Published:
Apr 12, 2023
Updated:
September 20, 2023
ESG Reporting Bright Line Materiality Threshold
Learn about the SEC's proposed materiality threshold for climate-related events and their disclosures
Introduction
On March 21, 2022, the Securities and Exchange Commission (SEC) announced a set of proposed rules that would require public companies to include certain climate-related disclosures in their SEC filings. The SEC desires a 1% aggregate absolute value bright-line materiality threshold for these disclosures, which requires companies to disclose the impact of climate-related events that affect financial impact or expenditure metrics by more than 1%. This bright-line threshold was included in the SEC’s proposal to reduce the underreporting of these disclosures, help reporting companies know when disclosures must be made, and promote the comparability and consistency of filings over time and across industries. This article discusses the 1% bright-line materiality threshold, its ramifications for management, and the responses the SEC has received on this topic.
Bright Line Materiality Overview
When determining whether a company needs to disclose the effects of climate-related events or transition activities on financial impact or expenditure metrics, the company must compare the aggregated effect of these events and activities to the 1% materiality threshold. The potential steps that management could take during this process are listed below.
1) Identify Qualifying Events and Activities
To meet the proposed requirement, management must first identify all qualifying climate-related events or transition activities that occurred during the reporting period. As defined in the SEC’s proposal, climate-related events may include “severe weather events” or “other natural events”.Although the SEC does not define this term further, the Commission provides several examples of climate-related events. Such examples include the following:
- Flooding
- Drought
- Wildfires
- Extreme temperatures
- Rising sea levels
Transition activities are business adjustments that are made in response to climate-related events. For example, to lower energy costs, a company may invest in its manufacturing facilities to increase energy efficiency. Similarly, a company may hire a consulting firm to reduce carbon emissions in its supply chain in order to reduce its carbon footprint.
Climate-related events and transition activities, in this context, are strictly historical. Because of this, management is not responsible for predicting or forecasting events or activities that would otherwise fit these definitions. To illustrate this concept, consider a company operating in a region where natural disasters occur regularly. Although a company’s management might be required to make disclosures regarding the high likelihood of a natural disaster occurring elsewhere in its financial statements, the impact of these future events does not need to be estimated and accrued for.
Unfortunately, management may find it hard to discern which events or transition activities are climate related. Although some events and activities are clearly related to the climate, such as the natural disasters listed above, others may be only remotely connected to the climate. When determining whether an event or activity qualifies as climate-related, management may choose to consult non-authoritative frameworks to which the SEC’s proposal refers, such as the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) or the GHG Protocol. In addition, management should consult future publications from the SEC as they provide clarifying guidance.
2) Determine the Impact of Qualifying Events
After identifying events and activities falling within the scope of the SEC’s proposal, management must track and calculate the aggregated impact of these events and activities on their company’s financial and expenditure metrics. In this context, "aggregated impact" is defined as the absolute value of the positive and negative impacts. To illustrate, the SEC provides an example in which climate-related activities negatively affect the costs of revenue by $300,000 and positively by $70,000 and $90,000. For determining materiality, the aggregated impact is $460,000, calculated as $300,000 + $70,000 + $90,000.
For financial impact metrics related to the line items on an entity’s consolidated financial statements, the aggregated impact is calculated on a line-by-line basis. Under the SEC’s proposal, management must examine each line item on the financial statements and determine the impact of the identified climate-related events and transition activities. Because the aggregated impact is calculated on an absolute basis, positive and negative impacts are not netted. By preventing companies from netting positive and negative impacts, the SEC provides financial statement users with a better understanding of a company’s exposure to climate-related risks.
For expenditure metrics, defined by the SEC as "expenditure expensed" or "capitalized costs incurred," management is required to calculate the aggregated impact that climate-related events and transition activities had on an entity's total expenses and capitalized costs during the reporting period. Again, because the aggregated impact is calculated on an absolute basis, positive and negative effects are not netted. This means that if separate climate-related events or transition activities increased and decreased an entity's expenses during the reporting period, these effects would not offset each other.
Determining the impact of climate-related events and transition activities could be a potential concern for management. Although some impacts might be relatively easy to estimate, other estimates may be time-consuming and expensive. For example, if a company were to cease operations because of a qualifying climate-related event, management would need to estimate the lost profits associated with foregone sales. Because this impact is not readily observable, management must spend time and resources gathering information to produce a reasonable estimate. Companies should keep in mind that despite the difficulty in obtaining some of these estimates, the SEC’s proposed rule still requires estimations to be made at a level that can withstand the scrutiny of a financial statement audit.
3) Compare Impact to Bright Line Threshold
Once the impacts have been calculated, management must then compare each aggregated impact to the 1% bright-line materiality threshold. If the aggregated impact is higher than the materiality threshold, then disclosures are mandated. If, however, the aggregated impact is below the materiality threshold, then no disclosures are required by the SEC.
For financial impact metrics, this threshold is computed as 1% of the corresponding line-item total. To illustrate, consider a company that experienced one climate-related event during the reporting year, resulting in an inventory impairment of $1 million. If the entity has $150 million in its inventory balance, the materiality threshold would be $1.5 million, calculated as 1% of $150 million. Because the $1 million aggregated impact of this climate-related event is less than the $1.5 million materiality threshold, the company is not required to make any disclosures.
