Deep Dives
The U.S. Securities and Exchange Commission released proposed rules on Monday that would – if enacted – require publicly-listed companies to make disclosures that outline the effects of climate change on their business (and how they plan to manage these impacts) and that detail their greenhouse gas emissions. The official release of the proposed rules – and call for public comments about them – come after SEC Chair Gary Gensler announced in 2021 that the commission would use its statutory authority to draft climate-related rules and require companies to make corresponding disclosures, citing the demands of “investors representing trillions of dollars,” who are looking for “more consistent, comparable, and decision-useful info about the climate risk of the companies in which they invest.”
At a high level, the SEC’s proposal calls for changes that do not necessarily call on companies to change their overarching operations, but that would require them to report more information in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a “material impact on their business, results of operations, or financial condition,” and “certain climate-related financial statement metrics in a note to their audited financial statements.” According to the SEC, “The required information about climate-related risks also would include disclosure of [the various Scopes of a] registrant’s greenhouse gas emissions, which have become a commonly used metric to assess a registrant’s exposure to such risks.”
Much of the proposed regulations are based on the Task Force on Climate-related Financial Disclosures, an existing framework that aims to help public companies and other organizations disclose climate-related risks and opportunities. (If the TCFD sounds familiar, that may be because it is has been adopted by a number of luxury goods groups, such as Kering, LVMH, Hermès, and Richemont, as well as mass-market entities like Uniqlo-owner Fast Retailing and Zara’s parent Inditex, among others; it is also standard that BlackRock CEO Larry Fink has backed in his annual letter to CEOs.)
Specifically, the proposed rule changes would require publicly-traded entities – and “international companies with operations in the U.S.,” per S&P Global – to disclose information about: “(1) [their] governance of climate-related risks and relevant risk management processes; (2) how any climate-related risks [they] identified have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short-, medium-, or long-term; (3) how any identified climate-related risks have affected or are likely to affect [their] strategy, business model, and outlook; and (4) the impact of climate-related events (severe weather events and other natural conditions) and transition activities on the line items of [their] consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements.”
For companies that already conduct “scenario analysis, maintain transition plans, or publicly set climate-related targets or goals,” Duane Morris LLP’s Darrick Mix says that the proposed amendments “would require certain disclosures to enable investors to understand those aspects of the registrants’ climate risk management.” The more burdensome – and costly – outcome, he notes, would come in the form of GHG disclosures, as the proposed rules require companies to disclose information about their direct GHG emissions (Scope 1), indirect emissions from purchased electricity or other forms of energy (Scope 2), and in certain cases, GHG emissions from upstream and downstream activities (Scope 3).
Reflecting on the specific call for GHG emissions reporting (and the need for attestation reports from an independent service provider covering Scopes 1 and 2 emissions disclosures for certain entities), Mintz’s Jacob H. Hupart states that “while materiality remains a touchstone for the majority of the proposed rules,” GHG emissions disclosures “will be mandatory regardless of the circumstances,” at least when it comes to Scopes 1 and 2. Materiality is relevant when it comes to Scope 3 emissions disclosures, with the proposed rule stating these emissions must be disclosed “if material, or if the registrant has set a GHG emissions reduction target or goal that includes its Scope 3 emissions.”
(The SEC has stated that “a matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important …The omission or misstatement of an item … is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”)
It is worth noting that there is a Scope 3 exclusion for “smaller” companies (i.e., “an issuer that is not an investment company, an asset-backed issuer, or a majority-owned subsidiary of a parent that is not a smaller reporting company and that: (1) had a public float of less than $250 million; or (2) had annual revenues of less than $100 million and either: (i) no public float; or (ii) a public float of less than $700 million.”), and a “safe harbor” for companies that make good faith efforts but nonetheless, get their Scope 3 numbers wrong.
Scope 3 emissions are the most difficult type of emissions to account for and reduce, and yet, they also “tend to make up the largest share of corporate carbon footprints, per S&P – with the fashion industry being no exception here due to the significant percentage of operations that occur outside of brands’ own factories, etc. and that take place further down the supply chain.
Companies across industries routinely push back against Scope 3 reporting, arguing – in essence – that not only is it difficult to measure upstream emissions (i.e., those from their supply chains, such as textile production), it is even harder to ascertain downstream emissions – or those generated from products’ use and end-of-life phases. The SEC stated in the proposed rule this week that while Scope 3 emissions are, in fact, “indirect,” registrants “can and do take steps to limit Scope 3 emissions and the attendant risks.” In other words: although a registrant may not own or control a noteworthy amount of the operational activities within its value chain, hence, the outsized impact of Scope 3 emissions, registrants may not be off the hook.
Registrants “may influence those activities, for example, by working with suppliers and downstream distributors to take steps to reduce those entities’ Scopes 1 and 2 emissions (and thus help reduce the registrant’s Scope 3 emissions) and any attendant risks.” As such, the SEC states that “a registrant may be able to mitigate the challenges of collecting the data required for Scope 3 disclosure.” (There are, of course, mixed views, including among SEC commissioners, about how to approach Scope 3 emissions.)
Given the sheer size of some players in the apparel/retail space, it is not unimaginable that they “carry enough weight to influence how their suppliers behave,” Kristen Fanarakis, a Senior Consultant, Center for Financial Policy, says.
At the same time and seemingly seeking to address inevitable pushback from companies, including giants in the fashion/apparel/footwear space, at least some of which outsource as much as 80 percent of their manufacturing, the SEC also puts forth a potential method for calculating Scope 3 emissions from “purchased goods or services,” stating that “a registrant could determine the economic value of the goods or services purchased and multiply it by an industry average emission factor (expressed as average emissions per monetary value of goods or services).”
In another point worth taking away: the SEC states that “the proposed rules would require a registrant to disclose a number of board governance items, as applicable,” including “a description of the processes and frequency by which the board or board committee discusses climate-related risks,” with registrants potentially being required to disclose “how the board is informed about climate-related risks, and how frequently the board considers such risks.” To check this box, Bloomberg’s Matt Levine states that companies “will have to start providing the board with regular reports about climate risk, and devoting time to it in board meetings. (This is true even if you are, like, a software company with a modest environmental footprint.)”
“Perhaps this will all be surly and pro forma, and your behavior won’t change,” he states, “but the (reasonable) theory seems to be that if you force boards to talk about climate change they will end up doing something about it, too.”
In addition to standing to impact the considerations – and likely the composition – of companies’ boards (the SEC mandates, after all, that registrant also identify “any board members or board committees responsible for the oversight of climate-related risks” and disclose “whether any member of [the] board of directors has expertise in climate-related risks,” the SEC’s mandates are expected to impact deal-making in fashion and beyond. To date, ESG elements have started playing an increasingly significant role in M&A due diligence, if for no reason other than to help acquiring parties to avoid reputational damage and other risks, including loss of revenue and goodwill.
“Given that ESG is now a day-to-day focus for management and directors across industries, companies would be well-served to undertake a thoughtful assessment of ESG risks when evaluating potential targets in M&A activities,” Cahill Gordon & Reindel LLP’s Helene Banks, Brockton Bosson, and Jennifer Potts said ahead of the release of the SEC’s proposed rules. “Incorporating ESG into M&A due diligence enables companies and their counsel to evaluate the legal and reputational risks that may accompany the acquisition of new operations and facilitates the integration of the acquired company into the buyer’s own ESG program.”
While a growing number of parties confirm that ESG issues are actively being considered – and given weight – in connection with M&A transactions, they are expected to play an even bigger role once the SEC’s final rules come into play, whatever form that may take.