SEC Climate Rule: Materiality - Great in Principle, Harder to Apply in Practice

When the US Security Exchange Commission (SEC) announced its proposed climate rules in 2022, corporations, sustainability practitioners, climate experts, and all sides of the political spectrum expressed strong views. Some hoped the SEC would match the rigorous and prescriptive nature of the European ESRS standards on climate, where others argued the SEC exceeded its remit.

The final SEC Climate Rule is not setting the bar like CSRD, rather it is raising the bottom and is still a significant step forward in US climate-related regulation. The SEC climate disclosure rules (886 pages) are looser and less prescriptive than either the ESRS or IFRS standards. 

These are the key components you need to understand.

‍Materiality

Perhaps the most dramatic change from the proposal: Most of the climate-related disclosures the rule covers are now mandatory only if they’re considered material. The SEC stayed consistent with its disclosure rules over the decades by requiring companies to only disclose climate issues that are “financially material.” 

The implication is that many of the disclosures in the climate rule are expressly tied to materiality, including those relating to scenario analysis, targets, goals, transition plans, internal carbon price, and some of the financial statement footnote disclosures. That’s great in concept, since it will enable companies in many cases to exclude disclosures they determine to be immaterial. 

It does mean that companies will have to go through the exercise of assessing materiality, which is sometimes easy, but other times much harder. There will be significant assumptions and potentially inconsistencies in how materiality is quantified and interpreted therefore potentially muddying the waters. Whatsmore, the definition of ‘financial materiality’ has been debated for years, the latest definition to use comes from the Supreme Court ruling (TSC Industries v. Northway) “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote or make other investment decisions.” 

There is also the risk that investors or the SEC will disagree with a company’s determination of ‘materiality,’ or it could be out of sync with the market or investor views. Companies will clearly have to explain why they might not deem Scope 1 and 2 emissions material. For many companies, it will be hard to argue that emissions are immaterial in a way that an auditor will approve. Therefore in the end most companies will likely still have to report their Scope 1 and 2 emissions.

So applying materiality is great in principle, but harder to apply in practice.

‍GHG emissions

The reporting of material Scope 1 and 2 emissions is required of large accelerated and accelerated filers. Reporting of Scope 3 (value chain) emissions is not required under the SEC climate rule.

In terms of disclosing Scope 1 and 2 emissions, the materiality principle comes into play. Here is the slightly paraphrased explantation from the SEC climate rule (see page 246):

‍Marteriality of Scope 1 and/or 2 emissions is not determined merely by the amount of emissions. The guiding principle is whether a reasonable investor would consider the disclosure of the company’s Scope 1 emissions and/or its Scope 2 emissions, important when making an investment or voting decision or such a reasonable investor would view omission of the disclosure as having significantly altered the total mix of information made available.

‍A company’s Scopes 1 and/or 2 emissions may be material because their calculation and disclosure are necessary to allow investors to understand whether those emissions are significant enough to subject the registrant to a transition risk that will or is reasonably likely to materially impact its business, results of operations, or financial condition in the short- or long-term.

‍Example: Performance on climate goals can make GHG emissions material

A company's greenhouse gas emissions might be material if knowing about them helps investors see whether the company is making progress toward meeting certain climate goals or transition plans they have to disclose according to the climate rule.

However, the fact that a company is exposed to a material transition risk does not necessarily result in its Scope 1 and Scope 2 emissions being de facto material.

‍Example: A material transition risk does not necessitate material GHG emissions

A company could reasonably determine that it is exposed to a material transition risk for reasons other than its GHG emissions, such as a new law or regulation that restricts the sale of its products based on the technology it uses, not directly based on its emissions.

Whenever deemed material, disclosed emissions can be aggregated in terms of CO2 equivalent rather than disaggregated by gasses. However, if a particular gas is material, that gas will need to be disaggregated. All emissions must be disclosed in gross terms, not netted against offsets.

There is flexibility in determining the reporting boundaries used for GHG emissions as long as the method is disclosed. Similarly, no particular calculation methodology is prescribed, but disclosure of the used protocol or standard is required.

‍Climate-related risks

Companies need to report climate-related risks, including both physical risks and transition risks, that materially impact (or are reasonably likely to materially impact) the company. It is important to note that companies must disclose material climate risks across the entire value chain. While value chain GHG emissions are not required, you will need to assess your entire value chain for material climate-related risks.

The key exception to the materiality determination is for physical climate risks: Companies must disclose all financial impacts greater than 1% of profits before taxes.

‍Task Force on Climate-related Financial Disclosures (TCFD) and GHG Protocol

The SEC has aligned its climate rule with the structure of the TCFD reporting framework, as this was designed to elicit information to help investors better understand a company’s climate-related risks to make more informed investment decisions. The TCFD framework is now becoming the core backbone of almost all major climate standards (e.g., the EU CSRD and ISSB Standards). Reading and understanding how the TCFD framework operates gives you a great starting point for most climate-related disclosures requirements.

‍Timeline

The SEC has given a relatively long runway for implementation of the climate rule, which still means it’s smart to start now with building capacity, capability, and systems to be ready to meet your reporting timeframe. Also note that attestation and assurance is still included for large accelerated and accelerated filers.

There are many efforts to visualize all the requirements in timelines. Two great efforts are by Tim Mohin and the Boston Consulting Group, and by Deloitte and Gray & Ropes.

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‍Takeaways

US companies will now have more clarity on what they need to report. Starting today with building your systems and internal capacity is important.

A good first step is conducting a materiality assessment. Materiality will drive disclosure and compliance preparation. Determine if climate is material to your business – and in the process, determine all the other sustainability matters material to your company.

Make sure your finance and sustainability teams (start to) communicate and collaborate. In the long-run, expect to issue a single annual report incorporating everything finance and sustainability related, all at the same time (ie. integrated reporting).

Most publicly traded companies already issuing climate disclosures are likely to align with the SEC climate rule. If your business is in scope of the EU’s CSRD/ESRS reporting, California’s new climate disclosure rules, starting to report on IFRS S2, or producing TCFD reports; these disclosures mechanisms have significant overlap with the SEC rules. That said, there is no explicit substituted compliance regime, so it will mean you’ll still have to make your climate disclosures as per the SEC rules (but the bulk of the work will have already been done under the other mechanisms).

If you are just starting out, conduct your materiality assessment and look at the TCFD framework as a good guide for preparation on the SEC Climate Rule.

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