Last week, at a meeting of the SEC’s Investor Advisory Committee, the Committee heard from experts on two topics: accounting for non-traditional financial information and climate disclosure. Interestingly, two of the speakers on the first panel are among the eight new members just joining the Committee. In his opening remarks, with regard to non-traditional financial information, SEC Chair Gary Gensler characterized the discussion as “an important conversation as we continue to evaluate types of information relevant to investors’ decisions. Whether the information in question is traditional financial statement information, like components in an income statement, balance sheet, or cash flow statement, or non-traditional information, like expenditures related to human capital or cybersecurity, it’s important that issuers disclose material information and that disclosures are accurate, not misleading, consistently applied, and tied to traditional financial information.” With regard to climate disclosure, Gensler returned to his theme that the SEC’s new climate disclosure proposal is simply part of a long tradition of expanded disclosures, addressing the topic of “a conversation that investors and issuers are having right now. Today, hundreds of issuers are disclosing climate-related information, and investors representing tens of trillions of dollars are making decisions based on that information. Companies, however, are disclosing different information, in different places, and at different times. This proposal would help investors receive consistent, comparable, and decision-useful information, and would provide issuers with clear and consistent reporting obligations.” In her opening remarks, SEC Commissioner Hester Peirce asked the Committee to “consider whether our proposed climate disclosure mandate would change fundamentally this agency’s role in the economy, and whether such a change would benefit investors. Are these disclosure rules designed to elicit disclosure or to change behavior in a departure from the neutrality of our core disclosure rules?”
[Based on my notes, so standard caveats apply.]
Non-traditional financial information. The Committee member moderating the panels on this topic began by emphasizing the importance to the capital markets of the availability of high-quality, decision-useful information. Investors rely on these disclosures to “understand and assess a company’s business, risks and prospects, to make critical decisions about how and where to direct capital. It is thus critical that this information remain both relevant and reliable. As the sources of value and risk have shifted over the past several decades, investors’ informational needs have necessarily evolved.” In 1973, 83% of the market cap of the S&P 500 was in physical assets—property, plant and equipment. In the midst of this “fourth industrial revolution,” more value resides in intangible assets, such as knowledge-based assets. Now, 90% of the market cap of the S&P 500 is in intangible assets. In light of this shift, do we need to rethink the type of information that is included in financial statements? Are investors getting the information they need? What types of financial information, she asked, are now relevant for investors?
The first panel summarized the bases for the SEC’s authority with regard to mandating financial disclosure. The panel observed that the SEC has broad rulemaking authority with regard to financial statements, but has largely outsourced standard-setting to entities such as FASB.
On the second panel, the first speaker, the former chair of FASB, suggested the possibility of setting up a special commission to examine current financial reporting standards, including the issue of reporting of non-traditional financial information. He also observed that the International Sustainability Standards Board had set out to cover more than just climate and human capital and was also considering a SASB-like framework with industry-based disclosure standards. He raised the issue of whether the SEC should consider a comparable approach. With regard to technology, he observed that many analysts and others do not use XBRL or Inline XBRL, notwithstanding the SEC’s continued expansion of the XBRL mandate. He wondered whether that reluctance might be attributable to accuracy questions and suggested that the application of XBRL be subject to review by companies’ auditors. He also suggested that there have been calls for some new reporting refinements, such as more disaggregation of line items, noting that technology may improve the cost-benefit sufficiently to enable that type of reporting.
Another panelist, from CalPERS, noted that tangible assets represent only 10% of market value, and advocated that financial statements needed to capture more information about remaining market value. He wanted to see more climate- and human capital- related financial reporting, leveraging the audit to create a bridge to the financial statements. He also explained that it matters where disclosure is located. For example, when mine safety disclosure began to be included in SEC reports, mines actually became safer. Because financial statements are audited, more attention is paid. If need be, FASB should “expand the box” that it traditionally addresses to cover sustainability-related financial issues. For example, he maintained, climate-related risk could affect, among other things, asset impairments, fair value of assets and changes in useful life of assets. Mandatory rules—not just guidance—should be adopted, he argued, regarding climate and human capital to help close the information gap between management and investors. He also contended that there was no real materiality constraint on the SEC in adopting these regulations; the focus should be on information investors would likely take into account in making investment decisions, and investors are not asking for trivial information.
