What do the proposed SEC rules on climate reporting mean for companies and investors?
Investors are increasingly looking for ways to ensure their portfolios align with their values; they’re demanding transparency from the companies and funds they’re invested in on all sorts of topics; from diversity and inclusion to environmental performance. On March 21st 2022, the SEC unveiled proposed new rules for publicly traded companies in the US that would require those companies to disclose their greenhouse gas emissions scopes 1, 2, and possibly scope 3 as well as the climate-related risks the companies face. This is good news for investors looking to both decarbonize their portfolios as well as minimize their investment risks. Let's unpack what this all means.
What are scopes 1, 2, and 3? Greenhouse gas (GHG) emissions are split into three “scopes” as a way of clarifying what an entity directly causes or directly enables. Scope 1 refers to direct emissions, which would be combustion releases that the company does itself. This would mean things like furnaces or company vehicles. By contrast, Scope 2 is indirect emissions from energy consumption: the electricity that a company uses, for example, if created by natural gas, coal, or other fossil fuel, would create greenhouse gases, albeit upstream from the company that uses the electricity. Scopes 1 and 2 are usually relatively obvious and simple to quantify since they’re often directly measurable.
Scope 3 emissions, however, encompass all upstream and downstream emissions of a company – their ‘value chain’ - and can be either under the total control – or not – of a company. Scope 3 is where the SEC’s proposed rules give a bit of leeway and indicate that they only need to be included if they’re deemed ‘material’ to the emissions of the company.
As an example of Scopes and why they matter, let’s consider one of the world’s most ubiquitous brands, Apple. Apple has claimed to have achieved carbon neutrality for its corporate operations. However, on closer inspection, this only covers Scopes 1 and 2. Yet, in the case of Apple, over 70% of its GHG emissions come from product manufacturing (Apple is, after all, primarily a product company), which are Scope 3 emissions. Without including Scope 3 emissions, this could give a false impression of the carbon neutrality of Apple’s products.
To be fair, Apple has also reported plans for all its footprint – including its supply chain – to be carbon neutral by 2030. This is to be welcomed, given the size of Apple’s supply chain, as it will mean their suppliers also have to take climate action if they don’t want to lose market share.
This example illustrates both the importance of understanding Scopes as they relate to claims of carbon neutrality, but also how including Scope 3 emissions in SEC reporting has the potential to accelerate GHG reduction efforts in smaller companies that wouldn’t be covered by this reporting obligation themselves.
What are climate risks to a company? There are a lot of potential climate risks – fire, flood, larger and more powerful storms, as well as supply-chain disruption as natural disasters exert influence on the extended network that is a global market. It feels obvious to say that some companies are located in higher-risk locations such as in/on the ocean (facing risks from hurricanes or rising seas), near forests or areas at higher risk of forest fire damage. California’s famous Napa Valley, for instance, has had troubles from increasing heat and wildfires, with many wineries now reportedly uninsurable.
The supply chain can also be impacted by the climate. Take, for example, the floods in BC last year – which resulted in four major highways damaged by flooding and landslides, causing major shipping delays in and out of the province. If a company sources products from overseas, which is extremely common these days, then that company faces a higher risk of supply-chain disruption than a company that can source local items, as long as those items are also not facing some sort of climate risk.
Investors are looking for climate accountability Regular investors are noticing that their investments are more than just their nest-eggs. Investment portfolios help fund all sorts of publicly-traded companies, and sustainable or low-carbon focused funds have reached $2.78 trillion in assets, more than double from two years ago.
The claim that companies make of sustainability and their reality may differ greatly, however, and the SEC’s new environmental, social and corporate-governance (ESG) rule proposal aims to ensure that companies’ claims are not overstated. The ESG rule and the carbon-disclosure rule go hand-in-hand – if a company is a major contributor of carbon emissions, and is positioning itself to be much greener than it actually is, the discrepancy will become visible to investors. Ultimately, this protects the investors from being misled.
The inevitability of the rules The rules proposed by the SEC are in line with the SEC’s mission to ‘protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.' Climate change poses risks to companies on several fronts – just ask any insurance company! - and investors must have information about the risks their investments face in order to manage those risks. Companies must first understand their Scope 1, 2, and 3 emissions and their climate risk exposure in order to take steps to reduce the business risk and to attract investment in a carbon-constrained economy.
Ensuring that the sustainability claims of a company are real is an important step to empowering investors to put their money where their values align – and thus to helping promote our transition to a low-carbon economy.
While the rules are not in place yet, this the SEC’s proposal could be an even more important step to maintaining the progress of reducing carbon emissions in the US given the recent overturning of the EPA’s power to regulate carbon emissions of power plants. After all, if the market is the one to decide, it must have all the information.
What does this have to do with Alberta? It should come as no surprise that Alberta has a number of companies that are listed on the US stock market. However, under the proposed rules they’ll face a rather large change from what they’re currently doing in reporting their scopes 1 and 2 emissions. Consider an oil and gas company, for example - while they can control their scopes 1 and 2 and can make reductions in these to become ‘net zero’ facilities - their scope 3 emissions will massively change their footprint size since the majority of their emissions are created when the product is used. This would impact Alberta O&G companies in a big way and would be yet another push towards decarbonizing our economy.
Conclusion If approved, the proposed SEC rules will present a new way for investors to allocate their funds according to their risk tolerance as well as their values. Acknowledging the risks that climate change bring to the markets is a timely and necessary measure to maintain the integrity of the market, and allows investors to operate with all the information they should have in order to make good decisions not only for their wallets, but for the planet.