Get ready for the great Net Zero commitment reset! …and other effects of the SEC’s new proposals for mandatory financial statement climate disclosures

Get ready for the great Net Zero commitment reset! ?…and other potential second and third order effects of the SEC’s new proposals for mandatory financial statement climate disclosures

?By: Justin Femmer and Rich Goode

?Last week the SEC released proposed rules mandating disclosure of climate-related sustainability data into annual filings for most large companies. This is a BIG DEAL. As highlighted in our article last November, many companies have made public sustainability commitments around achieving Net Zero or other aggressive greenhouse gas reduction goals. However, many did so without comprehensive plans backed by reliable data to support the feasibility of the goals and to forecast, track and report progress towards them. In their defense, setting aspirational goals around sustainability was seemingly what societal stakeholders demanded to see from companies. The pressure over drastically reducing greenhouse gas (GHG) emissions caused many companies to set Net Zero goals without really having a solid plan for how to achieve them or have any idea how much money achieving those goals will cost.

?Based on the long-anticipated SEC proposal around climate-related financial disclosures issued on March 21, companies who have made such proclamations will be required to not only report on their GHG emissions in their core financial statements, but to show how they plan on achieving them. If approved and implemented, the new SEC rule will require companies to report their greenhouse gas emissions, back up their GHG commitments with clear and transparent data around the assumptions and scenarios used, including the financial impact of meeting those reductions, and to have elements of this data subjected to audit.?This creates a potential predicament for many companies who set “stretch” sustainability goals, or those that made assertions around their sustainability progress (for purposes of?investment, customer differentiation, attainment of loans, or otherwise) without financial-grade data integrity.

?As a result it is conceivable that some companies may start to wonder whether they need to publicly temper some of their sustainability goals or decommit altogether from previous net zero goals. Companies that have yet to make a net zero commitment may refrain from doing so fearing that setting a goal will expose them to undue scrutiny or the inability to back up the goal with information on how they intend to achieve that goal. It is unclear how markets, customers, lenders, regulators, media outlets, and other stakeholders will react to companies pulling back previous sustainability commitments or historically reported data around sustainability - and whether a proverbial “off-ramp” will be provided.

?To appreciate the immediate, direct impact of the SEC reporting requirements proposed, it is important to have some understanding of?the added level of scrutiny given to any data that is presented in a company’s financial statements. Each element of information presented in the financial statements must be backed up by clear, auditable information, have dedicated information owners, proper controls, be presented in a way that is machine-language searchable (for example, XBRL tagging) and an understanding of the information chain of custody. For most companies today, this level of detail over non-financial information simply does not exist. In short - bringing more data into the 10k exposes companies to additional disclosure risks that they need to prepare for starting today. Let’s not forget that financial statement reporting and frameworks like GAAP have been around for decades while sustainability reporting is still evolving, with no one, all-encompassing framework that everyone can agree upon.

?Information presented in a company’s financial statements also brings personal accountability to corporate officers (a function of post-Enron / Sarbanes-Oxley), requires extensive audit procedures, and poses significant risk to the company if deemed to be materially inaccurate. False, misleading or inaccurate information can also damage a company’s brand and credibility, create exposure for fines and lawsuits, and require a company to restate its financials for prior periods. Further, it is unclear how markets will react to missed forecasts around reducing GHG emissions and other sustainability goals. Anecdotally, companies that have missed financial forecasts, even by a trivial amount, have not been treated kindly by Wall Street and have often taken a material hit to their market cap. With this additional context, it is understandable why companies may consider whether they want to adopt a more conservative approach to previously-stated sustainability goals relative to the new SEC regulation.

?In our experience we have learned that companies dislike uncertainty. They prefer a clear, objective target to align with, and objective ground rules. When it comes to the potential long term impacts of climate change on a company’s strategy and operations, especially with our financial system often only looking to the next quarter, it’s understandable that companies are confused or simply may have no idea what those impacts may have on their operations.

