Yesterday, the SEC’s Investor Advisory Committee (IAC) met to discuss a handful of topics, including the SEC’s own climate disclosure proposal. I missed some of the initial presentation, but was able to listen to most of the presentations. The playback is not yet available on SEC’s website. Here are my key takeaways from the panelists:
Data Quality and Assurance
- Voluntary climate disclosures have not closed the gaps on data quality and that is creating financial risk due to investor/rater reliance on bad data.
- The market appears to have an inadequate understanding of what limited assurance is and how limited it really is. Reasonable assurance provides value and credibility.
- With regard to assurance providers, the flexibility provided in the proposal by allowing non-traditional auditors not regulated by the PCAOB the opportunity to provide assurance on emissions may be a “race to the bottom” because there is a significant difference in quality assurance processes and independence norms between traditional financial auditors and others.
- Clarity and transparency in the assumptions and methods for the financial statement disclosures for climate risk are imperative.
- Because disclosures are currently voluntary, there is a lag in data reporting and data currency. In contrast, financial data is more timely and decision-useful.
I tend to agree with much of these views and have long been vocal about most of these same things. I am interested in what might happen in the assurance market if the rule is adopted with the same language as the proposal. When the proposal was issued in March, I wrote:
I foresee a battle in the market between environmental firms accustomed to and qualified in performing air emissions inventories (but not up to snuff in assurance/audit practices, experience, or securities law liability) and accounting firms who are generally the inverse. I expect acquisitions and staffing changes, along with a bunch of newly-minted “experts” on both sides. The vast majority of engineering/environmental consultants will not be familiar with the attestation report elements or the prescriptive audit practice requirements specified in the proposal. It wouldn’t be surprising if those factors serve to intimidate technical service firms and to some extent reduces the number entering the market on their own. However, they are better positioned to apply technical professional skepticism about emissions data based on their experience with manufacturing, chemical use, fuel burning and air pollution control equipment design, operation and maintenance.
Much of that perspective comes from my own experience in both validating air emissions data and conducting conflict minerals Independent Private Sector Audits (IPSAs). I am cynical that anyone without a technical understanding of air emissions processes, equipment, chemicals and pollution control/monitoring devices can adequately assess the quality of emissions data. With regard to IPSAs, under the SEC regulations promulgated pursuant to Section 1502 of Dodd-Frank, non-financial auditors are allowed to conduct IPSAs (which are filed, not furnished) provided the audit firms meet the standards of the Generally Accepted Government Auditing Standards (GAGAS), also known as the Yellow Book. Very few environmental or social audit firms took up the challenge to conform to GAGAS, which includes the need for a third party peer review of the audit firm processes, procedures, controls and independence reviews and publication of the peer review report on the audit firm’s website. In the end, I am not predicting a race to the bottom, but instead new partnerships between technical firms and financial auditors, or outright acquisitions of technical air emissions experts by financial audit firms.
Financial Valuation
- Disaggregating climate impact on line items in the financial statement is not reasonable.
- Measuring fair value of carbon offsets/trading will be extremely complicated given the wide range of absolute values in the various international markets.
- Sophisticated investors may look at climate and energy data as an indicator of operational and financial efficiency, rather than from the perspective of emissions as a direct indicator.
Various Matters
- Scope 3 emissions will be material for companies that use third parties to contract manufacture their products. Disclosure of contract manufacturing Scope 3 emissions will likely dramatically alter the picture for many high-tech/electronics brands who use Asian manufacturers to make essentially all of their products.
- Investors may be able to identify more efficient ways of managing climate risk for companies under the SEC proposal. For instance, while offsets may seem like a low-cost solution, there may be more efficient uses of capital that result in avoided emissions in the first place which are more financially advantageous.
- It was noted that while the preamble to the proposed rule language refers to TCFD and the GHG Protocol, the regulation proposal text itself does not, meaning the window is open for issuers to use alternatives to both the disclosure framework and the emission quantification methodology. In addition, TCFD and GHG Protocol can be modified without conforming to US administrative procedures or even official US involvement – leaving US companies and investors potentially at the mercy of these non-US, non-regulatory standards.
On this last point, I again go back to the conflict minerals rule for a similar situation. That rule refers to the use of an internationally recognized due diligence standard. At that time (ten years ago) there was only one – the OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas which was discussed extensively in the preamble but not called out by name in the regulation language. The same concerns were brought forward about reliance on an international voluntary non-regulatory consensus document within a US regulation. Today, the OECD Guidance remains the de facto standard, it has not undergone change or revision since 2013 and its use in SEC conflict minerals reporting context is generally no longer controversial or particularly problematic.
