The Securities and Exchange Commission issued proposed rules for emissions risk accounting and disclosures by public companies. After the 60 day comment window the SEC will work on final rules.
(Discussion from my other blog, Attestation Update, is posted here because of the impact these rules will have on economic freedom and prosperity. You can ponder the impact for yourself.)
The proposal creates three areas for measurement and disclosure. Scope 1 is emissions from a company’s own operations, whether it is manufacturing cars, producing coal, or running a bank. Scope 2 is emissions generated from the energy consumed by company as an input to their operations. This could be the electricity to operate the branches and computers of a bank or it could be all of the coal consumed to produce steel.
As if that does not stretch your brain far enough, there is Scope 3. Those are the missions of all of the vendors to a company and all the consumers of its products. This is not just immediate vendors and direct consumers. This includes the emissions of the vendors’ vendors and their vendors, all the way back to when raw materials were first pulled out of the ground.
This includes emissions generated by your customers as they use your products and also your customers’ customers’ emissions. This goes all the way to the end consumer. Furthermore, this is life cycle costs.
As a brain stretcher, for a utility providing natural gas to consumers Scope 3 would include the emissions generated as consumers heat their home. The lifecycle is very short since the gas will be used as soon as it arrives at the houses.
To stretch further, consider assembly of laptop computers. Scope 3 would include end-users’ consumption of electricity for the entire time they use the laptop. Now to really stretch your brain, ponder a car manufacturer. Scope 3 would include all emissions by consumers until the cars are scrapped in a couple decades along with the emissions to scrap said vehicles.
Going back to the supply chain, this includes the emissions generated to create your inputs. As another brain stretcher, ponder calculating the emissions of mining the ore that was put on a cargo ship that was trucked to a refiner that was converted into aluminum or steel that goes into the shell that holds whatever electrical contraption you are assembling.
Oh yeah, and you will have to get your external auditors involved.
Scope 1 and Scope 2 calculations will require an attestation report from a CPA stating that your methodology is reasonable and the calculations are reasonable.
Scope 3 disclosures have a safe harbor, in other words the company cannot get sued if those numbers are incorrect. The safe harbor does not apply to Scope 1 and Scope 2 disclosures. If a company misses on those Scope 1 and 2 disclosures, there will be liability exposure to users of the financial statements.
If you want to get in on the ground floor of a new line of service in public accounting with lots of potential for growth, dig into the SEC rules. I cannot even imagine how much work will be required to generate attestation reports on every company’s Scope 1 and Scope 2 disclosures. Annually and quarterly. With the rules changing and modifying as fast as we currently see in GAAP and SEC rules.
There is an explicitly stated exemption from having to disclose Scope 3 emissions, but the threshold will easily be overriden. Those emissions only need to be quantified if they are material to users of the financial statements. Also overriding the apparent exemption is low implied materiality in the regs.
The proposed regulations elsewhere require that climate risks have to be disclosed if the impact is greater than 1% of any financial statement line item.
That is a staggering materiality threshold since it is not what would otherwise be a reasonable percentage, say 2% or 3% of total assets or total revenue or 4% or 5% of net income. The threshold for materiality is set at 1%. Furthermore, the base for determining materiality is any line item on the financial statement. So that would be 1% of cash, or 1% of asset retirement obligation, or 1% of fixed assets. Such a cut off could be surprisingly small.
The dissenting SEC Commissioner summarized the rules as follows:
“We are here laying the cornerstone of a new disclosure framework that will eventually rival our existing securities-disclosure framework in magnitude and cost, and probably outpace it in complexity.”
Let me rephrase that observation – she is predicting the ESG disclosures will surpass the entire GAAP disclosure framework and the existing SEC disclosure rules combined both in terms of size of the rules, cost of compliance, and eventually complexity. In other words, compliance costs for public companies could double because of this.
As a brain stretcher, ponder the rules for hedging or income tax accounting. Emissions rules will soon be more complex than hedging is now.
Ponder the basic framework of risk quantification and disclosure requirements. You will quickly realize the commissioner’s observation is correct – these rules will soon rival existing disclosures in complexity, difficulty, and cost.
Article at Bloomberg Tax linked below points out that about 50 pages of the over 500 page proposed rule defines accounting requirements and financial statement disclosures. The rules call for explanations of how the estimates were made and the related assumptions.
The emission disclosures will roll into notes inside the audited financials.
Article also points out this is a rare occasion for the SEC to directly set accounting rules. Usually they interpret and clarify what they want to see in the financial statements. In this situation they are creating accounting requirements and specifying disclosures.
Quantification and disclosure will be required for many items. The cost to be considered range from financial impact of going carbon neutral, to write-offs from retiring energy inefficient equipment, to price tag of new high-efficiency equipment to sundry other costs of complying with emissions requirements.
I have barely touched on the rules and probably misunderstand some of the high level issues. Even with that, you can see this will be a major issue for public companies over the next few years. I cannot even imagine the impact on CPA firms who work with clients registered with the SEC. You thought there was talent shortage now in the public accounting world? Ponder the impact from staffing up to audit and attest on all the new disclosures and filings.
Here are two of many articles describing the proposed rules:
- 3/21/22 – Wall Street Journal – SEC Floats Mandatory Disclosure of Climate-Change Risks, Emissions
- 3/23/22 – Nichola White at Bloomberg Tax – Climate Plane Puts SEC in Rear Role as Accounting Rule-Writer