Accounting for Greenhouse Gases and Global Warming in Financial Disclosures

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In-Sites

November 30, 2009

A troika of decisions should send chills through the halls of many utilities and corporations. The first horse of the troika is the decision by the U.S. Supreme Court that says that the U.S. Environmental Protection Agency (EPA) has the authority to regulate greenhouses gases (GHG) under the Clean Air Act (CAA), 42 U.S.C. § 7401 et seq., and can be compelled to do so. The second horse is the decision by the Second Circuit granting states the power to abate GHG under the federal common law of public nuisance. The third horse is the decision by the Fifth Circuit that takes the final step and states that private citizens affected by global warming have the right to bring private nuisance suits.

In 2007, the U. S. Supreme Court ruled that carbon dioxide (CO2), a greenhouse gas, was a pollutant that could be regulated in new motor vehicles under the CAA since it either caused or contributed to “air pollution that could reasonably be anticipated to endanger pubic health or welfare.” See Massachusetts v. EPA, 549 U.S. 497, 522 (2007), quoting the CAA at 42 U.S.C. § 7521(a)(1). The Court also held that Massachusetts had standing to sue the EPA and challenge EPA’s decision not to regulate GHG. Id. at 532. Massachusetts had standing by reason of damage to its coastal waters caused by unregulated GHG that are warming the globe. EPA denied that the CAA authorized it to issue regulations and argued that even if it was authorized, it was not time to do it. Id. at 511. EPA also argued that Massachusetts did not have standing, but the Supreme Court disagreed. Id. at 517. Indeed, the Court found that the legislative branch by enacting the above-quoted section of the CAA implicitly gave Massachusetts standing to challenge EPA’s refusal to regulate GHG emissions. Id. at 520.

The second decision was that of the Second Circuit in Connecticut v. American Electric Power Co., Nos. 05-5104-cv/05-5119-cv, 2009 US App. Lexis 20873 (decided September 21, 2009). In that case, eight states, together with New York City and three non-profit land trusts, sued the five utilities that account for 10 percent of CO2 emissions and various electric companies, asserting that these utilities were contributors to the elevated levels of CO2 emissions and seeking abatement of their contributions to what they termed was a public nuisance. The Second Circuit found that the governmental entities’ Complaint did state a claim under the federal common law of nuisance. Moreover, both the state and non-state entities had standing to bring such claims. Id. at 132. The Second Circuit found that the EPA had not acted under the CAA to displace any federal common law right under the public nuisance doctrine, Id. at 202, and that the issue of GHG regulation was not a “political question” and could be addressed by the courts.

The third decision came from the Fifth Circuit in Ned Comer v. Murphy Oil USA (Docket No. 07-70756, decided October 16, 2009). The Fifth Circuit found that the plaintiffs had standing to sue defendants under a state private nuisance theory, because the defendants engaged in chemical and fossil fuel production in the U.S. Plaintiffs claimed these actions set in motion the sequence of events that brought Hurricane Katrina to the coast of Mississippi. In the same fashion that the Second Circuit found standing under the federal common law of public nuisance, the Fifth Circuit held that the private plaintiffs had standing to sue under the state common law of nuisance. Id. at 7-10.

In large measure, both the Second and Fifth Circuit Courts built on the decision by the Supreme Court in Massachusetts v. EPA, essentially finding that EPA, by not acting under the CAA, had not made a determination that GHG emissions are subject to regulation and in fact had not regulated them. American Electric, supra, at 202. Into this vacuum, the states and private individuals had the right to bring nuisance actions. Lawsuits imply damages or contingent liabilities, which complicates corporate balance sheets.

These three cases put enormous pressure on certain segments of industry that have been major emitters of CO2 in terms of accounting for liabilities. Essentially, private parties injured by GHG emissions and the effect of unchecked GHG now have standing to sue such emitters and obtain damages. The Ned Comer plaintiffs alleged over $5 million in damages. Id. at 2, footnote 1. Hurricane Katrina is estimated to have caused at least $125 billion in damages. http://www.swissre.com/Hurricane Katrina, January 25, 2007. Seventy-five thousand people were made homeless, and 400,000 jobs were lost. www.hurricanekatrinarelief.com. These individuals have a private cause of action under Ned Comer, according to the Fifth Circuit.

