New ESG regulations will have a big impact on tech and service firms - here's why

Brian Sommer Profile picture for user brianssommer March 11, 2024
Summary:
New SEC regs concerning climate change and more have finally materialized. These requirements will challenge software vendors, accounting professionals and more. Scope 1 and 2 are now required and Scope 3 gets a pass for now (sort of). Here’s the quick assessment.

standards

This week the United States Securities and Exchange Commission (SEC) finally released its disclosure requirements for ESG matters. These new requirements directly impact public firms; however, privately held firms will feel some impact from this as well. The requirements document from the SEC is material and clocks in at 490 pages. 

These new requirements were initially drafted in 2022 and comments were solicited about them. The final product has been expected since last fall. The extended timeframe may be partly due to the Commission receiving 24,000 comment letters and thousands of other pieces of correspondence. The fact that these requirements generated so many comments underscores the impact these requirements will have on businesses and the accounting profession. 

According to the SEC:

The Securities and Exchange Commission today adopted rules to enhance and standardize climate-related disclosures by public companies and in public offerings. The final rules reflect the Commission’s efforts to respond to investors’ demand for more consistent, comparable, and reliable information about the financial effects of climate-related risks on a registrant’s operations and how it manages those risks while balancing concerns about mitigating the associated costs of the rules.

These rules will bring a measure of clarity, specificity and comparability to the data that companies report. This data will become part of a firm’s annual reports, SEC filings and other documents. In effect, this non-financial data will get the same degree of assurance, controls and attention/oversight that financial data currently receives. 

According to the SEC, the new rules will require companies to report:

  • “Climate-related risks that have had or are reasonably likely to have a material impact on the registrant’s business strategy, results of operations, or financial condition;
  • The actual and potential material impacts of any identified climate-related risks on the registrant’s strategy, business model, and outlook;
  • If, as part of its strategy, a registrant has undertaken activities to mitigate or adapt to a material climate-related risk, a quantitative and qualitative description of material expenditures incurred and material impacts on financial estimates and assumptions that directly result from such mitigation or adaptation activities;
  • Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the registrant’s material climate-related risks;
  • Any processes the registrant has for identifying, assessing, and managing material climate-related risks and, if the registrant is managing those risks, whether and how any such processes are integrated into the registrant’s overall risk management system or processes;
  • Information about a registrant’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal or actions taken to make progress toward meeting such target or goal;
  • The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;
  • The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (RECs) if used as a material component of a registrant’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements; and
  • If the estimates and assumptions a registrant uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements.”

What this means may be better understood from some examples:

  • If your firm has operations near a coastline and rising global temperatures may trigger flooding in low-lying areas, then this climate change could have a material impact on operations, the useful life of these facilities, insurance costs, potential de-commissioning expenses, etc. Those potential or projected costs and risks will need to be reported to shareholders as these could impact the current or future value of your firm’s shares.
  • If your firm’s products (or their packaging, transportation, heating/cooling, etc.) require the consumption of copious amounts of hydrocarbons (e.g., natural gas) while competitor’s products in the market have shifted production methods and/or product designs (e.g., the move from gasoline-powered to battery powered lawn equipment) could materially impact your firm’s future sales and earnings. Again, this is something investors would want to know and understand. 
  • If the engineering behind your products may create a major environmental issue (e.g., your firm’s AI data centers are consuming massive amounts of electricity to power and cool servers), then investors have a need to know.
  • Investors want to know which firms are more/less exposed to climate change. That knowledge would help decide where to invest their money and what the long-term financial outlook for each firm is.  They are also concerned that some firms may face litigation or fees because these companies are polluting, contributing to climate warming, etc.

What these requirements do/do not cover

Throughout the key requirements documents, it’s clear that the key focus is on greenhouse gas emissions. Companies will need to track their consumption, recovery and remediation efforts involved in the use of carbon-based items. This would include energy consumption, transportation, de-carbonization, carbon entombing, and other activities. 

