For this third article in our series about the proposed rule from the US Securities and Exchange Commission, experts answer: What are the main concerns about corporate climate pledges and carbon offsets? How does this disclosure address the concerns?
Special Series: The SEC Climate Disclosure Rule
In light of a recently proposed climate disclosure rule from the US Securities and Exchange Commission (SEC), we ask experts to weigh in on what the rule entails and its implications. Browse the blog series by clicking through these articles:
- Introduction to the Series: Why Do Investors Need or Want the SEC Climate Disclosure Rule?
- Indirect Emissions Disclosures Are Important but Tricky
- Even with Moves toward Transparency, Corporate Climate Pledges and Carbon Offsets Will Be Complicated
- Will the SEC’s Proposed Climate Disclosure Rule Come Up against Legal and Economic Challenges?
- International Context of the Proposed Climate Disclosure Rule from the US Securities and Exchange Commission
Nearly 700 of the world’s 2,000 largest publicly traded firms have committed to some type of voluntary net-zero goal or emissions pledge by midcentury. However, the details about how these goals and pledges will be achieved vary widely across firms, and firms currently are not required to divulge their progress toward meeting these goals over time. The proposed rule from the US Securities and Exchange Commission requires companies with these voluntary commitments to be more explicit about their goals and to regularly report how progress is being made. In particular, the rule requires firms with pledges to report the use of offsets in achieving emissions reductions outside of their own greenhouse gas footprints by requiring the disclosure of the source of the offset, the underlying offset projects, any registries or authentication of the offsets, and the cost of the offsets.
So, what are some of the main concerns about corporate climate pledges and carbon offsets? How does this disclosure address—or not address—the concerns?
Joseph E. Aldy, Harvard Kennedy School and Resources for the Future
Thousands of publicly traded companies have recently adopted net-zero greenhouse gas (GHG) emissions goals. The “net” in “net-zero” indicates that these firms expect to attain their goal, in part, through the use of emissions offsets that can reduce emissions, or remove emissions from the atmosphere, to make up for the difficult-to-eliminate, residual emissions within their corporate footprint. These companies, as well as other companies with their own diverse types of emissions goals, have spurred a growing demand for offsets in the voluntary carbon market, which some forecasters estimate could grow to $50 billion per year (or more) by 2030.
The March proposal from the US Securities and Exchange Commission (SEC) tees up the importance of disclosing information about offsets. Mandating standardized disclosure of offsets could improve transparency in voluntary carbon markets, enable improved carbon offset price discovery, promote more cost-effective attainment of corporate emissions goals, and inform investors about corporate progress on these goals. The current offsets market, however, is characterized by substantial heterogeneity in offset prices in terms of the type of project; region; buying sector; verification standard; and, quite likely, by environmental integrity.
As an alternative, the SEC climate disclosure rule could promote enhanced environmental integrity and more efficient offset markets by indicating that corporations covered by these requirements also should disclose how they have insured the environmental integrity of the offsets.
Joseph E. Aldy, Harvard Kennedy School and Resources for the Future
By definition, the environmental integrity of an offsets project is challenging to demonstrate because an estimated ton of carbon offset requires a comparison of the project activity to an unobserved, counterfactual scenario. Should a wind power project’s offsets reflect the avoidance of emissions from a coal-fired power plant, a gas-fired power plant, or another wind farm that otherwise would have been built? With growing interest in so-called “nature-based solutions,” such as preventing deforestation and promoting reforestation, concerns have been raised about the permanence of the sequestered carbon. If a landowner plans to preserve a forest with the aim of capturing carbon from the air, should the strategy generate offsets if the forest burns at a later date and releases its stored carbon, through no fault of the landowner? And high-quality projects may result in emissions leakage, such that a given project may influence behavior through markets that otherwise increases emissions. For example, if a solar power facility reduces the demand for coal—and thus, existing coal plants operate for a longer period—should this emissions leakage reduce the offsets for the solar facility?