These three cases, along with other trends in GHG regulations, threaten a perfect storm on corporate balance sheets. On September 22, 2009, EPA promulgated the final rule for Mandatory Reporting of Greenhouse Gases. See 74 Fed. Reg. 56260 (October 30, 2009). Effective January 1, 2010, large emitters of GHG will be required to collect data and report their GHG emissions on an annual basis. EPA estimates that the reports will cover 85 percent of the emissions and 10,000 facilities. Obviously, in approximately one year, there will be hard data available as to GHG emissions. This data will have implications not only for suits like Ned Comer, but also for other reporting requirements.

GHG not only implicate the reporting of litigation contingencies, but also raise financial reporting obligations with respect to the generation of GHG. At some point in the near future, the federal government will enact a cap and trade law of some magnitude. The goal of such cap and trade regulations is to reduce GHG emissions. Kyoto Protocol’s proposed goals were to cap and trade CO2 with ever-declining annual amounts. These amounts could be auctioned. The northeastern consortium of states has a program called the Regional Greenhouse Gas Initiative that has already raised millions of dollars through auctions of the year’s allowable emissions, i.e., the cap. The owners can then trade them. Companies will have to retool to achieve greater energy efficiency or obtain alternative sources that do not emit CO2.

Andrew Cuomo, New York Attorney General, has filed suit under NY’s Blue Sky laws asserting that energy companies’ financial statements as to liabilities for climate risks were misleading to investors. Two of the companies have settled and will provide their analysis of the their financial risks from regulation, litigation, physical impacts of climate change, and emissions management. Based upon the foregoing, it is expected that 2009 SEC filings will evidence more climate risk disclosures by many more companies.

Therefore, there will be the need for capital expenditures. The Securities and Exchange Commission (SEC) Regulation S-K, 101 requires a company to disclose in its reports the effect of environmental compliance. The cost of compliance implicates capital expenditures such as equipment designed to limit the amount of GHG, as well as the cost to purchase emission allowances or credits. SEC Reg. S-K 303 also requires a company to disclose the impact of known trends on its financial condition. It remains to be seen if the SEC will issue a specific regulation related to climate change problems. However, both of the above regulations will be brought into play in a cap and trade environment. Companies simply will have to assess climate risks and the impact to business in terms of purchasing emission credits, of selling available emission credits, and of expending money for bricks and mortar costs to employ GHG reduction equipment. On the one hand, companies involved in suits like American Electric and Ned Comer will have to disclose under SEC Reg. S-K 101 and 103 any material effect the litigation may have on their businesses. The plaintiffs in American Electric seek to have the defendants abate their emissions. On the other hand, under current SEC regulations, the companies must evaluate any material effect that, if successful, abatement may have on their operations.

Companies subject to suits like Ned Comer have similar requirements under the SEC regulations and of course have to comply with Statement of Financial Accounting Standards No. 5 (Accounting for Contingencies) (FASB 5). FASB 5 already requires companies to assess and disclose any material effect created by the obligations to remediate contaminated sites under CERCLA or state-led cleanup actions as well as private party cost recovery actions. Explicit under FASB 5 is the necessity to reasonably estimate the amount of loss. In general, the financial disclosure requires an estimate of the range of possible loss or a statement that such an estimate cannot be made. In the realm of contamination, there are entities that can estimate remediation costs even to the point of assuming the obligation under a guaranteed maximum price. Since the goal of FASB 5 is to keep financial statements from being misleading, companies will have to assess their liabilities not only from GHG regulations but also for global warming litigation.

In sum, the troika of cases brings global warming litigation to the forefront, as the courts have stepped in where Congress has failed to tred and EPA has been constrained from acting. Global warming has been with us for some time. There are many theories about its cause; however, its effects are palpable. Justice Stevens said, “A reduction in domestic emissions would slow the pace of global emissions increases, no matter what happens elsewhere.” 549 U.S. supra at 525-526. The costs of slowing the amount and rate of emissions must be accounted for in financial statements in order to achieve the SEC’s goal of fiscal transparency.