Understanding the SEC’s proposed climate risk disclosure rule

| Podcast

The US Securities and Exchange Commission (SEC) has a proposed a new rule that, if adopted, would require public companies to provide detailed reporting of their climate-related risks, emissions, and net-zero transition plans. In this episode of the Inside the Strategy Room podcast, four McKinsey experts explain the ramifications of the proposal for CFOs and other senior leaders. Laura Corb leads the Sustainability Practice in North America while Kimberly Henderson is a core leader in the practice. They are joined by finance expert Tim Koller, coauthor of the best-selling book Valuation, and Shally Venugopal, North American lead for McKinsey’s climate advisory firm Vivid Economics. This is an edited transcript of the discussion. For more conversations on the strategy issues that matter, follow the series on your preferred podcast platform.

Sean Brown: What developments led up to this proposed SEC rule?

Laura Corb: A handful of forces are making sustainability a critical consideration for organizations today. First, up to $5 trillion annually will be invested in sustainability by 2025—the largest capital reallocation in history. At the same time, approximately $11 trillion worth of assets will have to be retired. Investor scrutiny of climate risk is rising, and consumers and employees are increasingly factoring sustainability into their decisions. This is akin to the early days of digital. Like then, we are seeing massive shifts in value pools that will create new sector winners and losers and the basis of competition will shift in most industries. In this context, the SEC’s proposed disclosure guidelines represent both an inflection point and a catalyst for business in North America.

Sean Brown: Is there any significance to the timing of the SEC’s announcement?

Kimberly Henderson: The proposed rule comes in the context of growing global momentum toward climate action and standardized disclosure of climate-related risks. The United Kingdom, New Zealand, Japan, Hong Kong, and the EU are all moving ahead with similar measures. The Task Force on Climate-related Financial Disclosures [TCFD] issued voluntary guidelines that 2,600 companies around the world endorsed in 2021. The vast majority of institutional investors are citing climate risk as a leading issue driving their engagement with companies, and last year the International Financial Reporting Standards Foundation [IFRS] created the International Sustainability Standards Board [ISSB] that will also release guidelines.

Sean Brown: What disclosures would the SEC rule require companies to make if it is adopted?

Kimberly Henderson: It would require three categories of disclosure: material climate impacts, greenhouse-gas emissions, and any targets or transition plans. On material risks and strategic implications, the rule as written would require companies to disclose risks from physical climate-related hazards such as fires or floods by location and by share of assets exposed. It also asks for disclosure of transition risks, which could be regulatory, technological, market, or reputational risks, over the short term, medium term, and long term. Filers would need to disclose strategic impacts, financial impacts, and operational impacts, as well as their governance and risk management processes to manage these risks.

The second category is greenhouse-gas emissions. The proposed rule would require reporting of audited Scope 1 and Scope 2 emissions, which are emissions generated by a company’s own operations and through the energy it purchases. The rule would also require Scope 3 disclosures if they are material or if the filer has a target. Scope 3 are upstream and downstream emissions along the company’s entire value chain. The emissions reporting would need to be in absolute terms and in terms of intensity, both per unit of revenue, that is, greenhouse gases per dollar in sales and per unit of product, such as emissions per car manufactured. Filers would need to disclose how they arrived at those estimates and what greenhouse gases the estimates cover—be they methane, nitrous oxide, or CO2—and the type of source.

The last category is targets and transition plans. Under the current text of the rule, companies would need to disclose any existing targets around emission reductions, energy use, nature conservation, or revenues from low-carbon products. The SEC would want disclosure of the transition plans to achieve those targets, including specific information on the use of offsets or renewable-energy credits. If a company uses an internal carbon price, that price, as well as how it’s set and what it covers, would need to be disclosed.

Sean Brown: If the rule is adopted, when would these measures take effect?

Kimberly Henderson: The proposed rule would apply to US 10-K filers as well as foreign private issuers who file 20-F forms with the SEC. Large companies would have to disclose most of this information as of fiscal year 2023, so filing year 2024. Smaller companies would have a yearlong grace period until fiscal year 2024. For Scope 3 emissions, the SEC would provide an additional year beyond those deadlines, allowing companies to lean on Scope 1 and 2 filings by other companies in the prior year. That said, Scope 3 quantification is extremely hard because few companies have a detailed understanding of emissions in their supply chains.

Shally Venugopal: Scope 1 and 2 reporting would come first in part because companies could then interpolate that data into their Scope 3 disclosures. The US Environmental Protection Agency already requires reporting of major point sources emissions and that covers most of US greenhouse-gas inventory. The question is, how do you quantify the small share not covered? And what about emissions in other countries, particularly where there are no disclosure mandates? Therein lies the challenge with Scope 3.

Public companies already do a fair amount of reporting, for example in their Carbon Disclosure Project [CDP] reports. Many data aggregators also pull together that information. We see a much bigger challenge in private markets, although a few start-ups are starting to collect this data. Our clients, particularly in banking where Scope 3 financed emissions are a key consideration, are already starting to form internal teams to tackle these disclosures. Whether or not the rule passes, everyone wants to have as much time as they can to prepare.

