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Climate, ESG disclosure rules may require “heavy lifting” from companies: KPMG

27 June 2022 Amena Saiyid

The US Securities and Exchange Commission (SEC) has issued three proposed rules since March aimed at improving climate risk disclosure by most publicly traded companies and funds and minimizing greenwashing.

Sean McKee, national leader of KPMG's public investment management practice, and Elizabeth Ming, audit partner with the firm's IMPACT and asset management practice, spoke to Net-Zero Business Daily by S&P Global Commodity Insights about what publicly traded companies and funds with an environmental, social and governance (ESG) focus would have to do to comply with the SEC's proposals once they are finalized.

In March, the SEC released a proposed rule for publicly traded companies to disclose climate risk, but as McKee and Ming explained, the rule extends to asset managers that have exposure to exchange-traded funds.

Following up on its March proposal, the agency issued two more proposed rulemakings in late May aimed at curbing greenwashing claims. The enhanced disclosure rule outlined a proposed framework for ESG-focused funds, while the names rule specified a fund's name should be reflective of its investment strategy, whether it is ESG, climate, or otherwise.

In the disclosure proposals for climate risk and ESG funds, the SEC has sought to require reporting of emissions directly released by operations (Scope 1) and those released through purchases of heating and fuel from third parties (Scope 2). However, the regulator has asked for comment on whether to require reporting of Scope 3 emissions only if they are material to a company's bottom line. Scope 3 emissions refer to those released in the manufacture, transport and use of a company's product or service. Ming said reporting of Scope 1 and 2 would be a "lift" for the entities involved.

Net-Zero Business Daily: Give us a brief overview of the three main rules that the SEC has come out with and the universe of companies and funds they cover.

McKee: The climate risk disclosure rule really applies to corporate registrants, not [directly to] funds or their advisors. In other words, anybody who sells their equities and is registered with the SEC. The proposal's significance lies in requiring use of reporting frameworks and third-party attestation.

[Apart from publicly traded companies], it also would apply to some asset managers that manage certain types of exchange-traded funds that include publicly listed business development companies and investment advisors.

The names rule, which mostly pertains to public and private funds including those with an ESG focus, should be seen as "truth in advertising and naming."

The ESG enhanced disclosure rule applies mostly to public funds and to all investment advisors who manage public or private funds that register with the SEC under the Investment Advisors Act of 1940. The disclosures under this rule include fund documents and extend to the Form ADV (SEC-required form about investor fund operations including fees and any disciplinary action) and the investment advisor brochure.

Net-Zero Business Daily: From a climate lens, where do these three rules supplement and complement each other?

McKee: In some instances, these rules supplement requirements while in others they are potentially duplicative. The climate disclosure rule would apply to the registrant, period, regardless of whether it's ESG focused. A company would have to disclose GHG emissions data along with financial risks, and that makes it different from the names rule.

Since the climate rule applies to corporate registrants, the naming rule becomes less significant as most companies, not all though, don't have a social or environmental perspective. And their names are based on other factors.

Whereas when you talk about funds, their names denote their very nature and investment strategy. So, the SEC designed the naming rule specifically for funds, especially public funds. The SEC wanted it known that if you name a fund a certain way then you're going to be held to certain standards.

…The enhanced disclosure rule for ESG investment advisors and public funds takes the names rule further. I think of it as an ancillary to the names rule because it goes beyond having a name consistent with the fund's performance. It holds funds to a higher disclosure standard by asking them to follow a reporting framework. The SEC didn't want fund disclosures to be nebulous. That kind of disclosure, the nebulous part, is consistent with the same sort of thinking that went into the climate rule: full disclosure.

And if you are an ESG-fund with a climate focus then the reporting framework must be aligned with the climate disclosure rule. However, the ESG rule doesn't go as far as the climate disclosure rule because it doesn't require tests for the data that funds and investment advisors are reporting.

Net-Zero Business Daily: The climate disclosure rule uses the GHG Protocol definitions for reporting Scopes 1, 2, and 3, but the ESG rule leaves it to the funds. Does that make reporting easier?

