9 Things to Know About the SEC’s New Climate Rule and How It Affects You

In the next couple of years, companies listed in the United States will need to start reporting climate-related risks and their plans to adapt to them, according to a sweeping new rule from the SEC.

The rule will also require the disclosure of scope 1 (direct) and scope 2 (indirect) greenhouse gas emissions, as well as how severe weather events like hurricanes will affect company financial statements. Greenhouse gas emissions are widely agreed to cause global warming, which in turn creates extreme weather. However, there is no requirement to report any scope 3 emissions (all of a company’s other emissions). A factsheet about the new rule can be read here.

The reporting guidelines will come into effect in several phases starting in 2025. Companies will need to disclose climate-related risks material to their operations, financial conditions, or strategies, the impact of those risks, and any plans they have to mitigate or adapt. (Some smaller firms won’t be affected.)

The new rule will create more relevant information with which fund managers (and you) can compare companies. Firms that aren’t addressing climate risk will be forced to up their game, leading to better management. Climate risks will become an important part of the traditional investment narrative.

“Requiring companies to report their material greenhouse gas emissions and climate risks in a consistent and comparable manner will help to harmonize a currently haphazard conversation,” says Adam Fleck, head of research at Morningstar Sustainalytics. “But there is still work to do. I hope to see further conversations around the topic as investors seek to measure financially material ESG risks and opportunities in valuing a company’s stock.”

Why is the SEC doing this?

• The SEC wants these reports because the majority of commissioners believe climate risks can affect a company’s business. In addition, investors need more standardized disclosures that are aligned with the well-accepted Taskforce for Climate-Related Financial Disclosures, or TCFD, and greenhouse gas emissions reporting protocol.
• In general, the SEC requires that companies disclose their material risks, and most have not articulated how climate change may affect them. Until now, US companies have been reluctant to disclose things they don’t deem material. This means coverage of climate-related information is spotty. Comparing companies is more challenging if they use different methodologies or consider different data points or information.

Why is the rule needed?

• The risks of a changing climate are accelerating. According to the National Centers for Environmental Information, there were 28 confirmed weather/climate disaster events with losses exceeding $1 billion in the US alone in 2023.
• If companies are not actively disclosing their climate risks, investors don’t have access to important information. For example, when Texas’ electric grid failed in 2021 during a cold snap, communications and transportation companies couldn’t provide service.
• “To combat the effects of climate change, we will need to transition to a low-carbon economy, meaning the transformation of business models, operating practices, and new technologies,” says Alicia White, senior product manager for climate solutions at Morningstar Sustainalytics. “Such a shift introduces its own risks—specifically, transition risk. Investors need to understand company-level exposure to transition risk and how this risk is managed.”

Are there any surprises in the rule?

• The rule will require companies to disclose the costs of physical risks, or “natural events and conditions,” such as severe weather. That’s a good thing. They must also disclose any management oversight in assessing and managing climate-related risk—something investors have pushed for.
• “In the end, I think more companies are going to face more volatility or impacts on financial conditions from physical risk than transition risk, which will primarily affect the big emitters,” says Julie Gorte, senior vice president for sustainable investing at Impax Asset Management.

Is the SEC behind the curve?

• Yes. Many regulations in jurisdictions around the globe go further. For example, companies that do business in Europe or California are preparing to make more detailed disclosures than what the SEC requires. Ceres estimates that one California law regarding greenhouse gas emission reporting could apply to more than 5,300 companies, and another requiring that they report on climate-related risks would cover more than 10,000.
• Examples of some of these rules:
  • In Europe, starting this year, the Corporate Sustainability Reporting Directive will require that companies disclose the impact their ESG risks and opportunities have on society and the environment. Individual countries within the EU can impose additional requirements building on CSRD guidelines.
  • In the UK, Streamlined Energy and Carbon Reporting requires companies to disclose their energy use, carbon footprint, and greenhouse gas emissions in their annual financial reporting.
  • New Zealand, Singapore, and the UK now require companies to produce TCFD reports to detail their governance practices for climate-related risks and opportunities.
  • California will require that big companies operating there with more than $1 billion in annual revenue report scope 1 and scope 2 emissions by 2026, and scope 3 emissions beginning in 2027. This rule goes further than the SEC’s, as it applies to both public and private companies and includes scope 3. It also requires companies that do business in California with a certain level of revenue to begin reporting on climate-related risks.
  • For more on sustainability reporting requirements around the globe, download Morningstar’s “Sustainability Reporting Requirements” white paper.
• Importantly, companies that follow the voluntary disclosure frameworks of the International Sustainability Standards Board also disclose scope 3 emissions. “Any impacts related to scope 3 emissions, such as carbon taxes, will affect companies and investors alike through policy risks,” says White. “Not supporting minimum standards of disclosure on scope 3 leaves investors prone to unknown risks.”

Corporate America and other companies around the world are already reporting this information in some form.