Kimberly Henderson: On the financed emissions point, in the current draft the SEC says these emissions would likely be considered part of Scope 3. That’s important because companies that are not required to file these disclosures may be financed by parties, or be in the supply chains of companies, that need to file Scope 3. So even companies that don’t file directly may be affected.

Sean Brown: How does this SEC proposal compare to the climate disclosure regimes in other countries?

Shally Venugopal: Generally, the climate disclosure standards in the UK and the EU, as well as the IFRS’s first draft of the ISSB standards, are very similar. However, the IFRS standards are broader than the SEC’s in two ways. First, IFRS requires Scope 1 and Scope 2 emissions as well as Scope 3 emissions whether they are material or not. It also requires a forward-looking analysis under different scenarios for decarbonization.

Across the board, however, these regimes all put a strong focus on governance, including board oversight. The rules all had a single parent, which is TCFD, and that parent defined many of the principles around governance, strategy, risk management, targets, and metrics. The key difference between the SEC and other disclosure regimes is that the SEC’s breadth is a little narrower and its prescription a little greater. That is akin to the differences between the US generally accepted accounting principles [GAAP] and the IFRS standards.

One further distinction is that the IFRS draws on the Sustainability Accounting Standards Board [SASB], which is a disclosure standard rooted in sector-specific guidance. SASB focuses on reporting relative to the sector so investors can compare company performance to its peers, whereas the SEC goes deeper on prescriptions around financial metrics.

Sean Brown: When Scope 3 emissions data on suppliers is not public, how would organizations access that information?

Shally Venugopal: Scope 3 is a challenge because while the Greenhouse Gas Protocol offers guidance on how to measure Scope 3, there is limited access to that information. The first triage point is getting the data directly from the company. The second is using emissions factors to approximate the emissions from specific activities. For example, if you know the vehicle miles driven, you can convert that into emission estimates based on the make, model, and year of a vehicle. The final triage point, which has a large margin of error, is approximating production metrics for a given sector and thus the imputed emissions.

Sean Brown: Wouldn’t most Scope 3 emissions be captured within suppliers’ Scope 1 and 2 reporting?

Kimberly Henderson: There are a few areas that Scope 1 and 2 disclosures won’t address. One is global supply chains, which may include companies not subject to these disclosures. Another challenge are private suppliers that would not be under SEC disclosure rules, so their emissions would be hard to identify and quantify. Additionally, supply chains are multilayered. A company may have detailed information on its direct suppliers’ emissions but that is only the first level. You also need data on your suppliers’ suppliers, and their suppliers, and their suppliers, and data quality grows poorer with each step.

This affects various aspects of disclosure, such as transition plans. Any company that has a Scope 3 target will find it challenging to understand where the emissions happen along its value chain, what drives them, and how to work with the suppliers and potentially the entire industry to reduce them. Many companies struggle to get even a basic understanding of the emissions upstream.

Sean Brown: Given that companies would be tracking both their own and their suppliers’ emissions, how do you prevent double counting?

Shally Venugopal: Double counting will almost by definition be hard to limit with Scope 3. It’s hard to demarcate those concentric circles between your entity and the economy around you. The SEC recognizes that this is a reality until we find better ways as a society. These disclosure regimes are, in a sense, forcing events to get people to start reporting emissions and face up to the challenges. We need to remember that earlier US regimes such as Comprehensive Capital Analysis and Review (CCAR) and the Sarbanes-Oxley Act took many years to figure out, and climate disclosure may be a similar case.

Kimberly Henderson: I would go a step further to say that double counting in Scope 3 is a feature, not a bug. It is expected. The same greenhouse-gas emissions could be Scope 3 for many companies. Those not filing these disclosures directly are impacted because they could be supplying to companies that are or they could be financed by companies that are, which would likely make them part of Scope 3 emissions calculations.

Sean Brown: Some companies have been reporting climate risk information for years. What do they find to be the biggest challenges, and what can others learn from their experience?

Shally Venugopal: Many entities have been reporting on a voluntary basis. Others have gone through mandatory disclosures required in the UK or the EU or through stress-testing exercises. The key challenge they identify is lack of ambition, focus, or urgency at the board and management level, especially when companies are still trying to figure out their climate ambition and the extent to which they want to report it publicly. Another issue we hear about are decentralized execution teams that lack sufficient resources or a holistic direction. The SEC’s proposed rule makes clear the importance of finance, strategy, and risk collaborating to pull together a coherent investor story.

The SEC’s proposed rule makes clear the importance of finance, strategy, and risk collaborating to pull together a coherent investor story.

Shally Venugopal

The third problem that comes up is companies setting climate targets without a pressure-tested plan or demonstrated progress. One takeaway from this proposal is the importance of having a feasibility plan when setting targets and a clear sense of decarbonization levers you can use.

