Thomas P. Conaghan and Gregory K. Lawrence
McDermott Will & Emery LLP, Washington, DC
Whatever happens in Congress with climate change legislation that may (or may not) include a cap-and-trade system for carbon emission credits created by greenhouse gas (GHG) regulation, federal agencies are gearing up for implementation of GHG reduction efforts.
The American Clean Energy and Security Act of 2009 (ACES), which contained GHG reduction mechanisms, languishes in the US Senate after its narrow House of Representatives approval last June. But the Environmental Protection Agency (EPA), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and other agencies have all launched regulatory initiatives that involve the potential for GHG reduction efforts.
The SEC's initiative has special significance for publicly owned upstream and midstream oil and gas producers. On Feb. 12, the agency released interpretive guidance on existing public securities disclosure requirements relating to climate change, ostensibly to facilitate consistency in disclosure and to enhance clarity to investors.
The SEC's interpretative guidance highlighted examples where existing rules may require disclosure in a company's risk factors, business description, legal proceedings, and management discussion and analysis. This guidance made it clear that companies other than those in industries considered to be most at risk by GHG legislation and emerging regulations (for example, oil and gas and electric utilities, as well as heavy manufacturing) need to consider how they might be affected indirectly by potential legislation and regulation.
By implication, then, oil and gas producers should be especially sensitive to whether a GHG-related development can be material and should be disclosed.
Materiality
The standard for determining the materiality of information (including climate-related matters) under the federal securities rules is whether there exists a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision.
This standard does not take into account subjective sensitivities that certain investors have to issues such as climate change. Materiality of potential events depends at any given time upon a balancing of both the probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.
The guidance that the SEC released does not in itself create any new disclosure requirements. Instead, it merely reflects the agency's position that the federal securities laws require disclosure of information that is "material" to all investors and that current disclosure requirements already provide a basis for disclosures related to climate change, to the extent the requisite materiality standards are met.
The SEC also reiterated its view that disclosure controls and procedures should not be limited to disclosure specifically required. So far as securities filings are concerned, if management determines reasonable likelihood, disclosure is required unless management determines that the occurrence would not have a material impact on financial condition or operations.
Climate change considerations
The SEC's interpretative guidance highlights the following four areas as examples where climate change may trigger disclosure requirements in the most relevant sections of a company's Form 10-K annual report: assessment of risk factors, business description, legal proceedings, and management discussion and analysis.
- Impact of legislation and regulation.
- International accords.
- Indirect consequences of regulation or business trends.
- Physical impacts of climate change. With respect to existing federal, state and local laws which relate to greenhouse gas emissions, companies should disclose any material estimated capital expenditures for environmental control facilities as part of an assessment of whether any enacted climate change legislation or regulation is reasonably likely to have a material effect on the registrant's financial condition or results of operation. Of interest to energy producers is that specific items for consideration include costs passed on to customers from upstream suppliers that are affected by climate change regulation. Companies should consider, and disclose when material, the impact on their business of treaties or international accords relating to climate change, such as the Kyoto Protocol, the EU Emission Trading System (ETS), and other international activities in connection with climate change remediation. Legal, technological, political, and scientific developments regarding climate change may create new opportunities or risks for companies, either by creating demand for new products and services or reducing demand for existing ones. Companies should be prepared to assess and disclose the impact of both, whether it involves increased demand for "green" products and renewable energy output, or decreased demand for goods that produce significant GHGs. Climate change itself can have a material effect on a company's business and operations through impact on personnel, physical assets, supply chains and distribution chains. This can include the impact of changes in weather patterns (such as increases in storm intensity, rising sea levels, and temperature extremes), changes in the availability or cost of natural resources, or increased insurance risk from extreme weather. Companies whose businesses may be vulnerable to such events should consider whether they constitute material risks and require disclosure.
Energy company materiality
The essence of this assessment is that publicly traded oil and gas producers should be especially sensitive to whether a GHG-related development can be material and should be disclosed. There are already a number of developments that illustrate the difference between "might happen" and "will happen" as events for disclosure. Here are three examples.