Another panelist, a law professor, addressed accounting for human capital and other intangibles. Total compensation costs, she said, are actually rarely disclosed—only about 15% of companies disclose that data. Instead these costs are typically aggregated with other costs. In addition, in contrast to the accounting for investments in physical assets, which are shown on the balance sheet and depreciated over time, R&D is not capitalized and reduces net income right away. Similarly, investments in labor reduce net income right away and are not even separately disclosed, requiring interested investors to search it out. She noted that some have suggested that it’s better, from accounting perspective, to buy robots than to invest in human capital.
To illustrate why more detailed information would be useful, she observed that many companies reported net losses in 2020. These were typically smaller, less mature companies that investors expect are going to scale up. But, she said, it’s hard to determine from an accounting perspective if that’s true: Why is the company losing money? Is it because of investment expenses or recurring maintenance expenses? She advocated that MD&A should include a discussion differentiating between maintenance expenses and investment expenses intended to increase future production. In the context of human capital, that would entail disaggregating different compensation costs; for example, salary would be a maintenance expense while training would be an investment. She also recommended that companies disclose employee turnover. That information would be financially material on its own, but if companies were able to capitalize labor-related investment costs, it would be important to understand the duration of employees’ employment. Finally, she advocated additional disaggregation of line items on the income statement. For example, with respect to cost of goods sold, how much is attributable to labor?
Climate disclosure proposal. There were four speakers on the panel to discuss the SEC’s climate disclosure proposal. Although the speakers all had separate ideas on a number of issues, the speakers on this panel all brought home why there has been such a clamor by investors for the SEC to act on a climate proposal.
The first speaker, a professor of law, discussed the reasons for the proposal, summarized the contents, compared it briefly to proposals from other regulators and organizations, and discussed the main points of contention that have arisen around the proposal. She observed that, while most large companies (about 90% of the S&P 500) voluntarily provide sustainability reports, the substance of the reports is in companies’ discretion and typically not subject to the same disclosure controls and oversight as the information included in SEC reports. Accordingly, the fear is that the disclosure is not consistent or reliable. While hundreds of companies have made net-zero commitments, investors can’t determine how serious those commitments are, what progress is really being made, what transition strategies are being employed and which climate risks have been taken into account. In addition, physical risk and transition risk affect many companies’ macroeconomic stability. For example, a recent survey from the World Economic Forum showed environmental risks as among the top 10 most severe risks, with the most severe risk being climate. Nevertheless, various surveys suggest that material climate risk has not been adequately incorporated into pricing. (Ironically, she observed, if the powerful folks at Davos decided together to take action on climate, they could probably go a long way toward addressing the problem.)
After summarizing the key aspects of the SEC’s proposal, she highlighted the requirement for GHG quantification (see this PubCo post), the one key component of the proposal that is not solely within the ambit of companies and also the component that has been subject to the most criticism—especially the requirement to provide Scope 3 GHG emissions data (the very broad requirement for emissions not within the company’s control, including activities upstream and downstream in its value chain). For some companies, she noted, most of their emissions are Scope 3; while companies in oil and gas might be obvious examples of this point, she said, surprisingly, 80% of the emissions for Mars candy bars were also Scope 3. Interestingly, however, given the lack of uniform standards for calculating Scope 3 emissions data, the speaker advocated against a Scope 3 mandate at this point, instead favoring a postponement until standards and methodologies were developed and companies had Scopes 1 and 2 reporting under their belts.
The speaker also noted that, relative to developments on climate disclosure in the EU and UK, the U.S. is behind the curve. Accordingly, she contended, there is no real merit to the argument that a climate disclosure mandate would put the U.S. at a competitive disadvantage. Other major concerns often voiced about the proposal are that it is beyond the SEC’s authority and that the proposal is really aimed at satisfying environmentalists, not investors. To the first concern, she contended that, as shown in this comment letter by 30 law scholars, of which she is a co-author, the SEC has ample and long-standing authority to issue this proposal. To the next concern, she reminded us that the TCFD, on which the SEC’s proposal is partially based, was developed because climate risks are financial risks. Climate-related problems, such as deforestation and loss of biodiversity, entail serious financial risk. For example, deforestation in tropical areas adversely affects cattle, palm oil, coffee and other products. She concluded her presentation with a cartoon that, after identifying prospective climate-related improvements such as clean air and clean water, said, “what if it’s all a big hoax and we create a better world for nothing?”