Poor quality of data and tracking is another issue. This goes beyond access to emissions data and risk information that we discussed. Many organizations need better internal data and technology if they are to bring together information from multiple businesses and geographies into reports that meet audit standards. Inadequate expertise and analytical tools can also be a problem. It takes high analytical acumen to identify what is material, not just from an accounting perspective but from a climate science perspective. Finally, companies often wait too long to get started. Our European colleagues have told us that waiting until the last minute to get your house in order can make for quite a scramble at filing time.

Kimberly Henderson: I would add that the proposed rule tackles some things outside most companies’ wheelhouse. Physical climate risk analysis, for example, is geospatial analysis of future climate events that most companies are not accustomed to doing.

Sean Brown: The CFO will need to lead much of this reporting, adding considerably to the complexity of the role.

Laura Corb: That’s right. CFOs will need to incorporate the sustainability lens into six dimensions of their role. The first challenge is understanding the organization’s starting point, not only on emissions but on transition risks and capabilities. Secondly, you need to ensure that you have a credible plan to meet your climate commitments while also driving value creation. That’s not easy. Many companies have publicized commitments with great intent, with the assumption that they will figure out the details later. For those companies, the “later” is now.

Many companies have publicized [net-zero] commitments with the assumption that they will figure out the details later. For those companies, the “later” is now.

Laura Corb

The third dimension is around governance. CFOs have to think through how they will interact with the board on target setting, risk management, and plan approval and how they will demonstrate the company’s progress against the plan. As a CFO, you will have to coordinate with the senior-management team and incorporate net-zero planning and performance management into the strategy and operational review cadence.

Another dimension is factoring in the costs associated with climate risk as well as the potential upside. What are the implications for your cost of capital assumptions, the portfolio strategy, and resource allocation? Where will you set the cost of carbon offsets? Which leads to the next point: all this work will require considerable time and talent, both financial and climate science, to create the tracking, reporting, and compliance mechanisms. Finally, the CFO will need to grapple with crafting an investor story that fully integrates the climate pathway and the value creation pathway.

Sean Brown: Tim, as an expert on corporate valuation, how do you see the reporting of climate-related risks affecting capital market perceptions?

Tim Koller: It’s important to understand the different audiences for this information. The SEC and other government agencies have used this as an opportunity to require new reporting, some of which will not be relevant to many investors because investors cannot absorb that level of detail. Filers need to realize that the audience is not just investors but the government and regulators, activists, politicians and political parties, and perhaps consumer groups. Different investors will approach this information differently as well. Some will be looking for a score to decide whether or not to invest in your company. Others are more sophisticated and will focus on elements that materially affect the economics of the business. So when you craft your investor story, you have to boil it down to the things material to those different audiences.

Sean Brown: Laura, you mentioned earlier that companies should understand both the potential downsides and upsides of the proposed regulations. What opportunities do you see?

Laura Corb: Fundamentally, you need to play defense on risk and offense on growth [exhibit]. That means figuring out how your climate strategy ties into the value creation story. In conversations with CEOs and CFOs, the question we pose is, “What is the full potential of the drags on economic profit and of the positive impact?”

To create value in the net-zero transition leading companies are making four complementary moves.

On the downside, you could face a higher cost of capital if you lag your industry peers and the costs of decarbonization over time. You may also face market share losses if your business is perceived as browner than competitors.

But costs can be offset by opportunities for growth given the shifting value pools. In terms of portfolio strategy, consider Danish power company Ørsted. It was a classic utility focused on fossil fuels before the management pivoted the portfolio to become a world leader in offshore wind energy. In addition, incumbents in most sectors have opportunities to build green businesses with new business models. They can also gain market share through product redesign and repositioning and by finding high-growth subsegments to pursue with a green focus. Finally, opportunities exist in green operations that not only help you advance your environmental goals but also reduce costs.

Tim Koller: One challenge for incumbents is that there are many entrepreneurs backed by venture capital money who will be pursuing the same green-business opportunities you are. You may have capital and cash flow coming in from your mature businesses, but you still have to develop a competitive advantage in these new businesses. That may be difficult because you may have to run these businesses differently than your existing businesses. You may also need different talent that may be hard to attract if you don’t have an entrepreneurial culture.

Sean Brown: Could this proposed climate disclosure rule serve as a jolt for companies to address the energy transition in their businesses?

Laura Corb: Absolutely. That’s why I referred to digital disruption earlier. We think this disruption will move even faster and be broader than digital. The proposed disclosure requirements are an important inflection point. They would set a new standard for compliance, but the mindset and approach need to go beyond that. Leaders need to embrace an intentional enterprise redesign, what we call really “green-sheeting” your company end to end, and the action needs to happen at pace. It will require considerable problem-solving to reach net zero in the timeframe to which most people have committed. The time between now and 2030 is critical from a planet perspective and what you do over the next few years will be decisive.

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