Recently, we submitted a letter in response to the Securities and Exchange Commission’s (SEC) Public Input on Climate Change Disclosures, outlining the actions that the SEC can take to improve market understanding of climate risk and therefore market integrity.
The SEC’s principles-based disclosure requirements contemplate all material risks and for many companies; climate is one such risk. However, “climate” has sometimes been seen as outside a company’s core business model, pushed into a parallel “ESG” (environmental, social and governance) framework. This thinking fails to accept the degree to which present-day financial statements are built upon future assumptions, many of which may be substantially altered by decarbonization. Climate change, and responses thereto, pose material financial risks and every U.S. upstream oil and gas company acknowledges as much in its risk factor disclosures.
Increasingly, information about these risks is needed to guide decisions around active stock selection, fixed income strategies, or the creation of indices, benchmarks and portfolios for passive strategies as well as engagement, shareholder resolutions, the reappointment of directors and auditors, and remuneration schemes.
To expedite this change in thinking and acting on climate-related risks we laid out the following recommendations:
- Enforce existing requirements that material assumptions and estimates be disclosed. This is especially important for asset valuations or tests that are reliant on forward-looking assumptions.
- Ensure that forward-looking assumptions used in investment planning are not inconsistent with those used in financial reporting.
- Ensure that companies are discussing the greater than “remote” chance of an energy transition in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and quantifying impacts, if reasonably available.
- Ensure that U.S. investors are receiving the equivalent or better information as their overseas counterparts and ensure that climate-related risks were considered in the audit reports (e.g., in the critical audit matters or CAMs).
- For all issuers, disclose the undiscounted costs, discount rates and timing assumptions of their on-balance sheet asset retirement obligations (AROs) and the undiscounted costs of all off-balance sheet AROs.
- For all issuers, include emissions reduction targets in annual/ filed reports.
- For all issuers, disclose scopes 1, 2 & 3 greenhouse gas (GHG) emissions in a supplemental schedule to the financial statements, and have such disclosures assured according to rigorous standards established by the Public Company Accounting Oversight Board (PCAOB) at the appropriate assurance level.
- For the upstream oil and gas sector, mandate provision of the currently optional sensitivity analysis under Item 1202(b) for upstream oil and gas reserves and cause the Standardized Measure of Oil and Gas to be modified to make it comparable to how impairments are tested in the oil and gas sector. Require the disclosure of all wells, including inactive and ancillary wells, under Items 1205 and 1208.
The above are actions that are well within the SEC’s jurisdiction. The first four actions can be completed in the near term and do not require new rulemakings (although some may benefit from additional guidance or Staff Accounting Bulletins). While actions 5-8 will require consultations, they build on existing work and in our view should be started soon.
The need for these changes is highlighted by, but not limited to, the following examples:
- The world’s seven top oil and gas companies took nearly $90 billion in impairments through the end of 2019 and early 2020. These impairments were driven not by poor returns but instead by reduced commodity price expectations, resulting in lower cash flow forecasts and the need to write down costly investments or forego marginal expansion projects. Some might see the write-downs as evidence that the market disclosure system is working; but more likely it is just the tip of the iceberg—the SEC should seek to provide information to help investors understand how big that iceberg might be.
- Increasingly, companies are trying to portray themselves as being aligned with a low-carbon future and have made promises to be net-zero by a certain date. Many also indicate the potential effects of climate-related risks on their businesses. However, without access to the right information investors cannot know if the accounting assumptions that companies are using in preparing their financial statements align with those pledges and statements or reflect the effects of climate-related risks.
- Recently many oil and gas companies have announced ‘net-zero by 2050’ targets. However, very few companies reveal whether the prices they use to evaluate oil and gas reserves or test the value of their fixed assets for impairment align with such targets or consider climate-related risks at all. What prices might industry use to align reporting with climate targets?
As these examples show, the risks and opportunities created by climate change and the energy transition are far-reaching and only accelerating. By implementing the suggestions listed above, the SEC can make sure investors and other stakeholders have access to the information they need to navigate these changes.
Written by Barbara Davidson and Rob Schuwerk