• The SEC says that some 90% of companies in the Russell 1000 Index already disclose this kind of sustainability data. More than 75% of Fortune Global 500 companies report annual emissions year over year, and more than half report on scope 3 in some form. Still, less than 25% have full scope 3 reporting. Calculating emissions outside a firm’s direct control is a complex project. It’s fair to say they’re waiting for more direction.
• “Corporate America has gone right ahead and started reporting the numbers anyway,” writes David Callaway, founder of Callaway Climate Insights. For example, Salesforce CRM has reported audited scope 3 numbers since 2022. Walmart WMT, the world’s largest company, reached a goal to cut its supply chain emissions by 1 billion tons more than six years early.

What’s next?

• Expect lawsuits from businesses that contend that the SEC has overreached, even without any scope 3 requirements. “The best explanation for the removal [of the scope 3 requirements] is that lawyers are surmising [they] will be shot down in court,” writes Andrew Poreda, senior ESG analyst for Sage Advisory.
• Already, big business groups have sued California to overturn its climate disclosure laws. Among the filers were the US Chamber of Commerce, the American Farm Bureau Federation, and several state business groups. They say the costs to business will be “massive” and that the laws violate free speech protections.
• Those who think the SEC didn’t go far enough, including the Sierra Club and Earthjustice, may also sue. “We certainly are disappointed about what appears to not be in the rule,” Earthjustice senior attorney Hana Vizcarra told Bloomberg Law.
• This year’s presidential election could also mean the rule is short-lived. “An SEC with new commissioners appointed by a new president could decline to appeal if plaintiffs get a ruling vacating the new disclosures, or new commissioners could revisit the rulemaking,” says Aron Szapiro, head of retirement studies and public policy for Morningstar.
• Sustainability groups will continue to pressure the SEC to revisit scope 3. “The only way this information can be provided in a consistent and decision-useful way is via a robust disclosure framework. As such, we hope to see the SEC continue to build on this rule after initial implementation,” Cambria Allen-Ratzlaff, an official for the Principles for Responsible Investment, said in a statement.
• Investors will also pressure individual companies to report scope 3 emissions. “Institutional investors have been seeking this information, and everyday investors would potentially benefit from knowing how the companies in their 401(k), IRAs, and other investments are addressing climate risk,” Leslie Samuelrich, president of Green Century Investments, said in a statement. She said that Green Century’s dialog with various companies resulted in Costco COST, Kroger KR, and Corning GLW reporting their greenhouse gas emissions.

What does this mean for investors?

• You’ll still have problems understanding the full scope of company emissions. According to Deloitte, scope 3 emissions account for more than 70% of the total carbon footprint of many businesses. For example, despite not having physical products, financial services companies still produce scope 3 emissions through their financing activities and supply chains.
• The rule shows that materiality matters. Climate risks pose huge challenges to society, but not all companies are exposed to these risks on the same magnitude.
• Most US companies have improved their climate disclosures, but laggards will have to boost the quality and detail of their reporting. “Better disclosures could lead to better management of climate risks,” says Poreda.
• The new rule also “solidifies the importance of climate risk as financial risk,” making climate an important part of the traditional investment narrative, says Jamison Friedland, sustainability analyst at AXA Investment Managers.

Why will it take so long for the rule to take effect?

• Even without having to report scope 3 emissions, it will be challenging for companies to get all this data. They will need to quickly adapt to collecting and auditing nonfinancial data.
• There is a fair amount of estimation associated with emissions data, and calculation and measurement methodologies are still evolving. Carbon emissions accounting relies on both direct measurements and estimations. Scope 3 accounting data from sources like business travel or value chain emissions are often estimated. Estimation may factor into scope 1 and 2 calculations as well, such as with energy consumption from the purchase of electricity, cooling, or heat. While some companies have access to direct meters, others rely on estimates from utility bills, building characteristics, and occupancy levels.

There’s cause for celebration.

• A few years ago, the idea of the SEC regulating anything related to environmental impact or climate change was unfathomable. This rule may not be as complete as sustainability leaders would prefer, or include all the data that is most useful to investors, but the fact that something will be regulated in climate is a huge step forward. We will have more comparable data, and companies will establish a process to collect and disclose this information. “This rule is a floor, not a ceiling, for companies to report how their business is adapting to a global economy that is transitioning away from fossil fuels. Investors will continue to push for further standardization of climate information as it has a clear financial impact on their portfolios,” Maria Lettini, CEO of sustainable investment trade group US SIF, said in a statement.
• Even if the SEC failed to require scope 3 emissions reporting, the new rule “marks an important milestone. The inclusion of requirements around transition plans and approach to climate governance is a valuable step forward for investors assessing climate-related risks,” says White.
• Plenty of companies and investors are finding opportunities to reduce emissions. As envisioned by the Paris Agreement, the target date for achieving global net zero emissions is 2050. “I don’t think anybody would have forecast 27 years ago that in 2023, onshore wind and solar generation would be more cost-competitive” than oil, gas, and coal, says Gorte. “In renewables, the whole arc of technology is ahead of us.”