of climate-related risks, some companies are making disclosures to fulfill these regulatory obligations. For example, in its 2020 Form 10-K, Diamondback Energy, Inc., an oil and gas company, reported climate-related transition risks from regulations that restrict GHG emissions, as well as President Biden’s move to rejoin the Paris Climate Agreement.[6] These developments could have a material impact on the demand for and price of the energy Diamondback produces, significantly affecting the company’s cost of doing business.

Moreover, according to Bloomberg, a range of companies, including insurance companies, financial institutions, and life sciences companies have begun reporting more climate-related risks during the last 12 years.[7] Many of these companies follow the 2017 recommendations from the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures ("TCFD"), a standardized climate risk disclosure framework.[8] TCFD recommends structuring disclosure around four core elements: the organization’s governance concerning climate risk, the impact of climate risk on the organization’s businesses and strategy, the process used to manage climate risk, and metrics and targets the organization uses to assess climate risk.[9] Despite the increase in voluntary disclosures, the landscape still could change dramatically if the scope of the reporting obligations becomes more comprehensive, making an understanding of the recent House bill, the Biden Executive Order, and SEC developments, as discussed below, crucial for businesses.

Both the House bill and the Biden Executive Order, which is a cornerstone of the new Administration’s policy objectives, have similar rationales; specifically, they address climate change’s "significant and increasing threat to the growth and stability of the economy of the United States."[10] The Biden Executive Order adds President Biden’s dual goals of a net-zero emissions economy by 2050 and combatting climate change’s effect on disadvantaged communities.[11] Even though these goals do not immediately impact disclosure requirements, they signal a changing tide that may have major future effects. The SEC’s recent investigative activities and consideration of the need for more specific rules in this space further signify that change may be inevitable. In its call for public comment, the SEC cited increasing investor demand for disclosure of climate "risks, impacts, and opportunities."[12]

The House Bill

The House bill (H.R. 1187, passed on June 16, 2021) gives the SEC two years to establish rules governing climate risk disclosure. Under these rules, companies must identify and evaluate their physical and transition risks; report on any established standards that apply for identifying, assessing, and managing such risks; disclose any current mitigation actions; discuss the resilience of their current strategy under different climate change scenarios; and describe how climate risk is incorporated into their overall risk management strategy.

The SEC rules required under the legislation would establish parameters and standards for disclosure specific to particular industries (finance, insurance, transportation, electric power, mining, and non-renewable energy, and others as appropriate); include reporting standards for estimating and disclosing direct and indirect GHG emissions, as well as the total cost of such emissions using the Social Cost of Carbon ("SCC") as a baseline; set forth reporting standards for disclosing fossil fuel-related assets; and require discussion of short, medium, and long-term resilience of any risk management strategy, as well as valuation scenarios based on different levels of climate change, including the current level and an increase of 1.5 degrees Celsius.

Standardized reporting requirements also would remove some of the guesswork from disclosures and, ultimately, may help both companies that are unsure of how to estimate and disclose their climate risk and investors seeking information about this issue. The House bill also includes a backstop should the SEC fail to finalize rules within two years; companies that follow the 2017 TCFD guidance would be deemed in compliance until the SEC fulfills its mandate.

The Biden Executive Order

President Biden’s recent Executive Order (E.O. 14030, signed on May 20, 2021) directs government advisors to formulate a strategy for identifying and disclosing climate-related risks of government programs, assets, and liabilities; seeks recommendations from financial regulators on how to improve climate risk disclosures, including addressing gaps in the insurance industry; suggests rescinding Trump-era rules that prohibited consideration of Environmental, Social, and Governance ("ESG") factors in pension investment decisions; and proposes amendments to the Federal Acquisition Regulation ("FAR") that would require government suppliers’ bids to disclose GHG emission and reduction plans, and for federal agencies to give preference to bids from suppliers with lower SCC.