Evaluations of past offset programs (e.g., hydrofluorocarbon offset projects in China and wind farms in India) illustrate how a credited ton of offsets may fall short environmentally. In the context of the permanence of biologically stored carbon, the SEC proposal suggests a buyer liability standard as a way to address concerns about environmental integrity. Buyer liability, however, could impose significant monitoring requirements and, as evident in other pollution markets, it could undermine market liquidity and price discovery. Moreover, the experience with forest-based offsets under the California cap-and-trade program suggests that a buyer-liability standard may not be sufficient to assure environmental integrity. The California buyer-liability scheme invalidated only 0.3 percent of forest offsets, but the program appeared to over-credit forestry projects by 29 percent.
As an alternative, the SEC climate disclosure rule could promote enhanced environmental integrity and more efficient offset markets by indicating that corporations covered by these requirements also should disclose how they have insured the environmental integrity of the offsets. Insurance instruments already are emerging for some types of offsets, and such insurance could deliver the integrity that advocates of buyer liability aspire to without undermining the market potential for offsets.
Margaret Peloso, Vinson & Elkins
In short, the required reporting about progress toward climate targets, including the use of offsets, is the SEC’s anti-greenwashing provision. Many public companies in the United States have made net-zero commitments to signal their seriousness about climate change. However, net-zero pledges vary widely in the scope and quality of their commitments, raising the possibility that these corporate pledges can be misleading to investors.
The efficacy of these provisions will depend on the information that companies actually disclose in response to the SEC’s requirements.
Margaret Peloso, Vinson & Elkins
Based on my experience in helping clients, three significant factors should be considered when evaluating a corporate net-zero pledge: (1) what emissions does the pledge actually cover, (2) how does the company plan to meet its commitment, and (3) what role will offsets play in achieving the net-zero goal?
To date, the most important gap in corporate net-zero strategies is the disclosure of how companies will get to net zero. Some companies have made net-zero commitments without doing the homework to understand what strategic investments will be necessary to decarbonize their business. In addition, even the companies that do have a sense of what’s needed may be relying on disruptive innovations or the rapid scaling of climate technologies beyond their control to reach their decarbonization goals. These factors can create significant uncertainties in the extent to which public companies will need to rely on carbon offsets to meet their announced net-zero goals.
The proposed rule attempts to address these information gaps by requiring public companies to disclose their targets, how the company intends to meet the targets, and data to demonstrate whether the company is making progress toward its targets. In addition, these disclosures will need to be updated every year to help investors understand if the company is taking the necessary steps to meet its goals.
In describing these requirements, the SEC has noted, “The fact that a company has set a goal or target does not mean that it has a specific plan for how it will achieve those goals. What is important is that investors be informed of a registrant’s plans and progress wherever it is in the process of developing and implementing its plan.” However, given increased investor attention to climate change risks, companies will be under significant pressure to flesh out any climate-related targets they have made with concrete implementation plans in advance of filing any required disclosures with the SEC.
In fact, climate-focused investors have been expressing skepticism about the use of offsets in meeting GHG goals. Many investors push companies to focus on allocating capital toward actual emissions reductions within their operations and turn to offsets only for those emissions that are unavoidable. This sentiment is reflected clearly in the Science Based Target initiative’s framework for certified net-zero pledges.
The quality of offsets also matters. Some companies and investors increasingly are focused on making sure that any offsets used in meeting climate targets represent actual reductions in atmospheric GHG concentrations (called “removal offsets”) rather than simply avoiding additional new GHG emissions. This move to discriminate among types of carbon offsets is driven largely by the sentiment that, if we are ever going to get to the “zero” in net zero, companies need to be seeking out carbon removals that balance out any emissions they cannot avoid.
The SEC has attempted to address these concerns about offsets through its requirements for disclosures, but, as with many elements of the proposed rule, the efficacy of these provisions will depend on the information that companies actually disclose in response to the SEC’s requirements. While the SEC has taken potentially significant steps to provide investors with some visibility as to where the “zero” in net zero is coming from, it remains to be seen what information these requirements will produce in practice.
Alex Rau, Environmental Commodity Partners
The SEC’s proposed climate disclosure rule has some intriguing implications for carbon markets, corporate “net-zero” targets, and other GHG reduction strategies. Compensating for corporate GHG emissions through the purchase of carbon offsets or renewable energy certificates does not alter a company’s exposure to physical climate risks nor ensure reduced future regulatory costs; thus, the proposed disclosure rule is right to require transparency in the use of offsets for corporate climate response strategies. Corporate GHG emissions must be reported—both gross emissions and net emissions that account for any intended use of offsets or renewable energy certificates—to provide an accurate picture of risk exposure.
