In March 2022, the SEC proposed rules that would require public companies to disclose their exposure to climate-related financial risks, including their efforts to mitigate these risks, in their annual reports and registration statements. In addition to proposing requirements for reporting on greenhouse gas (GHG) emissions, targets, and reduction strategies, the proposal discusses companies’ climate-related transition risks—and asks registrants to speak to them in their filings.
Climate-related transition risks refer to the financial risks that arise from the shift towards a low-carbon economy that is taking place around the world. These risks can affect companies, industries, and entire economies, and may stem from factors such as policy and regulatory changes, shifts in consumer preferences, and technological advancements.
Given the potential impact on financial performance, the SEC climate disclosure proposal would require companies to disclose their exposure to climate-related financial risks, including transition risks, in their filings. These disclosures aim to provide investors with a better understanding of the potential risks associated with climate change and to facilitate more informed investment decisions.
To learn more about the complete SEC climate disclosure proposal, you can check out our SEC climate disclosure overview, and stay tuned for the current updates. This blog post will help you understand climate transition risks and how to comply with the SEC’s proposed rules.
What are Transition Risks?
The SEC climate disclosure proposal is modeled on the Task Force on Climate-related Financial Disclosures (TCFD) and its definitions of climate-related financial risks. In both, transition risks are defined as:
“the actual or potential negative impacts on a registrant’s consolidated financial statements, business operations, or value chains attributable to regulatory, technological, and market changes to address the mitigation of, or adaptation to, climate-related risks.” (SEC Climate Disclosure Proposal).
In other words, transition risks refer to the financial risks that companies face due to the transition to a low-carbon economy, which may impact their financial performance. For example, companies in industries that rely heavily on fossil fuels, such as coal, oil, and gas, may face increased regulatory pressure to reduce their greenhouse gas emissions. Failure to manage such emissions and associated transition risks could result in reduced profits for these companies.
Of course, transition risks aren’t the only climate-related financial risks a business may face. Climate-related financial risks are generally divided into two major categories: transition and physical risks (you can read more about the difference here). Under the SEC climate disclosure proposal, both types of risks must be considered and disclosed. Transition risks may be less intuitive than physical risks but are equally critical to understand.
Transition risks fall into four categories:
- Policy and Legal
In the following image, you’ll see examples of climate-related risks, and the potential associated financial risks:
Transition Risks in the SEC Climate Disclosure Proposal
So, where would transition risks be relevant in the SEC filings? The SEC proposed rule would require companies to disclose their exposure to transition risks and the nature of those risks in their annual reports and registration statements to register public offerings of securities. The proposal would also require companies to discuss their governance structures for identifying and addressing climate-related financial risks, and their strategies for addressing those risks. This would include providing information on the financial risks associated with transitioning to a low-carbon economy, such as the potential impact of policy and regulatory changes, shifts in consumer preferences, and advancements in clean technology.
In addition to discussing the relevant risks, the proposed rule would require companies to disclose how these risks could impact their business, operations, and financial performance, as well as any strategies they have in place to manage these risks. For example, if a company has established decarbonization targets to mitigate its transition risks, it would have to disclose how they plan to meet its targets. This might involve diversifying their products or services, or investing in new technologies that reduce their carbon footprint.
The SEC proposal would require companies to disclose the resiliency of their climate risk mitigation strategies in light of potential future changes in climate-related risks. The SEC does not regulate corporate conduct, so the rule would not require companies to do stress testing or perform scenario analysis. However, companies may conduct a climate scenario analysis to evaluate the resilience of their strategies. In this case, the SEC would require disclosure about the scenario analysis conducted.
The SEC’s climate proposal would include the following reporting requirements:
- The registrant’s governance of climate-related risks and relevant risk management processes
- How any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short-, medium-, or long-term
- How any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook; and
- The impact of climate-related events (severe weather events and other natural conditions) and transition activities on the line items of a registrant’s consolidated financial statements and the financial estimates and assumptions used in the financial statements.
These disclosures would enable investors to better understand the transition risks (and physical risks) a company faces, and whether the company is taking steps to mitigate or adapt to those risks. Though not required, many companies will want to develop a concrete strategy, called a transition plan, complete with relevant metrics and timelines, to mitigate these risks.
GHG Emissions Measurement and Reporting for Transition Risks
One of the most important metrics for understanding a company’s transition risks is its GHG emissions footprint. Investors have a close eye on GHG emissions data because the data provides quantifiable and comparable metrics that speak to the climate-related risks a business may face.
“An increasing number of investors have identified GHG emissions as material to their investment decision-making and are either purchasing this information from third-party providers or engaging with companies to obtain the information directly. In each situation, there is a lack of consistency, comparability, and reliability in those data that our proposal seeks to address.” (SEC Climate Disclosure Proposal)
At a high level, a registrant would be required to disclose:
- “Direct greenhouse gas (GHG) emissions (scope 1) and indirect emissions from purchased electricity or other forms of energy (scope 2).
- GHG emissions from upstream and downstream activities in its value chain (scope 3), if material or if the registrant has set a GHG emissions target or goal that includes scope 3 emissions.” (SEC Climate Disclosure Proposal)
Companies will need to apply appropriate controls to ensure proper accounting for their GHG emissions. As proposed, larger companies will also need to obtain external assurance over their scope 1 and scope 2 disclosures.
Transition Risk Management
Developing a strategy to assess and manage transition risks can demonstrate to investors that companies are addressing the current and future financial impacts of the transition to a lower carbon economy.
The first step is to identify your risks. This process includes:
- Understanding the policies that apply to you based on your location, industry, and operations.
- Surveying your current products or technology for lower-emissions-producing alternatives that could threaten your sales and market share.
- Evaluating your portfolio risk exposure, and how exposed your assets may be to risks or changes in the market.
- Market research on the expectations and preferences of stakeholders, including consumers and investors, and what is needed to stay competitive in your industry.
After completing a transition risk assessment, companies will build strategies to mitigate their risks. Some strategies identified in the SEC proposal include:
- The development of products that facilitate the transition to a lower carbon economy. This might include the development of electric vehicles, renewable energy, and other alternatives to high-emitting products
- The generation or use of renewable energy
- The use of recycled products, or products that require less carbon-intensive production methods
- The supply of goods or services that help other companies or consumers as they transition to a lower carbon economy
Because transition risks are nuanced, and stretch across various parts of an organization — from legal teams to product development, marketing, and beyond — collaborating within your organization and engaging stakeholders is critical to the success. Alignment on GHG emissions measurement and strategy is at the heart of this teamwork to mitigate transition risks. Using software to implement a controlled, reliable environment for data collection and disclosure readiness helps ensure alignment and accuracy across teams.
Where to Start to Mitigate Your Transition Risks
Ultimately, the SEC proposed rule aims to provide investors with a clearer understanding of the potential financial risks associated with the transition to a low-carbon economy to help inform their investment decisions.
Companies should take proactive steps to manage transition risks now. Failure to do so may subject them to financial risks, such as stranded assets, regulatory penalties, and reputational damage. On the other hand, companies that are able to proactively manage transition risks and adapt to a low-carbon economy may benefit from new opportunities, such as access to new markets, customers, and technologies. Overall, taking proactive steps to manage transition risks and contribute to a more sustainable future is the right thing to do and makes good business sense in the long run.
Starting with accurate, precise emissions reporting is the best way to deeply understand the transition risks you’ll face—and to begin building a strategy that properly accounts for them. Persefoni was built to make climate data collection easy, reliable, and efficient. Our in-house experts help you build strategies that comply with regulations and mitigate your organization's risks. Chat with us today to learn more about how we can help.