Ming: Absolutely. That said, I do think there is a general market coalescence around the [GHG Protocol] being the most appropriate and widely accepted framework for emissions reporting. Keep in mind that funds have been offered some flexibility in how they report data. I don't expect too much variety in the use of frameworks though. Perhaps, there may be less disclosure from a fund with an environment focus than the protocol would require otherwise, but I expect consistency from a measurement and reporting perspective.

The SEC has already identified several prominent emissions frameworks. We would expect inconsistent use of those frameworks from funds that include private companies in their portfolios. That may create challenges when it comes to aggregating fund-level data. However, public registrants are more likely to be consistent about using the frameworks.

Net-Zero Business Daily: During a LinkedIn discussion on the ESG proposal, Elizabeth said disclosing Scope 1 and 2 emissions would be a heavy lift. If emissions are already being reported under the climate disclosure rule, wouldn't that make it easier, or duplicative?

Ming: Hypothetically speaking, if a publicly registered fund is investing in public companies, those companies would already be reporting that data under the climate proposal so it would not be a lift for them. But if you have an impact fund with a portfolio of private and public companies then it could be a lift because the private companies are exempt from the climate disclosure rule.

Net-Zero Business Daily: Can you explain what you mean by "it's going to be a lift?"

Ming: By lift, I mean reporting energy consumption and related GHG emissions. Companies would be required to measure that data in the same way they're required to account for fixed assets.

McKee: Climate disclosures for corporate registrants will vary from those required for public funds. For corporates, disclosures will be based solely on actual emissions while those by funds will include emissions data gleaned from companies listed in their investment portfolios.

Net-Zero Business Daily: What is the difference when it comes to disclosure between an ESG fund and one with a climate focus? Would it be more or less than what the corporate side is being asked to disclose in the climate rule?

Ming: I think it's relatively consistent. When you think about corporate-level reporting, there are requirements beyond just emissions data in the [climate proposal]. By that, I mean the SEC is asking companies to submit data that will help investors understand the financial impact of climate risks in their quarterly statements. An ESG-focused fund or an impact fund wouldn't be required to furnish such information.

Both the ESG and climate rules require a fair amount of disclosure around processes for collecting data and the controls to verify the data's integrity. Even if you're not an ESG-focused fund, and you're still required to report that data, there's a fair amount of lift involved in understanding and building the infrastructure process and controls to ensure the data is reliable. It's not simply a matter of data collection.

Net-Zero Business Daily: What about Scope 3 emissions? It seems to me that both the climate disclosure and ESG rules do not require Scope 3 reporting unless it is material.

Ming: Measurement of [Scope 3 emissions] involves a great deal of estimation uncertainty. Broadly speaking, it'd be rare for companies to determine that Scope 3 emissions are not material. While the [climate disclosure] rule says that a company is only required to disclose only if material, most companies will be required to disclose Scope 3 emissions because such emissions make up a material portion of most companies' total emissions. However, the protocol allows for variability in the use of methodologies to estimate that data as long as some general principles are followed. As long as the reporting entities are disclosing their methodology, it should be acceptable to the SEC.

Net-Zero Business Daily: How would you advise your corporate clients to report Scope 3 emissions?

Ming: A company has to start somewhere so I would say begin with understanding which Scope 3 categories would be more material to your firm. A number of tools currently exist that can help companies gain a baseline understanding of which categories might be most material. The other thing I would say is to be transparent about the estimates you use. Management should understand how those estimates are being made. That's kind of the "do what you say and say what you do" principle.

McKee: Because of a lack of consistency [for Scope 3 emissions], what typically happens in the development of reporting protocols that are nuanced is that companies try to emulate the approaches that others have used. Companies will still wind up with very disparate reports out of the gate, but once the rules go final and more disclosure takes place then the market will move people to more comparable protocols.

We're still very early in the innings though.

Net-Zero Business Daily: Can you confirm that there's no threshold for materiality?

Ming: The SEC has maintained the definition of materiality based on how it would affect a user's decisions. The commission has not offered clarity with respect to Scope 3 though.

Net-Zero Business Daily: Do you see the auditing provisions as challenging in the climate disclosure rule as the ESG rule? What's the biggest challenge?

Ming: From my perspective, the biggest challenge is just readiness for assurance. Independent accounting firms like ours are used to attesting data in line with professional standards. But I would say the challenge is really on the readiness front. Since the highest level of attestation is an evidence-based approach, I think a firm's ability to produce the evidence will be a challenge.

