Anticipating A Greenhouse Gas Compliance Strategy

Sunday, April 1, 2007 - 01:00

Some observers dispute whether global warming is actually caused by human activity, or is simply a result of natural climate cycles, but a political consensus is emerging that immediate regulation of greenhouse gases (GHGs), even if ultimately proven to be unnecessary, is preferable to ignoring an uncertain risk with potentially catastrophic results. Leaders in Congress, governors in many states, as well as some industry CEOs,1 now consider some form of GHG regulation to be prudent and inevitable. At last count, there are five different bills pending in Congress and several initiatives advanced by coalitions of states in the Northeast and on the West Coast, each proposing their own, potentially different, approach to GHGs and threatening a disjointed patchwork of regulation.

Most proposals thus far include some variation of a "cap-and-trade" approach,2 which could raise a variety of novel questions, including the following:


Which GHGs will be regulated? At what levels will ambient "baselines" and "caps" be set? What are the relevant geographic areas for determining compliance with caps?


Will the tradable commodity created by legislation be an "allowance" or "offset" under the Clean Air Act, or a more generic form of "carbon credit"?


How are tradable assets to be documented and what jurisdictions (state, federal and international) will recognize such assets ( e.g., "global" recognition under Kyoto vs. regional or local recognition under state/federal law)?

The foregoing questions highlight uncertainties in potential GHG regulation. In light of contingent liabilities that may arise out of new legal requirements, and in order for firms to transition proactively while these and other issues are sorted out, corporate managers should implement a GHG compliance program that targets the following objectives:


Identify and report GHG emissions and associated material risks in compliance with applicable securities laws and best practices;


Mitigate GHG levels by, for example, improving energy efficiency, using alternative fuels and renewable energy, investing in carbon capture and sequestration technology, and considering climate risks in project finance and corporate transactions;


Shape public policy by: (1) advocating federal legislation that harmonizes potentially inconsistent federal, state and regional approaches and rewards proactive management of GHG emissions; (2) advocating discussions under the U.N. Framework Convention to harmonize U.S. and international carbon trading systems and ensure participation by developing economies such as China and India; and (3) monitoring other state and federal proposals.

Key aspects of these objectives are discussed below.

Securities Law Disclosure Issues

Effective reporting and management of GHG risks is responsive to legal obligations and increases shareholder value. U.S. businesses are confronting at least two categories of GHG risks: first, the risk that their operations will generate GHG emissions that constitute contingent liabilities; second, the risk that their assets and personnel may be adversely affected by climate change events triggered, in whole or in part, by increased GHG emissions. Each of these risks has ramifications for "issuers" under the U.S. securities laws.

In general terms, U.S. securities laws require that an issuer periodically disclose "material" information regarding its financial condition in accordance with generally accepted accounting principles (GAAP). The U.S. Securities and Exchange Commission's (SEC's) Regulation S-K specifies several of such disclosure requirements: Item 101 of Regulation S-K requires disclosure of the material effects, including contingent effects, that compliance with federal, state and local environmental laws may have on an issuer's capital expenditures, earnings and competitive position.3 Item 103 requires disclosure of pending or contemplated material legal proceedings involving the issuer.4 Item 303 requires that the Management Discussion and Analysis (MD&A) sections of federal securities filings provide a narrative discussion of any changes in financial condition of the issuer.5 Item 303 also requires disclosure in the MD&A of known trends, events or uncertainties that will or are reasonably likely to have a material effect on the issuer's liquidity, capital, sales, revenues or income. Thus, the MD&A may require disclosure of matters that are not yet "ripe" for Item 103 or GAAP financial disclosure.

Recent state and regional initiatives, such as California's comprehensive climate legislation,6 the Western Regional Climate Action Initiative7 and the Northeastern Regional Greenhouse Gas Initiative,8 make it essential that public companies consider their disclosure obligations in the context of potential GHG liabilities. GHG-specific disclosure initiatives are also evolving among institutional investors, environmental groups, corporate governance advocates and other corporate stakeholders (including state pension funds and other institutional investors), all of whom are forcefully advocating greater disclosure of potential GHG risks. In October 2006, a consortium of investor groups released a "Global Framework for Climate Change Disclosure," which (among other things) encourages companies to disclose and analyze (1) historic and current GHG emissions, (2) climate risk and emissions management initiatives, (3) potential physical risks from climate change, and (4) risks related to GHG regulation. These events, together with pending state and federal legislation, are exerting ever greater pressure on issuers to identify and report GHG-related risks and highlight the need for integrated management of GHG risks.

Mitigation/Remediation Of GHGs

GHG mitigation strategies fall into two general categories. The first includes technologies and processes that capture or reduce GHG emissions. The second includes renewable resources that generate energy without GHG emissions. Both categories of mitigation confront the same challenge: how to ensure that mitigation results in verifiable documentation that can be used to demonstrate compliance with applicable laws (which in the case of GHGs, have yet to be enacted) and generate value in the form of "carbon credits" or similar certification of mitigation efforts.

Remediation generally focuses on reducing the amount of GHGs currently present in the atmosphere. "Carbon sinks" are perhaps the most common form of GHG remediation. Large scale re-forestation projects have the potential to process and eliminate large quantities of carbon dioxide that presently exist in the atmosphere. Likewise, carbon sequestration projects ( e.g., through underground injection of carbon dioxide) reduce levels of ambient carbon dioxide by physically removing carbon dioxide from ambient air.9 GHG reduction efforts to date have focused on the use of alternative fuels and renewable energy sources; technologies for carbon capture and sequestration are still emerging.

