Momentous events often lead to fundamental governmental regulatory response. So it was with the Great Depression and now is with the climate crisis.
Almost 100 years after the Securities and Exchange Commission was created, a new proposal by the Commission to manage how public companies disclose their climate risks fits squarely into this category. It is analogous in scope to the introduction of GAAP, the accounting rules that have standardized how public companies compile their financial statements. The biggest surprise, however, is how this regulation will impact private companies.
After the stock market crash of 1929 and the resulting Great Depression, the SEC was formed as an independent agency to enforce the law against market manipulation. Central to this mission was a need for uniform financial reporting standards, so the SEC turned to the accounting profession to create the Generally Accepted Accounting Principles. The effect was fundamental, as companies—both public and then private—changed what they reported to avoid SEC enforcement. Today, it is easy to forget there was once a time when companies reported whatever and however they wanted, with rampant fraud as a result.
Last month, the SEC issued a new draft proposal to add standardized climate reporting to required disclosures by public companies. Chair Gary Gensler wants companies to disclose the risks that climate change represents to their business, any plans they have to lower their emissions, and the total level of greenhouse gas they emit, directly and indirectly. This last category is the doozy. It sets disclosure rules for what are often referred to as Scope 3 emissions. The SEC would require companies to analyze not just their own emissions but all the emissions that come from their suppliers, such as purchased goods and services. Gensler understands the challenges inherent in the sweep of the requirement and has sought to exempt companies that don’t have a Scope 3 target. But, given social pressure on companies to address the climate crisis, most public companies of scale already implicitly have such a target through a stated commitment to be net-zero by a certain date.
Predictably, the public response has diverged. Some applaud the SEC for taking a bold step (perhaps not so bold given the Climate-related Financial Disclosure regulations that became UK law last January), while others argue the SEC has overstepped its mandate. Litigation is to be assumed. But that is unlikely to matter, as the market has already spoken. Climate disclosures by companies are inevitable because investors worldwide are demanding this information and large asset managers will respond. Consider that climate change is the leading topic for shareholder proposals in this year’s proxy season.
But what does not seem yet understood is that although the SEC’s jurisdiction focuses on public companies, its climate disclosure rules will also affect all private companies of size. The reason is simple. If a large public company has a net zero target – which they all have or will soon—it will have to figure out the emissions from its supply chain partners, which are almost universally private companies. As a result, any private company that sells its products or services to a public company with a net zero target will have to provide the same kind of climate disclosure as its much larger public partner.
As a matter of public policy, this should be a good implication. Carbon emissions and the resulting damage to our climate is a true tragedy of the commons and requires all players, across verticals, to do their part. New regulations that only affect public companies will miss the boat, as carbon molecules don’t limit their movement according to corporate legal structures.
Today there are around 50,000 public companies and 200 million private ones. If we assume that 5% of private companies serve public companies as suppliers, it means approximately 10 million companies will have to quickly become sophisticated at deciding which ESG metrics to track, how to calculate them, where to store the data, and how to interpret and report on it.
This sea change is like GAAP 2.0 in its scope, but even more complex given the difficulties inherent in a range of ESG calculations. Most of these millions of private companies are far smaller than their public peers and many lack the analytic capabilities to navigate this challenge. Yet such private companies employ the majority of the world’s working population and are central to the ability for business to be a positive lever for change when it comes to the climate crisis. They must be empowered to do their part. Just as the Great Depression spawned a new accounting industry, so too will the climate crisis—a slower-moving but far more consequential human-made disaster—lead to whole new industries to help companies effectively interpret their critical, non-financial data.
Our species is facing an existential threat and all major players need to be held accountable to doing the right thing. The SEC’s new disclosure rules will help make that happen.