Net-Zero Business Daily: Can you spell out how the process of disclosure would work for a company? Where does reasonable assurance fit into this equation?

Ming: The process of disclosure would require a company to first collect the data, then build processes and controls in place to ensure its reliability such that management can vouch for its completeness and accuracy. At this point, a company would engage a third-party assurance provider to attest to the completeness and accuracy of that data.

Net-Zero Business Daily: Do you believe a phase-in period is needed? Will this be helpful in allowing companies, funds, etc. to become comfortable with this brand-new process?

Ming: Absolutely. Companies are going to need time to collect this data, and to build the appropriate processes and controls to ensure the data is reliable. Think about it, multinational corporations have facilities and operations all over the world. This is by no means a small lift to collect this data, much less to ensure they're doing it consistently with appropriate controls in place to guarantee its reliability and accuracy.

Net-Zero Business Daily: At a recent SEC Investor Advisory Committee discussion on the climate disclosure rule, some were concerned that the limited assurance provision is less rigorous than its reasonable assurance counterpart, and that could lead to under-reporting or under-estimating GHG emissions. Do you agree?

Ming: Yes, I certainly agree that limited assurance does not have the same rigor as reasonable assurance. But I would reiterate that you have to start somewhere. I think limited assurance is an appropriate place to start, and phasing would be appropriate from the perspective of the journey that companies will be on to collect and report this data.

McKee: Given the subjectivity associated with the subject matter, if you don't allow companies time to transition then you are mandating it as an absolute, prescriptive standard against which companies will be tested. Isn't it better to have a phased approach where companies can evolve and refine the process?

[EDITOR'S NOTE: Accounting firms normally offer two common levels of assurance engagement. First is the limited assurance engagement, which also is known as a negative assurance. This is when auditors reveal whether they found anything to counter the party's assertions. Reasonable assurance is a more detailed review normally expressed in a positive form.]

Net-Zero Business Daily: How does a company decide whether the data the SEC is seeking is proprietary?

Ming: The rules are essentially asking companies to submit already published data into one place. The idea is to have a company be transparent about its energy transition commitments and related climate risks, and the processes and metrics it uses to [manage those risks].

The climate [disclosure] proposal says a company must be clear about its energy transition strategy and investments. I think that's potentially where you could get into disclosing something that would pose a competitive advantage. The reality is that prior to this proposal SEC did require registrants to disclose risks and uncertainties and how they were managing them. However, I think it is fair to say that companies will have to think about how they can benefit from this data and sell their value to investors without losing their competitive edge.

Net-Zero Business Daily: Can you provide any examples of disclosure in either the ESG or climate rules that in your opinion could be construed as encroaching on proprietary data?

Ming: I think climate data, such as absolute emissions data, is not viewed as proprietary. Being transparent about the methodologies to estimate data is also not necessarily proprietary either. The idea is to make sure you are clear about your methodology, so investors understand the differences between companies. I think the proprietary information is really more around the opportunity side of the conversation.

Net-Zero Business Daily: Will American companies be placed at a disadvantage with SEC's rules, considering the EU has already come out with its Sustainable Finance Disclosure Rule? Or will these rules enable American companies to operate in a level playing field?

Ming: I think the EU piece of the conversation just reiterates that whether the entirety of the SEC proposals come to fruition or not, companies that operate in the EU and in other parts of the world will still have other reporting requirements to consider.

Net-Zero Business Daily: Do you believe these rules will lead to greater scrutiny of greenwashing claims?

McKee: Ultimately, disclosure brings things into the daylight, and that enables scrutiny. Scrutiny can result in actions, whether it's just companies on their own accord making changes, or whether it's compliance findings, or whether it's even enforcement cases. It all depends on how companies disclose, what they disclose, and how well they do it.

Ming: I would add that this is an opportunity for companies and funds to tell their ESG story with authenticity and proof in reliable data. It is not just a compliance exercise. Regardless of how the final rules shape up, there's a lot of demand for this information. And I think companies that embrace it would be able to use it to their competitive advantage.

Posted 27 June 2022 by Amena Saiyid, Senior Climate and Energy Research Analyst

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.


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