Firms can also report on carbon offsets, too. 

ESG has three components: Environment, Social and Governance.

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The Environment component addresses your firm’s interaction with the world’s environment. It’s the key focus of these regulations. The Social component addresses how your firm interacts with its workforce, the communities it operates within, the subcontractors and others within your extended value/supply chain. And, the Governance component deals with the mechanisms that ensure the right things get tracked, discussed, protected, etc.  A number of the proposed SEC requirements also fall into the Governance area. 

The Social aspects of ESG didn’t seem to get much coverage in these regulations but other reporting requirements address these items. So, businesses won’t necessarily get a pass on these. And, despite the headlines some people (particularly politicians) are making about DEI this week, these new regulations are mostly about greenhouse gas emissions and their impact on global warming. 

There are a number of different standards globally but many are coalescing around a couple of key sets of requirements. One commonality is the concept of Scope 1, 2 and 3 requirements. Scope 1 reporting 

requirements are focused on a firm’s direct emissions. This includes things like the water consumed, dust created, scrap generated, etc. as part of a firm’s production or service activities. Scope 2 emissions are also tied to a firm’s direct production or service activities but are provided by a third-party on behalf of your firm. The best example of this is the electricity your firm consumes to power its plant and equipment. Firms must report these emissions, too. 

The following graphic shows these reporting requirements. Your firm’s Scope 1 data is mostly a reflection of the carbon consumption/emissions/remediation activities your firm DIRECTLY triggers. These are in the pink area and some in the bottom blue band. One exception to this is that Energy consumption is usually a Scope 2 activity unless your firm has its own generation or co-generation capabilities. Scope 3 data is found in the left and right portions of the graphic. These are emissions or other environmental impacts that other people/businesses generate as a result of your firm, its products or services.  

bs2

Scope 3 is NOT part of these new SEC requirements. This may cause some relief for firms with long, complex supply chains. Scope 3 requirements are quite difficult to fulfill as the needed data spans the entirety of a firm’s supply and value chains. In addition to emissions data, companies need Scope 3 information like:

  • Do any suppliers (even those n-tiers deep in the supply chain) use forced labor?
  • Are all suppliers paying livable wages to their employees?
  • Are some suppliers using contractors, freelancers, etc. and are they paid fairly and working in safe environments?
  • Etc.

Multi-national and other firms may still be on the hook to capture and report Scope 3 data as SEC requirements mostly impact U.S. headquartered firms. Smaller firms and suppliers to many non-US (and other) firms may get requests to provide this or similar data, too. Bottom line: just because the SEC isn’t mandating Scope 3 data now, your firm may need to supply it to other companies to satisfy the emissions and ESG requirements from their regulators. 

Data Challenges

ESG data is frequently described as non-financial data – a term that is somewhat of a misnomer. Yes, many data elements will be statistical in nature (e.g., million tons of CO2 released) but financial measures will also be important if companies are to make solid business decisions. For example, one client historically bought fresh water from a local utility as its price was less than the cost to reclaim its wastewater. Now that the cost of disposing of this wastewater has grown, the company is evaluating the use of more reclamation technology at its other plants. Accurate consumption data, costs and forecasts are needed to make informed business decisions. 

A client project was especially noteworthy in pointing out scores of data issues. Space limitations prevent me from providing a full and detailed listing but here are some of the key items:

  • Much of the data that could be collected today is averaged, aggregated and a year or more old. It might meet some regulatory reporting needs but it is useless in making great business decisions.
  • To get better data that is more granular and timelier, the company will need more meters, scanners, etc. to capture energy, water, raw material and byproduct information at every step in the conversion process.

Implementation challenges

These new requirements will trigger a number of challenges. 

