June 23, 2022 - On Friday the LSTA submitted its comment letter responding to the SEC’s inaugural climate proposal, “The Enhancement and Standardization of Climate-related Disclosures for Investors”.  The proposal would amend the SEC’s rules under the Securities Act of 1933 and Securities Act of 1934 to require that registrants provide specific climate related information in their registration statements and annual reports. The mammoth proposal – spanning more than 500 pages —  is the opening gambit of climate-focused regulation by the SEC.  Where some market participants had believed the proposal would follow a principles-based approach as federal securities regulation typically does or a comply-or-explain approach as has been adopted in the UK and elsewhere, the proposal instead would introduce numerous prescriptive climate-related reporting requirements for US and foreign registrants with the SEC in registration statements and periodic reports. Below we highlight several key aspects of the proposal as well as the LSTA’s response. (For a more complete discussion of the proposal, please find here materials by Allen & Overy, Practical Law and Sidley.)

The proposal – as explicitly recognized by the SEC – follows familiar concepts of the Task Force on Climate-related Financial Disclosures (TCFD) which includes governance, strategy, risk management, and metrics and targets. Given the broad adoption of TCFD-based voluntary reporting by companies around the world, it is expected that this – together with reference to the GHG Protocol – will be welcomed by most market participants. The LSTA is supportive of this approach. With respect to reporting, registrants would be required to disclose (i) the impact of climate-related risks on their business, (ii) their climate-related governance and risk management systems, (iii) greenhouse gas (GHG) emissions, including Scope 1 (direct) and Scope 2 (indirect) emissions, and, for many registrants, Scope 3 emissions, which captures additional upstream/downstream emissions in the registrant’s value chain, (iv) climate-related financial statement metrics and related disclosures, and (v) information regarding climate-related targets and goals, if applicable. For companies that are already disclosing certain climate-related information, these proposals would require heretofore voluntary disclosures to be included in company SEC filings, and in many cases, go further in scope than current disclosures. This is particularly true for Scope 3 emissions reporting. Few companies currently report Scope 3 emissions, but the proposal would require this disclosure by registrants (other than smaller reporting companies) if their Scope 3 emissions are material or the registrant has set a GHG emissions reduction target or goal that includes its Scope 3 emissions. Aside from the absence of Scope 3 reporting generally, the collection, calculation and analysis methods for Scope 3 emissions are still in very early stages. While the SEC’s proposal does permit reliance on estimates and third party data, in the LSTA and many others’ view, does not provide a sufficiently robust safe harbor for those disclosures. In addition, some of the information that would be required to be reported would be subject to attestation or independent audit requirements. In addition to the reporting in a registrant’s registration statement or Form 10-K, one of the biggest surprises in the proposal is the proposed amendment to Regulation S-X. Unlike analog regulation in other jurisdictions, the proposal would require registrants to include footnote disclosures in their consolidated financial statements on a line-item basis if financial impacts or expenditures related to transition activities meet or exceed 1% for the relevant fiscal year for each line item. The LSTA, like its fellow financial trade associations and many others, have made clear that such a proposal is unworkable, problematic, and arbitrary, and should not be included in the final rule.

It was predicted that this proposal would solicit an enormous amount of public comment and that prediction has come true as comments are becoming publicly available. There are a wide range of comments, but there are clear, consistent messages from the financial trade associations. Like the LSTA, other trade associations, such as BPI, SIFMA, AIC, IAA and ICI, support the SEC’s efforts to assure that investors receive consistent, comparable, and decision-useful information on climate-related risks and opportunities. However, reconsideration is warranted on several key aspects of the proposal to achieve the SEC’s stated goal. It is critical that the traditional standard of materiality that has informed reporting since the 1930s continue to underpin SEC regulations. Examples of deviations from that standard are found in the requirement of Scope 3 emissions reporting and the proposed footnote disclosures per amended Regulation S-K.    Any departure from the traditional materiality standard will result in variable and immaterial information that would undermine the SEC’s goal. Moreover, with respect to Scope 3 emissions reporting, the proposal would be impracticable for bank registrants (who would need to include their financed emissions), or publicly-traded private funds (who would gather and report on information relating to a plethora of individual investments even if no single investment is material). Of key concern to the LSTA is the knock-on impact that mandated Scope 3 emissions reporting will have on private companies, outside of SEC regulation, who operate within the value chain of a registrant. It is expected that the adoption of this proposal will indirectly force private companies to share their own GHG emissions data. Many private companies are not sophisticated in ESG and climate matters and may not have sufficient resources to collect, calculate and share GHG emissions data with other entities in their value chains. The proposal would impose an undue burden on these companies and, given the dearth of GHG emissions reporting by private companies, will necessarily mean that registrants will have to rely significantly on estimates which will not yield reliable, comparable information for investors. For these specific reasons, together with the immature state of Scope 3 emissions collection, calculation and analysis, the LSTA’s recommendation is that Scope 3 emissions not be included as a mandated disclosure item in the final rule.

While it is certainly anticipated that a final rule on climate-related disclosures will be adopted later this year, the proposal contemplates phasing in these new requirements based on a registrant’s filing status. Large accelerated filers would report on all but Scope 3 emissions for the first time in 2024 (covering FY 2023), accelerated filed in 2025 (covering FY 2023), with smaller reporting companies having until 2026 (covering FY 2025). Scope 3 emissions would then be required one year after initial reporting begins (except for smaller reporting companies which are exempt).  Given the novelty and breadth of this rulemaking, bumps in the road can be expected. Market participants have charted out potential paths of litigation questioning the jurisdiction of the SEC to adopt these requirements. Legal challenge seems likely.