However, the remaining disclosure rules around the use of offsets are as yet superficial, covering barely a handful of pages in the 500-page proposal draft. Some sensible requirements are included in the draft and will help markets start to evaluate the integrity of corporate carbon offset strategies—for example, the proposed disclosure of the volume of offsets; type of source projects; and authentication standards such as offset methodologies, verification standards, and crediting registries. But these provisions arguably are the bare minimum steps needed for markets to characterize the various offset strategies.
Determining quality standards for carbon offsets clearly is beyond the scope of the SEC’s technical capacity or mandate. But the draft of the rule does provide some limited guidance.
Alex Rau, Environmental Commodity Partners
The SEC rightly does not attempt to arbitrate the quality of offsets nor establish limits on the amount of offsets used. Both points are better served (at least at this stage) through transparent disclosures, rather than through protracted ideological debate and complex review of technical considerations, as witnessed in other venues recently. For example, consider the current questions about offset projects in agriculture and biocarbon, which revolve around the precision and permanence of emissions measurement, reporting, and verification. Despite popular narratives about the voluntary carbon market, certain aspects about defining such criteria for carbon offset eligibility will never achieve consensus within the market alone. But a need persists for greater regulatory guidance on quality standards for offsets, so companies and investors alike can benchmark the wide diversity of GHG mitigation and sequestration methods. The regulators who ultimately will be responsible for GHG accounting standards in their respective jurisdictions, and for aggregating emissions inventories for international commitments, eventually will need to establish and adopt quality standards for the supply side of the offset market for carbon reduction and removal.
Determining quality standards for carbon offsets clearly is beyond the scope of the SEC’s technical capacity or mandate. But the draft of the rule does provide some limited guidance; for example, the SEC makes reference to definitions established by the US Environmental Protection Agency for renewable energy certificates that are purchased to match Scope 2 emissions. (Renewable energy certificates are inherently simpler to define than GHG offsets.) And other recent initiatives may help fill any regulatory gaps by providing more practical guidance for companies that want to source high-quality offsets which may retain “pre-compliance” value under future regulations. For example, the US Department of Agriculture aims to standardize carbon offset protocols with initiatives in the agricultural sector, while the International Civil Aviation Organization has outlined eligibility requirements for the carbon offset market in the global aviation sector, which it calls the Carbon Offsetting and Reduction Scheme for International Aviation.
But where the SEC disclosure requirements may have more interesting long-term impacts is on the demand side of the offset market and renewable energy certificate market. By integrating the use of offsets into climate risk–management strategies across hundreds of listed companies, the SEC requirements may help catalyze a material demand pull for offsets that largely has been absent in the United States, given the lack of federal carbon policies and only a very limited compliance offset market in California. Difficult questions around offset quality will be addressed over time only by iterating and converging on best practices—which itself can happen only after practical solutions are revealed through live transaction volumes and market activity at scale.
The nature of this demand for offsets will vary by sector and by the type of emissions that the firm is offsetting. For example, in the technology or media sectors, where Scope 2 emissions footprints dominate, firms may favor renewable energy sources and renewable energy certificates—and those same firms may be price insensitive when it comes to offsets for smaller Scope 3 emissions. But for sectors with large Scope 1 emissions that likely will be covered by future carbon regulations, the stakes are far higher, and questions arise with the safe harbor provisions of the SEC disclosure rule: Will the safe harbor provisions extend to include offset purchases and plans? If so, how? Will the lack of guidance on offset quality end up increasing the risks that are associated with lower-cost and lower-quality credits?
Conversely, and perhaps more interestingly, if a company reduces its Scope 1 emissions on its own accord, will the SEC disclosure statements and any safe harbor provisions serve as a precedent in determining baselines for future regulatory coverage? Could we see a scenario in which a company’s 10-K annual reports serve as a de facto log or registry of early corporate action in reducing emissions, and therefore avoid penalizing early actors?
These, and many more questions beyond the use of offsets, will be important to consider as the critical details of the SEC climate disclosure rule are fleshed out.
For more information, contact Marc Hafstead, the director of RFF’s Climate Finance and Financial Risk Initiative.
Browse the articles in this blog series about the SEC’s proposed climate disclosure rule.
