For climate disclosures, is this a race to the top?

29 March 2022

The announcement last week by the U.S. Securities and Exchange Commission (SEC) that it intends to introduce wide-ranging climate-related disclosure requirements for registrants marks a high point in ESG and environmental reporting.

Since their initial publication in 2017, the final recommendations and recommended disclosures of the Taskforce on Climate-related Financial Disclosures (the TCFD Recommendations) have, slowly but surely, been gaining ground and embedding themselves within corporate culture and reporting.

Large companies in the UK have been required to report basic emissions and energy usage metrics for some time now under the so-called Streamlined Carbon and Energy Reporting (SECR) regime.

But it was not until 2020 that integrated reporting on climate change on financial and strategic matters truly gained a foothold, when the Financial Conduct Authority (FCA) introduced new rules requiring premium-listed commercial companies, for financial years beginning on or after 1 January 2021, to disclose formally against the TCFD Recommendations or explain any failure to do so.

Since then, the FCA has extended its rules to standard-listed companies and, for years beginning on or after 6 April 2022, statutory climate-related disclosures, modelled on the TCFD Recommendations, will be fully mandatory for a wide range of UK companies, including not only blue-chip businesses, but also larger issuers on the UK’s AIM growth market and the largest private companies.

The SEC’s vote last week represents a move in a similar direction. It signals an intention to provide clarity, consistency and depth of transparency for investors in US companies that goes right back, in the SEC’s words, to the “core bargain from the 1930s”.

Like the UK’s statutory rules, the SEC’s proposals, (to come into effect from 2023, with reporting beginning in 2024) are modelled on, but stop short of lifting directly from, the TCFD Recommendations. And, like the UK’s rules, there has already been a focus on three key areas.

As in the UK, the SEC proposes mandatory reporting on scope 1 emissions (those arising directly from own activities) and scope 2 emissions (those created by energy a business consumes). But each would take a different approach to scope 3 emissions: those created not by the issuer’s activities, but by activities and other businesses embedded within its value chain.

Scope 3 emissions are more challenging, as they relate to activities over which a business has no direct control, relying instead on the influence a business can leverage over its partners. There is also the issue of “double-counting”, as one business’ scope 3 emissions could form part of another’s scope 1 or 2 emissions.

UK statute does not mandate scope 3 reporting. As such, only listed companies are asked to report on scope 3, and then on a voluntary basis. Whilst many issuers will strive towards reporting, the trickier task of collecting scope 3 data may push a good number of issuers into reasoned non-compliance.

The SEC proposes a different approach: mandatory reporting for large companies, but only if scope 3 emissions are “material” or the registrant has set a scope 3 target. It’s worth noting than any business seeking to make a science-based emissions reduction target would need to include material scope 3 emissions in its planning.

Whilst this arguably still provides wiggle room for issuers to shy away from scope 3 reporting, those inclined not to make disclosures will need to interrogate carefully whether scope 3 emissions are “material” to their business. The SEC has provided some useful examples.

Then we have scenario analysis. UK statute effectively mandates scenario analysis in line with the TCFD Recommendations. The SEC will not require scenario analysis, but many of its proposed mandated disclosures come close and it does intend to apply enhanced disclosure requirements to issuers that choose to conduct scenario analysis.

Scenario analysis has long been regarded as a cost-intensive but worthwhile procedure, and it will be interesting to see how vigorously the SEC pursues this point.

Finally, transition plans. Although mandatory disclosures in the UK should shed a light on companies’ steps towards adapt to a net-zero economy, there is currently no requirement to publish net-zero transition plans. The Government has indicated its intention to require listed companies to publish a plan or explain why they have not done so, but this this still remains to be developed.

For its part, the SEC proposes a similar approach to scenario analysis. Whilst reporting on “transition activities” would be mandatory, full publication of transition plans would remain voluntary, although registrants that do so would need to provide more context to allow investors to understand it.

What we are beginning to see is a carefully crafted competition between jurisdictions to create a balanced framework for climate-reporting that gives markets and investors a more transparent view of climate risk and opportunity in the economy whilst at the same time attempting to achieve a proportionate burden for businesses. And this is before even looking at other markets, such as the EU and Hong Kong.

It is these subtle differences on which regulators are now playing to attract both issuers and investors alike. The hope is that, in the end, the result of jurisdictions jostling for top spot in this way will be a more climate-friendly outcome for all of us.

The fact that a major global player is proposing to take this approach suggests that the arguments for light-touch regulation are unlikely to succeed when it comes to managing climate risk. In this context, it will be interesting to see how regulators respond to the much more complex reporting frameworks developing around biodiversity and natural capital reliance in the economy.

If finalised, the rules would be the first mandatory disclosures issued by the SEC on climate risk.