- EPA regulation - The US EPA is already moving ahead with its own GHG regulatory program. On Dec. 7, 2009, the agency released its finding that current and projected concentrations of emissions combining six GHGs, including carbon dioxide, threaten public health and welfare. The EPA's action responded to the 2007 US Supreme Court decision Massachusetts v. EPA, which found that the EPA had the statutory authority to make such a finding. While the endangerment finding does not impose any emissions reduction requirements, it permits the EPA to finalize proposed GHG standards for light-duty vehicles that are expected to be finalized in March 2010. The finding also follows a recent trend of EPA activity aimed at curtailing GHG emissions. In late September 2009, the EPA published the Final Mandatory Reporting of Greenhouse Gases Rule, which requires certain facilities and industries — including energy producers — to begin collecting GHG emissions data on Jan. 1, 2010, and to begin annual GHG emission reporting by Mar. 31, 2011, for 2010. The EPA also has announced a proposed rule that requires operating permits for large stationary sources (such as coal-burning power plants and refineries) that produce 25,000 tons of GHGs or more per year. The endangerment decision may open the door to more EPA regulation of GHG emissions, whether or not Congress acts on climate change legislation.
Bottom Line: The data reporting program is "will happen," stricter GHG regulation is "may happen." Each company's management must decide the degree of materiality.
- Budget proposals - The Internal Revenue Code provides a number of credits and deductions that are targeted towards certain oil and gas activities. President Obama agreed at the 2010 G-20 Summit in Pittsburgh to phase out subsidies for fossil fuels. Thus, the administration has advocated for the repeal of a number of tax preferences available for fossil fuels in its 2011 Budget Proposal. That includes the elimination, beginning in 2011, of such tax preferences as the enhanced oil recovery credit, the credit for oil and gas produced from marginal wells, the expensing of intangible drilling costs, the deduction for injectant costs paid or incurred in a tertiary recovery method, and the exception to passive loss limitations provided to working interests in oil and natural gas properties. Also, two-year amortization of independent producers' geological and geophysical expenditures would be replaced by the seven-year period for integrated oil and gas producers.
Bottom Line: Tax law changes could be a material event for any company, and these are proposed specifically as part of a GHG reduction effort. Of course, at this point they are only proposals, subject to Congressional modification. But materiality is a consideration.
- Market trading - CFTC Chairman Gary Gensler has testified that his agency is fully capable of regulating trading in any carbon markets, based on its demonstrated capabilities to regulate such aspects of commodity and energy trading as standard setting and allocation, recordkeeping, oversight of trade execution, oversight of trade clearance, and protection against fraud and market manipulation. Gensler has cited the CFTC's experience in overseeing trading and clearing of futures contracts in support of allowing the CFTC to oversee carbon trading, adding that the agency has demonstrated its ability to protect market participants, ensure fair and orderly trading, minimize potential manipulation, and enforce exchange compliance. All of these capabilities are familiar to upstream and midstream energy companies. The energy markets have been transformed by financial innovation in the past decade, but the recent financial crisis created much support for increased market regulation of hydrocarbon commodities. Such regulation can be seen as beneficial or as inefficient, confusing or overly restrictive. Without question, the CFTC is fully prepared to be the regulator in any GHG-focused trading system.
Bottom Line: The CFTC's role as market regulator is a "may happen" circumstance at this time, but energy companies that are significantly impacted by the agency's existing market regulation and compliance activities may wish to point out the implications of such regulation if applied to carbon trading markets in which producers or marketers have a stake.
Conclusion
This discussion is intended to offer a hypothetical consideration of issues that energy companies could consider to be material under the new SEC guidelines. Materiality is and will remain the key, and materiality is a question of management judgment and legal prudence. On the latter point, some commentators have suggested that by releasing its guidance, the SEC is signaling that it intends to scrutinize compliance with existing disclosure rules. If so, the guidance it has provided will serve as the basis for SEC comments issued to companies questioning the adequacy of companies' climate-related disclosures in their SEC filings — especially if they are in "at risk" industries like oil and gas.
Upstream and midstream companies are thus well advised to consider carefully the impact of this regulation and update their disclosures accordingly to reduce the likelihood of receiving a comment from the SEC that the climate-related disclosures in their SEC filings are inadequate in light of existing disclosure rules.
About the authors
More Oil & Gas Financial Journal Current Issue Articles
More Oil & Gas Financial Journal Archives Issue Articles
View Oil and Gas Articles on PennEnergy.com