Even though the Biden Executive Order primarily focuses on the climate-related risks of federal government programs, it likely will have ripple effects into the private sector. Banks, insurers, and government suppliers may all be affected by heightened disclosure requirements stemming from the Biden Executive Order. If Trump-era rules are rescinded, investment firms would be permitted to consider ESG risk factors in pension investment decisions, making disclosure of these risk factors more pertinent. The Investment Company Institute and BlackRock, Inc. have been big proponents of standardizing disclosure of ESG-related risks, and would welcome the ability of funds to consider such risks.[13] Further, an amendment to FAR requiring the SCC to be considered in federal procurement decisions would affect government suppliers and their disclosure requirements. Ultimately, it may encourage energy companies to reduce their GHG emissions.[14] Also, in fulfilling an objective of the Biden Executive Order, companies may need to disclose additional details about the impact of their activities on disadvantaged communities.

Potential SEC Rulemaking 

While the Biden Executive Order simply asks for guidance and the House bill faces hurdles in the Senate, these events signal that heightened climate risk disclosure requirements may be inevitable. Moreover, beginning shortly after President Biden’s inauguration in January 2021, the SEC has taken steps that signal a willingness to address climate risk disclosure, sue sponte. In February 2021, the agency’s Acting Chair Allison Lee, reported that she had requested the Division of Corporation Finance to review the extent of public companies’ compliance with the 2010 guidance and to begin updating the guidance based on its findings. In March 2021, at the direction of Acting Chair Lee, an ESG Task Force was created within the SEC’s Division of Enforcement, aimed at developing "initiatives to proactively identify ESG-related misconduct," and identifying any material gaps or misstatements in disclosure of climate risks.[15]

Further, on March 15, the SEC published a statement that asked staff to evaluate current disclosure rules "with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change," and requested public input on a series of questions, including whether to require disclosures of climate and other ESG risks.[16] The comment window closed on June 13 and a majority of commenters supported increased disclosure of climate-related risks.[17] The SEC Chair appointed by President Biden, Gary Gensler, also has expressed his support for heightened climate risk disclosure rules. The SEC’s regulatory agenda, announced June 11, states that rulemaking concerning climate-related risk disclosure will be a top agency priority.[18] While two SEC Commissioners have signaled a reluctance to support such rulemaking measures, the three Democratic-appointed Commissioners provide the majority needed to promulgate more prescriptive climate and ESG-related disclosure rules.

Overall Impacts of Developments

Heightened investor concerns regarding climate risks have led to increased government and private sector scrutiny of current 10-Q and 10-K reporting practices, resulting in the pending legislation, the Biden Executive Order, and recent SEC activity. Importantly, the pending legislation and the Biden Executive Order may themselves need to be reported by certain companies under Regulation S-K if the costs of compliance and other potential effects are material to investors. The bottom line is that public companies must be able to demonstrate compliance with current disclosure requirements, while being prepared to proactively address further developments in the changing climate risk disclosure landscape.

[1] https://fas.org/sgp/crs/misc/IF11307.pdf

[2] Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).

[3] https://www.sec.gov/rules/interp/2010/33-9106.pdf

[4] Id.

[5] https://www.sec.gov/rules/interp/2010/33-9106.pdf

[6] Diamondback Energy, Inc., Annual Report (Form 10-K) (Feb. 21, 2021).

[7] https://news.bloomberglaw.com/securities-law/climate-change-risks-surge-in-companies-annual-reports-to-sec

[8] https://www.whitecase.com/publications/alert/esg-disclosure-trends-sec-filings

[9] https://assets.bbhub.io/company/sites/60/2020/10/FINAL-2017-TCFD-Report-11052018.pdf

[10] https://www.congress.gov/bill/117th-congress/house-bill/1187/text

[11] https://www.whitehouse.gov/briefing-room/presidential-actions/2021/05/20/executive-order-on-climate-related-financial-risk/

[12] https://www.sec.gov/news/public-statement/lee-climate-change-disclosures

[13] https://news.bloombergtax.com/financial-accounting/fund-group-seeks-new-rules-on-corporate-climate-risk-disclosure

[14] https://www.enr.com/articles/51835-court-investors-biden-push-energy-firms-harder-to-address-climate-change

[15] https://www.sec.gov/news/press-release/2021-42

[16] https://www.sec.gov/news/public-statement/lee-climate-change-disclosures

[17] https://www.natlawreview.com/article/public-weighs-how-sec-should-regulate-esg-disclosures

[18] https://www.sec.gov/news/press-release/2021-99