The proposed October window for the SEC to release its long-anticipated climate disclosure rule for public companies has come and gone, making it increasingly likely we won’t see the final rule until next year. As Mallory Thomas of Baker Tilly explains, that doesn’t mean companies can twiddle their thumbs until then.
The recent passage of climate disclosure legislation in California is shining a spotlight on the need for U.S. companies to prepare now for increasingly stringent reporting regulation. If they haven’t started already, U.S. companies of all sizes are wise to get up to speed on the disclosure landscape and understand the interconnectivity between the various regulatory reporting requirements and voluntary frameworks and what will be needed to comply.
Voluntary ESG reporting frameworks
It’s important to remember that ESG concepts aren’t new; most companies have been focused on many, if not all, of the concepts for years. What is new, however, is combining these topics under one framework and complying with multiple stakeholders’ pressures to show transparency, comparability and action on these items.
Currently, most reporting is voluntary in the U.S., meaning not yet mandated by legislation, but the newly issued International Financial Reporting Standards (IFRS) sustainability disclosure standards incorporate previously established climate-related reporting guidance, including from the Taskforce on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol. Therefore, when considering the current ESG regulatory landscape, it’s important for companies to understand these two important voluntary reporting structures.
TCFD is a framework that provides specific recommendations detailing how climate-related issues can impact an organization’s financial performance. The framework covers four areas: governance, strategy, risk management and metrics. TCFD recommendations take into account potential financial and reputational risks associated with transitioning to a lower carbon economy as well as physical risks posed by climate change itself.
The TCFD recommendations were incorporated within the standards issued by the International Sustainability Standards Board (ISSB), which recently launched its inaugural International Financial Reporting Standards (IFRS S1 and IFRS S2), ushering in a new era of sustainability and climate-related disclosures in capital markets worldwide. The standards aim to improve trust and confidence in company disclosures about sustainability to inform investment decisions, creating a common language for disclosing the effect of climate-related risks and opportunities on a company’s prospects.
Likewise, the GHG Protocol sets the standards for the accounting and reporting of GHG emissions. GHG emissions, including carbon dioxide, methane and nitrous oxide, are one of the most popular ESG metrics reported on. They are easily quantifiable and strongly relate to how well an organization measures and manages its carbon footprint.
European Union standards have led the way
CSRD and SFRD
So far, European Union policymakers have paved the way on ESG and sustainability standards around the world, creating a roadmap for companies in the U.S. as they await formal SEC or state guidance.
In 2019, the European Commission presented the European Green Deal, which provided the EU with a roadmap for developing a sustainable economy through policymaking and represented a commitment to solving climate- and environmental-related challenges. Two key directives resulted from the European Green Deal: the Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosure Regulation (SFDR). While both these directives significantly impact the EU market, they can also affect U.S. organizations.
The EU introduced the CSRD to drive transparency and consistency in sustainability reporting by requiring companies to report on the impact of corporate activities on the environment and society and providing investors and stakeholders with the information necessary to assess investment risks arising from sustainability issues. The comprehensive directive covers various ESG topics and centers on the concept of double materiality — meaning organizations must disclose financially material ESG impacts as well as those that could materially impact broader society and requires the audit (assurance) of reported information. The CSRD has been in effect since January 2023, but disclosures aren’t required until 2025. On July 30, 2023, the European Sustainability Reporting Standards (ESRS) 1 and 2 were adopted by the European Commission. These standards outline the reporting requirements for companies subject to the CSRD, including alignment to the TCFD framework and explicit materiality assessment reporting requirements.
EU leaders recognize that to achieve their ambitions, as set out by the European Green Deal, significant investment would be required. As part of this goal, the EU introduced the SFDR to steer the flow of capital toward sustainable investments, encourage transparency in the financial market and combat greenwashing. In effect since March 2021, the SFDR requires financial market participants and financial advisers to disclose sustainability risks that could cause a material negative impact on the value of an investment. Released in tandem with the SFDR, the EU Taxonomy Regulation is a green classification system that defines criteria for investments aligned with a net zero trajectory by 2050 and to other environmental goals set forth by the European Green Deal.
How do the EU regulations affect my business?
While the regulations are most applicable to the EU market, U.S. organizations may still be subject to their policies, as both the CSRD and the SFDR identify applicable non-EU companies that must comply. With the CSRD, U.S. organizations generating a net turnover of €150 million in the EU will be under its purview, while U.S. organizations that are financial market participants, financial advisers in the EU or that appear to market investment products to the EU will be subject to the SFDR.
What will be expected of my business?
Disclosure will be required if your business is subject to the CSRD or the SFDR. U.S.-based organizations that meet the requirements of the CSRD would be required to report on a range of ESG and general topics with timing varying depending on reporting thresholds. The main reporting requirements of the CSRD include disclosure of five main dimensions from the Non-Financial Reporting Directive (NFRD), a precursor to the CSRD: environmental protection, social responsibility and workforce treatment, respect for human rights, anti-corruption and anti-bribery and diversity of boards. Companies would also be required to disclose general, environmental, social and governance topics.
The SFDR’s main reporting requirements include disclosure of ESG conditions/events and principal adverse impacts (PAI) — both of which are any negative effects that investment decisions or advice could have on sustainability factors across the entity and individual funds. U.S.-based organizations that meet the requirements of the SFDR would be required to report various entity and fund-level information for the fiscal year of 2023.
The U.S. is catching up
Recent passage of the California Climate Corporate Data Accountability Act is a clear sign that some states are eager to put rules into place to hold companies accountable for their sustainability efforts. Under the bill U.S. companies, both public and private, with over $1 billion in revenue that do business in California would need to report their full carbon inventories, including scope 3 emissions, indirect emissions incurred by suppliers to large companies. It seems likely that other states, particularly those that have enacted other climate-related policies, will follow California’s lead.
In March 2022, the SEC announced a proposed rule that will require publicly traded companies to disclose greenhouse gas emissions, climate-related risks, effects and risk management processes within registration statements and annually (10-K). This rule has not yet been formally enacted, as debate continues over whether or not to include Scope 3, but regulation likely will include Scope 3 for larger companies, following the reporting precedent set by the California regulation.
The federal government has also introduced legislation to enable prudent fiscal management of its suppliers. In November 2022, the Department of Defense), General Services Administration and NASA proposed an amendment to the Federal Acquisition Regulation (FAR) to increase the transparency of climate-related information related to government contracting. This proposed rule directly engages the federal contractor supply base, specifically impacting U.S. government contractors that receive $7.5 million or more in federal contracts.
It’s time to take action
ESG and sustainability-related regulation across the globe is clearly not a passing trend. Capital markets fueled by global supply chains, along with increased requests for ESG and sustainability-related information from stakeholders, are clear indicators of what’s to come worldwide. Forward-thinking organizations are maximizing financial performance, attracting and retaining talent and mitigating looming climate and ESG compliance risk by embedding sustainability into their business strategy and core operating model.
As the ESG and sustainability regulatory landscape continues to mature, being unprepared to meet these reporting obligations presents a material risk to companies of all sizes, public and private. Protect and enhance your organization by staying a step ahead of the regulatory requirements.