?Even if the SEC draft rule was not enacted, many companies still face exposure to the EU equivalent law, the Corporate Social Responsibility Directive (CSRD), coming into effect on a similar timeline to the SEC rule. Finally, let’s not forget the investor perspective either - with many of the large, institutional investors likely to step up their own requirements for financial disclosure should regulations somehow fail to come into effect. In short, regardless of whether it’s the SEC, the EU or some other stakeholder, all companies must consider the impact of climate change on their operations and disclose those impacts in their financial statements in the near future. The next step is to consider how to get started.

?We have met with dozens of companies in the past few weeks who are scrambling to understand the rules around climate related disclosures. Below are some of the things companies need to consider while figuring out how to comply with this new suite of climate-related financial disclosures:

?1- One of the most obvious impacts is the significant expansion of the compliance ecosystem required to support SEC sustainability reporting: hiring of internal resources, implementation of technology solutions to support faster and auditable climate information (see our prior Article ?a few months ago about the future sustainability data and tech ecosystem), and services from technical experts and assurance providers. These new obligations will exacerbate staffing shortages and challenges many companies already face in the wake of the “great resignation.”?Many companies that we work with don’t exactly have sustainability and finance experts sitting on the bench and are likely struggling to fill their open job reqs. Companies will quickly need to fill gaps in technical, operational and financial roles to prepare for and execute on these initiatives through hiring and the use of outside experts. Further, companies will need to develop the technology and data solutions for a carbon/emissions ledger at a much faster pace to support investment grade reporting.

2 - Legal and enterprise risk functions are asking questions about whether these rules create exposure relative to previously stated net zero pledges and other assertions about current sustainability results- so let’s break these into two buckets:?As it relates to long-term net zero pledges, one of our clients we met with last week had a good take: effectively, their view was that if they walked back their prior climate-related pledges it would send the message that they had no intention of actually achieving their goals and likened it to the ultimate form of greenwashing. So their position, which we believe is perfectly acceptable, is that while they may not have 100% clarity on how they will attain net zero, walking back prior commitments is a slippery slope. Instead of pulling back from their long-term commitment, they are going to instead focus their energy towards looking at how they can improve data collection, accuracy and transparency to support more robust reporting AND to inform how they move ahead to achieve their sustainability goals.?

Different from net zero pledges, which are primarily about future aspirations, many companies have disclosed information around their current sustainability performance for their businesses and products.?This information may have been relied upon by customers to make procurement decisions, by banks to meet specific loan/financing covenants, or by local agencies to award projects or other support. Considering these and other types of reliance, if a company that develops more precise and complete calculations finds they have a materially larger emissions footprint than previously understood, it is certainly possible there could be some negative reaction or exposure.

In summary, some companies have not even calculated their GHG emissions, others have only calculated some components of emissions using high level estimates based on industry averages or other indirect benchmarks - and virtually all companies have room to enhance their understanding of their own emissions footprints across their entire supply chain. As the SEC proposals drive companies to get a more accurate picture of their emissions, any material “reset” of current state data may impact sustainability-tied relationships that should be understood and thought through. The first step here is clearly to understand your carbon footprint fully.

?3- Companies will need to collaborate with their supply chain partners, industry peers, assurance providers and regulators to calculate their scope 3 emissions. Many companies have stated they cannot accurately compute scope 3 emissions today as justification for not disclosing that data to date in sustainability reports. Large filers will need to rely on their suppliers to provide the amount of scope 3 emissions associated with the products they procure; these suppliers will be pressured to establish their own robust emissions data reporting methods and processes on the same timeline required to support the obligations of their customers. This sharing of information between supply chain companies brings its own data security, technology, and privacy considerations as well.