An accounting professor challenged the popular perception that issuers disfavor the SEC proposed rulemaking, identifying a number of big companies that support the rules because, among other things, the rules would provide comparability and harmonize the requests for information. However, he said, others have contended that Congress should first resolve the issue and that the EPA is a more appropriate agency to handle the rulemaking. Other criticisms voiced are that the proposal prioritizes the interests of progressives, that the information elicited is too speculative and that the SEC’s estimates of compliance costs are too low. The speaker’s analysis showed that the compliance costs would likely be offset by savings in the cost of capital and were de minimis relative to the anticipated social benefit. He did agree, however, that the proposed metrics in the financial statement notes could be difficult to determine reliably.
The next speaker, from an investors’ consortium for assurance, maintained that investors favored the SEC proposal because they were concerned about the impact of climate risk on their investment portfolios and find it hard to assess that risk in the absence of a standardized framework. The disclosures elicited, however, cannot be misleading and must be reliable and tie back to the company’s reports and financial statements. The proposal addressed this issue in its requirement to include in the notes to the financial statements disclosure about the impact of climate-related risks on estimates and assumptions. Also important in her view is the requirement to address the impact on strategy as well as the GHG emissions disclosure. For example, in her view, GHG emissions disclosure is not about allocating responsibility, but rather about assessing the level of dependency of the company’s business model on emissions and its resulting exposure to transition risks, potentially affecting the quality of its earnings. She also viewed the requirement to provide disclosure about carbon offsets to be key in that it could help to reduce greenwashing, especially in the context of various climate claims and commitments.
With regard to the quality of voluntary climate disclosure, she thought it was largely not subject to internal controls or attestation. In her view, limited assurance did not solve the problem; more rigorous assurance was needed. With limited assurance, the reviewer performs some limited procedures and perhaps conducts a site visit, but performs no testing. The assurance provided is simply a statement that nothing has come to the reviewer’s attention indicating that there are material misstatements. That type of assurance, she said can yield poor quality information. Reasonable assurance, the typical financial audit standard, involves testing, procedures, risk assessments and an opinion. In the SEC’s proposal, attestation for Scopes 1 and 2 emissions commences with a requirement for limited assurance and later requires reasonable assurance. The speaker was also concerned about variations of quality among assurance providers. In the absence of oversight from an entity such as the PCAOB, she feared a race to the bottom among unregulated providers. Independence issues could also present a problem.
The final speaker, who was in charge of ESG investing at an asset manager, explained how, for investors, ESG information may be material to financial performance. Right now, it’s difficult to take climate risk into account because there is insufficient decision-useful information. Many companies, he said, just do not provide any data. For example, Scope 2 disclosure about electricity usage can provide information about operational efficiency and productivity, but currently, the information available about electricity usage is “patchy.” His firm has asked for this data and there has been some improvement in some sectors, but not enough. Investors also want to understand how companies are working to mitigate risks, but information is inadequate. The SEC proposal should help in this context, for example, by requiring disclosure regarding targets.
Scope 3 data has become controversial and is not widely available. As a result, in making decisions about investments, third-party estimation models are used. These models can lead to very different outcomes, which can be problematic in making assessments about risks and create concerns about estimation error. Scope 3 information is also important in providing insights into efficiency. For example, a company that outsources its manufacturing would, without Scope 3 disclosure, show quite different emissions data than a company that manufactures in-house, perhaps creating false confidence in its efficiency. Scope 3 data would provide a more complete picture by including information about emissions from its supply chain. However, absent a mandate, many companies don’t provide any GHG emissions disclosure.
In addition, voluntary disclosures often have a time lag; the proposed rules would shrink this time lag, the speaker said. The speaker also addressed the issue of capital allocation, identifying as a risk the possibility that companies, faced with the disclosure mandate, would just buy carbon offsets to assuage investors. They are seeing this occur, which can lead to poor outcomes. He suggested that companies would probably experience a better outcome if they first considered spending those same funds on investments that would actually reduce their carbon footprints. Fortunately, the proposed rules do address disclosure of carbon offsets. He also favored the granularity required by the proposal. For example, he thought the location data by zip code would be valuable in helping with more precise physical climate-risk modeling. He also noted that his preferred standard for materiality for Scope 3 was 40% of total emissions.