For expenditure metrics, the materiality threshold is calculated by multiplying the corresponding expenditure category (expenses or capitalized costs) by 1%. As an example, consider a company that spent $15 million on transition activities and experienced no climate-related events during the reporting year. If the company’s total expenditures for the reporting year were $900 million, the materiality threshold would be $9 million, calculated as 1% of $900 million. Because the aggregate impact of the transition activities (and any climate-related events) was less than the materiality threshold, the company would not be required to make any disclosures regarding the transition activities.
4) Make Appropriate Disclosures
For all aggregated impacts that have surpassed the materiality threshold, management must make appropriate disclosures. Pursuant to the SEC’s proposal, these disclosures would be made in the footnotes of the financial statements. Furthermore, the SEC’s proposal mandates that these disclosed numbers be disaggregated to present positive and negative impacts, separated into climate-related events and transition activities. As a result, an entity may have to include metrics for each disclosure category: positive impacts from climate-related activities, negative impacts from climate-related activities, positive impacts from transition events, and negative impacts from transition events. Examples of potential disclosures that are consistent with those in Deloitte’s firm guide are provided below. For a more exhaustive explanation of the nature of the required disclosures, please refer to the SEC’s proposal.
Ramifications For Management
The 1% bright-line materiality threshold and corresponding disclosures create many ramifications for management, including the establishment of procedures to collect and process necessary data and the creation of internal controls.
Currently, companies are unlikely to collect enough information to properly calculate the aggregated impact of climate-related events or transition activities.1 Therefore, when implementing the standards in the SEC’s proposal, management must establish processes to identify climate-related events and transition activities and collect information regarding their impact. Moreover, any collected data should be traceable and monitored from its collection point to its destination.
Because the disclosures related to financial impact and expenditure metrics are “subject to audit” and “within the scope of the registrant’s internal control over financial reporting,” management must also design internal controls over the outlined processes.2 In addition to complying with Sarbanes-Oxley, these controls must ensure identification of all relevant climate-related events and transition activities, correct estimation of impacts, and proper disclosures. Furthermore, given the low materiality threshold of 1%, controls must be robust enough to meet these demands.
Historically, ESG matters like those discussed above were tracked and quantified in other, non-accounting departments. However, a monumental shift in the view of ESG matters as financially relevant has occurred, and shareholders and investors now demand information related to ESG matters. This trend is one reason behind the SEC’s proposal. Although accountants and auditors were not required to be involved in ESG reporting in the past, the SEC’s new proposal demands their involvement going forward.
Response to Proposal
The SEC has received pushback from many companies regarding its March 21, 2022 proposition. This negative reaction is, in large part, due to the 1% bright-line materiality threshold.1 The primary reason for the strong opposition is that companies believe the low materiality threshold is not cost-effective and the required information is not available.1
As discussed above, the implementation of the SEC’s guidance will require management to establish new processes and design new controls. This will take a significant amount of time and resources, especially given the level of precision needed to comply with such a low materiality threshold. Those who oppose the 1% materiality threshold argue the associated costs are unwarranted as the threshold is too strict, and shareholders do not necessarily benefit from having such a low materiality threshold.3
Companies also maintain that the data needed to comply with the disclosure requirements for both financial impact and expenditure metrics is unavailable or only obtained by conjecture.4 Basing calculations and their subsequent auditable disclosures on unavailable or unreliable data, these companies hold, defeats the purpose.
Because of the firm, negative response that the SEC has received, many believe the proposal will not be implemented as it stands now. Indeed, entities are threatening that if the proposal does move forward, the SEC will be met with litigation.5 Although the current arrangement might not become authoritative, some form of the proposal will almost certainly be included in the SEC’s final decision. Because of this, management should still be conscious of the requirements and start planning to implement additional disclosures for climate-related impacts.
Conclusion
In conclusion, the SEC's proposal on ESG reporting requires companies to make disclosures related to both financial impact and expenditure metrics if climate-related impacts are above the 1% materiality threshold. As a result, management will be required to create new processes and controls to handle and monitor the collection and processing of relevant data. Although many companies are pushing back on the proposal, a version of the current framework will undoubtedly appear in the SEC's final regulations. Accordingly, management should be prepared to implement the SEC's final decision.
Resources Consulted
- https://www.sec.gov/rules/proposed/2022/33-11042.pdf
- https://dart.deloitte.com/USDART/home/publications/deloitte/heads-up/2022/sec-analysis-climate-disclosures
- https://www.pwc.com/us/en/services/esg/library/sec-climate-disclosures.html
Footnotes
1. Energy Industry Reacts to SEC Proposed Rules on Climate Change p.94
2. Proposed rule: The Enhancement and Standardization of Climate-Related Disclosures for Investors
3. https://www.sec.gov/Archives/edgar/data/1056288/000105628822000031/fhi-20220630.htm pg.31
4. https://www.sec.gov/Archives/edgar/data/1025378/000102537822000041/wpc-20211231.htm pg.9
5. https://www.sec.gov/Archives/edgar/data/1056288/000105628822000031/fhi-20220630.htm pg.28
Footnotes
Apr 12, 2023