Outlook for environmental regulation

If companies thought environmental, social and governance (ESG) reporting standards were already rigorous, they should brace themselves for an even more stringent and complex regulatory regime.

Whether it’s in the US, EU or China, policymakers appear determined to introduce a batch of new rules demanding greater transparency and accountability from corporations on climate risk, even if such efforts jar with growing investor scepticism over the merits of ESG, especially ahead of the November US presidential election.

In the US, for example, new regulations that will require two out of every five listed companies to report on scores of climate-related risks could come into force in the next couple of years.

The US rules could become a template for companies worldwide, says Michael Gerrard, Professor at the Sabin Center for Climate Change Law at Columbia Law School.

“These rules will affect the corporate reporting and transparency landscape for years to come. This is a global trend that is unlikely to slow down no matter who will become the next US president,” says Gerrard, who is also a member of Pictet Asset Management’s Thematic Advisory Board.

New disclosure requirements will have far-reaching consequences, Gerrard says.

For businesses, they will inevitably add to the cost of collecting and verifying sustainability data and updating internal systems and processes.

But the financial impact appears manageable, and benefits are likely to outweigh the cost. A more harmonised global reporting framework promises to improve the quality, consistency and reliability of climate data, making it easier for companies and investors to collect relevant information at a time when demand for sustainability reporting is already increasing.

SEC and California

In a landmark move, the US Securities and Exchange Commission (SEC) proposed in March a new measure that requires thousands of companies to report their climate-related risks, such as greenhouse gas emissions, water-related risks and their transition plans.

Specifically, this includes direct emissions and those derived from energy they purchase, known as Scope 1 and 2 emissions.For more on emission scopes, see https://am.pictet/en/uk/global-articles/2022/expertise/thematic-equities/understand-emissions-for-climate-risk#overview

The rule makes climate risk reporting mandatory for about 40 per cent of the 7,000 US public companies registered with the SEC, if their emissions were considered material.

It may also extend to roughly 50 per cent of the 900 foreign private companies registered with the SEC if their emissions meet the criteria.

Some businesses and investors fear that the rules will add to the cost of doing business.

But evidence show the impact is manageable.

A survey by sustainability advisory firm ERM has found companies already spend an average of USD677,000 per year on climate-related disclosure activities, well above the SEC-estimated annual cost of USD530,000 for compliance.https://www.sustainability.com/globalassets/sustainability.com/thinking/pdfs/2022/climate-disclosure-survey_fact-sheet-april-2022.pdf

A separate study by Duke University has shown the cost impact was likely to be small because each firm has already established robust in-house climate disclosure systems that can easily be leveraged to comply with any new rules.https://econ.duke.edu/sites/econ.duke.edu/files/documents/The%20Cost%20of%20Climate%20Disclosure.pdf

It could also generate capital market benefits for companies. Academic studies cited by the SEC have shown firms reporting credible disclosures tend to experience lower costs of capital and higher asset prices or valuations.https://www.federalregister.gov/documents/2022/04/11/2022-06342/the-enhancement-and-standardization-of-climate-related-disclosures-for-investors#footnote-584-p21394 The beneficiaries include investors, who according to another recent survey, currently spend an average of over USD1.3 million a year on collecting and analysing climate data to inform their investment decisions.https://www.sustainability.com/thinking/costs-and-benefits-of-climate-related-disclosure-activities-by-corporate-issuers-and-institutional-investors/

The controversial SEC mandate has nevertheless faced criticism from both sides of the political spectrum and is being challenged in courts from states and groups which say it is either too strict or too loose. In view of the multiple lawsuits, the SEC voluntarily put implementation of its rule on hold pending resolution of the litigation, yet Gerrard thinks companies will still need to prepare for the 2026 deadline.

“The SEC’s move marks the latest regulatory push towards greater transparency, following a similar – but much more stringent – one from California last year,” Gerrard says.

California enacted in 2023 two sweeping laws that will require companies with significant revenue generated in the Golden State to disclose their emissions data.

The Climate Corporate Data Accountability Act and the Climate-Related Financial Risk Act are designed to enhance transparency, standardise disclosures and encourage businesses to address climate change.

While they are state-level regulations, they promise to become the rule that any major companies cannot afford to ignore.