?4- The internal ownership balance for sustainability reporting is going to shift. In the past, emissions reporting was usually owned primarily by sustainability teams. In an SEC reporting world however, the controllership /CFO function will take on a primary role to establish the proper governance, procedures, documentation, and reporting integrity for the sustainability data going into the financials to manage risk and quality. And by extension, the CFO/controllership organization will effectively need to take an increased level of ownership for all sustainability disclosures (even the non-audited climate reports). The latter point is that any data disclosed around sustainability should have the same level of governance and verifiable data in place as that in the financials since inconsistencies can create potential exposure for the company. To be clear - sustainability teams, legal, supply chain and operations all still play a critical role in sustainability reporting - but this shift of reporting ownership to the CFO will bring opportunities for traditional accountants, controllers and other finance professionals to lean into sustainability, and will likely result in dedicated ESG finance positions.

5- As better-quality sustainability information becomes available, there will be increased scrutiny from investors, media, customers and society overall. The progress that companies make in achieving sustainability goals will become more credible, visible and valued. For companies that use sustainability to differentiate from competitors (e.g. lower emissions products), this increased transparency will drive monetizable value. While it is still difficult to develop a single equation that determines how much it is worth to improve sustainability metrics, access to better data will provide better insights around ROI to drive decision making. Many of our clients are already modeling scenarios that incorporate assumptions on future taxation on emissions, incentives, bank lending rates and other key assumptions to drive better decision making. Achieving sustainability goals will require companies to ensure that everyone, from the CEO to the shop floor, understands how their job is impacted.

?6- Scope 3, or supply chain GHG emissions consist, in part, of emissions from upstream suppliers. This means that in a more transparent future, companies will be able to understand the GHG emissions associated with purchased goods and services. This transparency drives the opportunity for companies to differentiate their products with lower emissions profiles. Suppliers that can offer products and services with lower emissions will be at a competitive advantage in the market and able to have a price premium over higher emissions alternatives.

?7- Executive compensation targets tied to sustainability (which are becoming increasingly material for many large companies) will be subjected to more scrutiny and rigor. More transparency over compensation data and the linkage to achieving sustainability goals will help drive internal incentives. In the future, a company that awards large bonuses to its executives while not showing improvement in GHG emissions intensity metrics overall may draw public ire.?

?8- The broader public will better understand the variability in definition and types of “offsets” claimed as part of achieving “net” sustainability goals. More demand will arise for offsets that are deemed to be undoubtedly additive and validated to be performing as expected (e.g. wanting assurance carbon offsets are not claimed for trees that may no longer be standing due to fires) vs those potentially deemed non additive or questionable. The price of renewable energy certificates and carbon offsets may also rise over time as demand increases.?

?In summary - Buckle up! These are just some of the areas companies need to consider in this brave, new world of sustainability reporting. The SEC proposal and the EU’s CSRD are responses to years of investors asking for clear, comparable and reliable information around how climate change affects your company. Both in terms of risk but opportunity as well. There are so many opportunities to capitalize on the transition to a low carbon economy, and investors are clamoring to find and invest in those opportunities.

?We expect most of the large institutional investors as well as leading companies to come out publicly in support of the proposals.?Whether the proposals will be changed, are deemed to be overreach or not practical to implement on the timelines proposed remains to be seen. However, one thing is clear: change to how companies report on climate change and emissions is here.

?The view between these two authors is that these new rules, in some substantive form, will get enacted this year. Companies will bear most of the direct costs of compliance, but these actions also uncover opportunities; opportunities to innovate, differentiate and lead in the market. Between the war for talent, the need to enable the transition to a low carbon future and increased demand for energy efficient products and services, there is an opportunity to use this time as a means to build a more resilient company to weather the road ahead.

?If you are interested in working with some of the world’s leading companies in addressing these issues, reach out to us. The journey ahead will be exciting!

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Justin Femmer is a Partner at PwC, leading the US Data Automation & Governance Practice. He supports many leading companies with their ESG, Tax & regulatory strategy, governance, operating model design, risk analysis and management, and enabling technology and data solutions.???

Rich Goode?is a Principal in PwC’s ESG Trust Services Practice and an adjunct lecturer at Harvard University. Rich has been a leading practitioner of sustainability strategy for the last 15 years, supporting clients, standards setters and regulators on sustainability and economic policy, strategy, compliance and market impacts.

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