An important element of any mitigation or remediation strategy includes an assessment of current GHG emissions. In this regard, companies should consider the following steps:


Audit company operations ( e.g., product manufacturing and distribution logistics) that may produce GHGs and determine the extent to which company assets and operations are exposed to climate change risks;


Establish company-wide targets for reducing GHG emissions;


Prioritize technologies, processes and projects to remediate existing GHGs or mitigate future GHG emissions; and


Consider existing GHG risk, remediation and mitigation strategies in complying with applicable reporting requirements

U.S. law does not currently provide for the creation of tradable emission "credits" for GHG reduction. However, under the 1992 Energy Policy Act, the Department of Energy established a registry to document GHG reductions achieved through voluntary programs, such as DOE's Climate Vision and EPA's Climate Leaders programs. The registry also tracks progress toward the goal of reducing GHG intensity by 18 percent by 2012.

Legislation/Policy Issues

As the move toward GHG legislation accelerates, companies will be under increased pressure to coordinate their strategies with evolving legal requirements. In this regard, three types of legislative trends should be monitored: (1) trends that create legal benefits and/or risks, (2) trends that affect the value of tradable assets from mitigation and remediation efforts, and (3) trends that integrate or rationalize initiatives across state, regional or national boundaries.

If GHG legislation tracks the "cap-and-trade" model, timely monitoring and analysis of proposed legislation will be necessary to ensure that management strategies are responsive to the proposed cap-and-trade approach. If an alternative to "cap-and-trade" ( e.g., carbon taxes) is selected, analysis should focus on whether the approach chosen by Congress allows firms to tailor GHG initiatives to achieve maximum "credit" for their early action.

Likewise, federal legislation should address the challenge of standardizing and integrating disparate regulatory approaches in order to facilitate trading in GHG credits across state, regional, and even national boundaries. Finally, the overall approach to "carbon credits" should be addressed with a view towards harmonizing the emission reduction attributes of "allowances" and "offsets" with the technology and clean-fuel innovations pioneered by the "renewable" and "clean-tech" movements, and maximizing the value of both.

Conclusion

Perhaps more than any other environmental problem, the climate change effects attributed to GHGs transcend local, regional and national boundaries. However, unlike other globalization trends, regulation of GHGs affects a by-product (GHG emissions) previously assumed to have a zero cost to society. With the advent of global climate change, there is little doubt that the zero cost assumption is under increased scrutiny. In this context, managers that ignore the global aspects of GHG regulation do so at their own peril.

Companies with significant GHG emissions and those involved in financing GHG-intensive projects or corporate transactions must manage their risks and identify opportunities in a rapidly evolving environment in which major legal and policy developments are quickly unfolding in Congress, courtrooms and statehouses across the country. With more states regulating GHG emissions, and the prospects of national GHG regulation seemingly inevitable, corporate managers should consider a strategic response that mitigates GHG risks and optimizes shareholder value. Such a response should include, at a minimum, GHG monitoring in support of company reporting obligations under applicable law. More broadly, company management should consider alternatives for making GHG compliance an asset creation as well as a risk mitigation function, and should carefully monitor rapidly unfolding developments in GHG regulation and mitigation for risks and opportunities that transcend state, regional and national boundaries.

1 The U.S. Climate Action Partnership, a coalition of ten leading companies, including DuPont, GE, Alcoa and Duke Energy, together with an array of environmental organizations, issued a report, "A Call for Action," in January 2007, calling for federal legislation establishing a cap-and-trade program and other policies that harmonize federal, state and regional programs, give credit for early action, invest in technology research and development, and discourage investment in high-emitting power projects.

2 Proposed cap-and-trade programs generally include capping GHG emissions at current levels, requiring stepped reductions over time, and allowing GHG emitters to create tradable "credits" reflecting a quantifiable, verifiable reduction that may be traded like other commodities and used by other GHG emitters to satisfy an obligation to reduce their own GHG emissions.

3 17 C.F.R. 229.101.

4 17 C.F.R. 229.103.

5 17 C.F.R. 229.303.

6 In September 2006, the California Legislature passed the Global Warming Solutions Act of 2006, requiring the California Air Resources Board (CARB) to develop strategies, including a cap-and-trade program, to reduce California's GHG emissions by 25 percent by 2020.

7 In February 2007, the Governors of five western states (California, Washington, Oregon, Arizona and New Mexico), announced the formation of the Western Regional Climate Action Initiative to reduce GHG emissions, pledging to "devise a market-based program, such as a load-based cap-and-trade program, to achieve targeted emission reductions."

8 Originally announced in September 2003, the Regional Greenhouse Gas Initiative (RGGI) is an effort by the Governors of 9 Northeastern and Mid-Atlantic states to develop a regional "cap-and-trade" program with a market-based emissions trading system. The founding states are Delaware, Connecticut, Maine, New Hampshire, New Jersey, New York, and Vermont; Massachusetts and Rhode Island signed on in February 2007. The proposed program will require electric power generators in participating states to reduce carbon dioxide emissions.

9 Some remediation strategies (e.g., reforestation) are recognized as "certified emission reductions" under the Kyoto Treaty, but the Kyoto status of other remediation methods is less clear.

Roger D. Stark and John F. Spinello, Jr. are key partners in K&L Gates' Climate Change Task Force. Mr. Stark, resident in the Washington, DC office, can be reached at (202) 778-9435. Mr. Spinello, resident in the Newark, NJ office, can be reached at (973) 848-4061.

Please email the authors at roger.stark@klgates.com or john.spinello@klgates.com with questions about this article.