This is because the rules apply to any large company that is “doing business” in the Golden State, which would be the fifth biggest economy in the world if it were a country. It is estimated that 75 per cent of the Fortune 1000 companies will be subject to them.https://www.citizen.org/article/california-sec-climate-disclosure-report/

“These rules go further than the SEC’s and given the importance of the Californian economy could become the de facto standard,” Gerrard says.

The new California rules are ground-breaking for other reasons too. They tackle one of the most controversial issues in climate regulation by requiring companies to report Scope 3 emissions – a hard-to-measure set of data that involves indirect emissions across the supply chains.

Gerrard notes that the laws detail 15 categories of Scope 3 emissions, with hardly any company reporting all of them at present.

“There are still many open questions – whether the rules will apply to affiliates, whether they are industry specific, which of the 15 Scope 3 categories must be reported, and what climate scenarios will need to be included,” he says.

Like the SEC, Californian rules are being challenged in courts. But absent adverse court action or a delay by the state legislature, they will go into effect in 2026. Non-compliance could result in USD500,000 in penalties per reporting year.https://www.corporatecomplianceinsights.com/california-climate-law-court-challenge/ Major companies such as Apple, Microsoft and Ikea have already endorsed the bill.

Gerrard cites other US initiatives that go in the same direction, including a pending New York state legislation that is similar to that of California.https://www.nysenate.gov/legislation/bills/2023/S5437 and https://www.nysenate.gov/legislation/bills/2023/S897/amendment/A

Europe and beyond

Companies large enough to fall under California’s laws will also likely be within the scope of the disclosure rules of jurisdictions like the EU.

From mid-2026, the continent’s Corporate Sustainability Reporting Directive (CSRD) requires all large European companies, including subsidiaries of non-EU companies, listed or not, to disclose information on environmental and sustainability risks that include climate change if they meet certain thresholds.

Non-EU companies are also subject to mandatory reporting if they generate over EUR150 million in revenues in the bloc.https://kpmg.com/nl/en/home/topics/environmental-social-governance/corporate-sustainability-reporting-directive.html

In Europe, the total bill for complying with the region’s rules will amount to EUR3.6 billion over a period of ten years, according to estimates from the European Commission.

Despite the lofty headline figure, the Commission’s own impact assessment shows the cost of compliance represents a negligible share of the company’s turnover at no more than 0.005 per cent in the first year for companies across all sizes, which is expected to fall in subsequent years.https://op.europa.eu/en/publication-detail/-/publication/1ef8fe0e-98e1-11eb-b85c-01aa75ed71a1/language-en/format-PDF/source-201819497

Over in China, the country’s three main stock exchanges have proposed sweeping environmental disclosure rules for large listed companies.

Around half of China’s listed companies will be obliged to report on the impact their activities have on the environment as well as the risks and impact of environmental factors on their business in what is called a “double materiality” approach.

The rules, which will cover Scope 1 and 2 emissions as well as Scope 3 for a smaller group of firms, are set to apply from this year onwards with the first reports due at end-April 2026. A similar internationally-aligned mandatory disclosure framework is also proposed in Australia from the 2024-2025 financial year.https://treasury.gov.au/consultation/c2024-466491

In a US election year, the political climate concerning the overall ESG issues is demanding greater attention from investors.

In particular, concerns are growing that Donald Trump’s possible return to the White House could result in major environmental rollbacks. Trump has already set boosting fossil fuels as one of his top priorities and vowed to repeal many of the landmark climate laws, namely the Inflation Reduction Act.For a related article, see https://am.pictet/en/us/mega/2023/ira-and-impact-on-europe

However, a wholesale unravelling won’t be that easy. A repeal of the IRA for example, which was enacted by Congress, will require 51 votes in the 100-member Senate that is currently controlled by the Democrats.A repeal of legislation usually requires 60 votes, but ones related to tax and spending, which include the IRA, require only 51 votes.

Gerrard adds that several provisions such as carbon capture, hydrogen and fuel credits have bipartisan support.

“Many red states have benefited from the IRA, which created jobs and investments for large solar, wind and storage projects,” he says. The benefits are estimated to be worth USD337 billion.https://www.whitehouse.gov/briefing-room/statements-releases/2022/08/17/state-fact-sheets-how-the-inflation-reduction-act-lowers-energy-costs-create-jobs-and-tackles-climate-change-across-america/

Similarly, a move towards greater climate transparency is likely to benefit investors, whatever their political affiliation is, who are keen to incorporate climate and sustainability risk into their decision making.

“The trend towards environmental disclosure around the world is unstoppable,” Gerrard says.