  • Accountants, consultants, software firms and others will need time to understand the impact of these requirements on accounting systems, controls, reporting tools, operations, training and many more disciplines.
  • Questions, ambiguities, etc. will likely occur. Time will be needed to sort these issues out.
  • Corporate accounting staffs are already overworked and understaffed. Adding this to their workload won’t help talent woes in the accounting profession.
  • The accounting profession, while knowing ESG mandates were coming (they are already significant in Europe), will likely face hurdles scaling up capabilities to meet new demand.
  • All firms should expect shortages in skilled greenhouse gas, ESG, etc. personnel. Some consultancies intend to hire 100,000 or more people to meet demand. Where these people will come from is still a mystery. This could create a corollary problem where there may be a number people entering the space with thin, poor or unproven skills.
  • Traditional accounting and other business application software (e.g., ERP) was not designed for an ESG or climate accounting world. Bolt-on tools may have to suffice for the time being but more software innovation is needed now.
  • Public accounting firms will see this a big fee-generating opportunity and will move quickly to train staff, hire new people and line up work before other competitors can gain market share. Comparisons to the Sarbanes-Oxley Act (aka Sarbox or SOX) are already popping up. 
  • Data going into these reports is often annualized, highly aggregated and not of much use for managerial, operational or planning purposes. Firms might benefit if the information were more detailed and real-time.

Will it be a big deal?

For some firms, the answer will be ‘no’.  

In interviewing executives for the book The Executives ESG Playbook, a surprising number of companies discussed all kinds of changes they are quietly and materially making to reduce their carbon footprint. Some firms reported:

  • Significant reductions in the heating/cooling of buildings
  • Material redesigns of core products to make them massively more fuel efficient and emit fewer greenhouse gases
  • Reworking their supply chains to trigger more local production and fulfillment
  • Relocating data centers to take advantage of geothermal, hydroelectric and solar power 

In fact, many firms have been actively working on large initiatives for a decade or more. You don’t hear much about this as many of these changes are still in process or will become a competitive advantage. Regardless, these changes are material and these firms have been aggressively focused on reducing their carbon footprint as well as the footprint that their products create for years. For these firms, these new requirements are just a reporting issue. 

A different way to look at this is to ponder: why would any competent executive, today, be surprised that their firm will need to report this information? Companies have been preparing CSR (Corporate Social Responsibility), sustainability and other optional reports for years. Many have been complying with different European environmental or ESG reports for years. And, in the US, some states have been pressing ESG reporting on companies based in those states. 

This will be a growing problem for some companies though. SMB firms often have less sophisticated systems than their larger enterprise counterparts. If large firms are facing tough IT challenges getting needed data, integrating systems, etc., then smaller firms will likely face bigger challenges and be in less of a financial position to deal with them. SMB firms may also lack the personnel to do this work. 

Likewise, companies or subsidiaries in the Asia-Pacific region may have to provide a number of data elements to the US parent companies or customers. ESG reporting compliance has been more pronounced in Europe with North America following. Asia-Pacific is drafting behind these two areas. 

My take

For any software vendor that was still on the fence about supporting ESG/Greenhouse gas reporting, the wait is over. You need capabilities now or your customers will “seek true love elsewhere”.  

There are currently over 40 fairly complete ESG technology vendors out there and readers should expect to see some of these get acquired by larger ERP, process automation and/or EPM (enterprise performance management) firms.

We should expect to see more blurring of the lines between consolidation, EPM, budgeting and ESG software. EPM tools have the controls, rollup structures, integrations, allocations and other functionality that ESG applications need. 

It’s also time to rethink the data model of ERP software. It’s clear that enterprise data requirements now go well beyond the four walls of a company (the traditional boundaries of an ERP product). Data needs to be captured, analyzed, reported, etc. across the entire value and supply chain no matter how many tiers deep the supply chain or how many customers a firm has. ERP needs new places to store this information and leadership is definitely needed here. 

The ’Social’ component of ESG is not to be ignored. Now that environmental and governance components have been mandated in the USA, the social components will get the next wave of attention. 

Yep, the ESG landscape fundamentally changed last week…

Image credit - Pixabay/ Graphics from The Executives ESG Playbook and used with permission of the author.

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